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.
Very few people meet all three of these rules, especially if you are closer to the beginning of your career. These rules should be your first financial steps; making these your first goals to achieve will create a solid foundation and create capacity for bigger, longer-term goals in the future. For all of these goals, most people take incremental steps and slowly build up to these rules - the key is to make progress every year.
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.?
There are only two pieces to this equation: (1) How much money is coming in (take home pay); and (2) How much money is going out. It is far easier to adjust the spending side than the income side so accomplishing this goal requires keeping track of how you spend your money. You have to know where your money is going to be able to prioritize and make good spending decisions.
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.
This goal is inherently linked with the first. If you are spending every dime you make, it will be impossible to build a cash reserve. The key here is to start with something and build so you are making progress each day. Review all those monthly subscriptions you are paying, for example, and turn something off. Direct that to savings instead. When you get a raise at work, don't change your lifestyle and direct that new cash into the cash reserve or your retirement plan - Rule #3.
Maximize your Contributions to an Employer Retirement Plan
The first, best place for most of us to invest 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 current 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.
This goal is tough to achieve right out of the gate and entirely linked to the other two. As you start to make spending decisions, you will free up cash flow that can be used to either build a cash reserve or save. Bring your retirement plan savings up to any matching level first to take advantage of that free money, then push new savings to the cash reserve until it is "full" and then come back to the retirement plan. My tip here is to use your raises at work to increase. If you get a 4% raise, that is a great opportunity to increase your contribution rate by 2%. More goes into the plan AND you take more home (to push to the cash reserve if needed).
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, the 8 Wealth Management Issues and you will be ready to Invest With A Plan.