Americans are wealthier than any people in the history of the world. Yet many are stressed out about their finances. Are people living beyond their means even though their incomes are relatively high?
Are they maxing out credit cards and living paycheck to paycheck? Are they saving for unexpected expenses? Can you be financially secure even if you don’t make a lot of money?
Can ordinary folks invest in the stock market with manageable risk? The answers to these questions are the beginning of a checklist for what we call financial literacy. When you talk about the checklist of things that people need to understand to be considered financially literate, I think it delves into a number of categories.
It numbers into your basic everyday financial living, the basics of debt, and understanding just sort of what credit card debt means, what mortgage debt means, what a car payment means, budgeting, understanding money in, money out. It's stuff that really sometimes can seem very basic, but clearly is not. If you're not financially literate, then you have to worry about your spending.
You have to worry if when you retire, you can meet your goals. It all starts with income. Income means the money you have coming in.
How do you make your money? The Law of Comparative Advantage comes in handy when making career choices. Figure out what you do well and enjoy that others value highly.
I’ve worked very hard and built a successful business, and I don’t have to worry anymore in my life about, you know, your month to month bills and things like that. But that is true only because I did use to. I didn’t have parents to give me money.
I didn’t have anything to fall back on. There wasn’t a safety net. But what I did was rigorously plan and sort of set goals and then try to go about achieving them.
You don't have to own a business to think this way. Start thinking how you can make yourself more valuable to potential employers, coworkers, and customers. How can you do your current job better, even if it is a minimum wage job, internship, or volunteer position?
Are you working harder than others - first one there, last one to leave, not texting while on the job? These types of choices help differentiate you from others, and they create value for you in the job market. Remember, in the real world, you don't get paid for effort, but rather when you create value for others.
And managing that money is just as important as earning it. Expenses are money going out. How do you spend the money you've earned?
Do you even know where all your money goes? Many people don't. If I could only teach to young people today, just one financial literacy skill, a necessity that people understand, is to construct their own financial budget and how they execute upon that.
All I mean by this is to understand that there are fixed expenses. They have $3,000 that comes in, and they have $2,500 of expenses. They need that fixed expenses, the stuff they have to: your rent, your car payment, your whatever the case may be.
They need that number to be lower than what's coming in. I think the easiest way is the 50, 30, 20 rule, which is 50% of your monthly income goes towards bills and housing. 30% goes towards finances, which is paying off debt or saving, and the final 20 goes towards entertainment or going out, for things that you like to do.
So obviously, the fixed have to come first, and you chip those away, and those get done. And then applying percentages to the rest. I think there's very little of that that goes on.
Some of the things can go wrong when one doesn't do it, and this is, of course, very common, you end up living your life in a way that you're always playing catch up, and it becomes very debilitating when someone gets behind. They may have the benefit of the consumption. Then a new paycheck comes, a new bonus comes, and they don't get to enjoy the fruit of it because they're paying off the last toy that they purchased.
And so you live behind instead of forward. I think that has a profound impact on one's stress level, but also, just their incapacity for the enjoyment of life. If people just started with that, the layering of financial priorities in their month to month cash-flow planning, I think that would be the immense first step towards financial literacy.
Assets are stuff you own. Everything from your savings account, to a house, to a car. The road to building assets starts with saving.
The best reason I can offer for why even a high school student with a part-time job should start saving to some degree, just the habit, it's habit-forming. I believe that there is something to be said that for the merit of just getting in the practice of putting aside $5 a week, $10 a week, whatever the number may be. Save regularly for "unexpected" expenditures.
You know that your car will need a repair, your cell phone may get stolen, and you may fall ill. I like to set up a savings account so I don't see that money because if I see it, then I will spend it. So each paycheck, I take out a certain amount of money towards my bill for my car insurance at the end of the year, and it's automatically moved to the savings account.
So that your paycheck hits your account and then automatically you have your bank account set to send from your checking account to your savings account or just electronically off the top. You make your savings a fixed expense. It has to come straight out of your checking account.
You're paying yourself first. When that's in place, that opens up a lot of freedom to then go do other investment accounts. This approach will help you live a life with minimal financial stress and anxiety.
It'll help you avoid financial troubles and pitfalls. As you build some savings, make sure to diversify your investments. Remember, never put all your eggs in one basket - just don't.
Because if that one basket should fall. . .
well, you get the picture. When you purchase a stock on the exchange, you're buying into a small piece of that company. So you are getting an interest in that company, and you're becoming an owner of that company.
And it entitles you to the stream of profits of that company hopefully will make in the future. It has risk because the company may not make it. So the stock market is a way of funding business in America that carries with it an appropriate level of risk and reward.
The best way for somebody to invest in stock market with a small amount is by purchasing an index fund, or an ETF, or a mutual fund because they are getting broad exposure to many different companies instead of just buying one position. What’s all this talk of index funds and mutual funds? A mutual fund is a professionally managed investment portfolio that pools money from all sorts of investors, like you, who are looking to diversify their investments.
It’s the easiest way to ensure you aren’t putting all those eggs in one basket. Index funds or Exchange Traded Funds, ETFs, are similar, except they are managed to match the performance of a particular group of companies – say, a group of tech companies or a group of consumer goods companies. Instead of picking individual stocks, I want to own Apple, and I want to own Nike; they might just buy an index that includes a whole basket of these companies together.
