Three Foundational Rules
When you believe that investing is a process, not an event, it means that there must be a starting point to the process. Just like building a house, you have to start with a firm foundation so that the rest of the structure will be stable. The same is true with investing. If your financial foundation is strong, everything else will be more stable and increase the chances you will meet your goals.
There are three financial rules that everyone should start with. Handling these three rules will create a firm financial foundation to build upon:
- Live below your means;
- Maintain a solid cash reserve; and
- Maximize your contributions to an employer retirement plan.
Live Below Your Means
While this sounds obvious and basic, it is hard for most of us to achieve in practice. Notice that the rule does not say "Live within your means" - it specifically calls for us to live below our means. We need to create the capacity to save and invest. Having a buffer each month creates that capacity and makes sure that we are not generating debt to sustain our lifestyle. If your lifestyle spending is too tight against your income, an unexpected expense will force debt without a way to pay it off. The ultimate goal of this rule is to live debt free. Think about that for a second; what would it mean if you had no mortgage payments, no car payments, no student loans, etc.?
Maintain a Solid Cash Reserve
The first financial goal that everyone should have is to build - and maintain - a solid cash reserve. Some people call this an emergency fund, but that isn't broad enough. Our spending pattern is not smooth and equal every month. Whether because of an unexpected event or simply the annual property tax bill, we all go through periods where our spending is higher than normal. In addition, we all experience what I call recurring, one-time events. It sounds like an oxymoron but there is always something we didn't specifically plan for, but it might be something different every year. The roof replacement, the car repair, the special vacation, the health issue, the job loss, etc. The core purpose of a cash reserve is to avoid debt when things don't line up perfectly. The size of the reserve is up to you and will depend on your situation and your tolerance for risk. If you have a stable job with few variables in your life, 3-4 months of spending set aside might be fine. For a sales professional working on commission with kids to support, 10-12 months of spending might be more appropriate. The key is to size the reserve to let you sleep well at night.
Maximize your Contributions to an Employer Retirement Plan
The first, best place for most of us to save is with our employer sponsored retirement plan. These plans (e.g., 401(k), 403(b), SEP-IRA, 457, etc.) offer features that cannot be duplicated anywhere else. First, they are often the only place we can save in a tax-deferred way. The contributions you make to your plan are made before taxes are calculated so you can lower your tax bill. In addition, many employers offer matching contributions as extra compensation and encouragement to save. These two benefits are like finding free money. Because employer plans are often relatively low cost and offer these (and other) unique benefits, it is often best to maximize your contributions here before you start investing elsewhere. The minimum you should contribute is enough to maximize any employer match; the maximum you can contribute is set by the IRS each year. Most importantly, if you start early and contribute regularly, you may find that your retirement planning is well under way.
Start by addressing these first Three Foundational Rules and you will have a firm foundation to build on. Once you have these under control, you can start to work on your longer-term goals and the 8 Wealth Management Issues.