There's all kinds of different indexes and, therefore, index funds out there. The most common might be the S&P 500 representing sort of 500 major publicly traded U. S.
Companies. With diversification, you can take comfort in knowing that when the value of one asset is down, others will likely be up. But they want to make sure that the purpose of the money they're putting in is longer term money.
The return of the stock market's been very good over time, but there's periods of time where it can be quite volatile. And so that's where one's financial literacy will hopefully lead to them understanding what instruments are good for short term goals, what instruments are good for intermediate goals, and then longer term. One powerful tool in your plan is compound interest.
Albert Einstein once stated, "The most powerful force in the universe is compound interest. " The best way to take advantage of it is to start saving when you're young and investing strategically after you have your real-world savings account ready. Over the course of 20-30 years of compounding, it’s adding hundreds of thousands of dollars.
I'm saying for regular middle-class families, the difference between starting to save at age 50 and starting to save at age 25 can be hundreds of thousands of dollars, and that's just simply from the benefit of time and allowing that money to work for them for a greater period of time. Even with all of the recessions and expansions of recent and distant past, diversified stock holdings have earned about a 7% real annual rate of return. Rate of return is extremely important.
An asset earning 3% annually will double in value in twenty-three years, but an asset earning 7% will double in value every ten years. Investing in the stock market offers opportunities for everyone! It makes such a difference when you can really exploit the time value of money when you put time on your side.
The leverage they get onto that contribution to themselves because of the time value of money is monumental. And there's calculators that people can play with to go see, and they never believe the results. Simple interest would just work like this: you have $100, you earn 5%, you now have $105, and then you're going to make another 5% on that $100.
Now you have $110 and the next year $115, the next year $120, so that 5% is simply being applied to your original $100. Compounding means that your $100 goes into $105 the first year, but then 5% gets applied to $105, and let's add numbers $111, and then it gets applied to that. So the numbers start to break apart from the original denominator of the money.
And so that's why compounding carries with it just a real special force, mathematically. I think that there is really no financial literacy when people don't understand time value of money. Liabilities are debts you owe.
The time value of money can also work against you. A lot of people get into financial trouble by constantly spending more than they earn. Credit is readily available today.
That's both good and bad. It's good because credit can enhance your ability to undertake attractive investments such as a college education or a home. I fundamentally believe that there's a key difference between buying something with credit that is an asset versus consuming something with credit.
Okay, when you go to the pizza place with your friends and use money you don't have, you don't still have the pizza, it is really gone. Whereas when you buy a home, you are borrowing money, but you are purchasing an asset that retains some degree of value and then assuming that the servicing of that debt, paying that person back with interest is affordable, it enables you to buy a very expensive asset before you have to save for the whole amount. By being able to make a really sacrificial endeavor to save the down payment and take on an amount of debt that the service of which might even be less than they're paying in rent anyways, or maybe equal to it, then they're building equity.
The other example has always been, we talked about student debt, where you're taking on debt, you're going to have to pay it off, but at least you're building an investment into a career into future to education. But borrowing can be bad: when you borrow to buy things that will soon be of little value, use student loans to go on spring break or max out credit cards only to pay the minimum amount due. When you recklessly spend more than you earn, your financial anxiety will build as your wealth declines, and you make large interest payments on items you've already consumed.
As a general rule, paying for your vacations and your surfboards, and your clothes shopping, and your nights out with your friends with credit, well, clearly, the asset is gone. You have zero of asset, but you still have the debt. So all you're doing is making yourself poorer by doing that.
The avoidance of credit card debt early on is probably one of the great blessings a young person can ever give themselves. It's very debilitating to have to unwind significant credit card debt when you're really trying to get ahead and move forward in your adult life. It's going to make you a lot less financially secure because you're going to have stress and have to worry about your interest rates going up from not being able to pay off those cards every month.
Someone could get to a point where they're literally spending over $1,000 a month, and they're not chipping away at the debt at all. And I think that that is what really ends up happening is, you get used to the idea, I have a fixed expense of just making a credit card payment. I just paid 700, 800 bucks a month for a credit card payment.
And that could be a very high percentage of one's income. It ultimately leads to that kind of exasperation of feeling like you're never getting ahead. You get a raise, but you don't get to save or invest any the money cause you're still getting behind, getting out from being behind.
The worst ramifications of excessive debt have always been emotional. They drain on people's joy. They add to their anxiety, but they take away hope.
They take away from that feeling that you can move forward. So, income is the money you earn. Maximize those earning opportunities.
Save to build up assets – things you own. Put together a financial plan, and limit your expenses and liabilities to things that increase assets or your ability to earn an income. Most people don't need an education to know how to buy more pizza or go out with their friends more, but it takes education, and it takes sacrifice, character traits, if one's going to really learn the practice of saving, goal setting, budgeting, things of that nature.
I think the biggest thing with people not knowing about the financial market or not knowing about a plan, or saving, a budget, any of the things that we discussed today is because they are afraid that they'll sound stupid or they don't know anything about it. So just don't talk about it at all. But I think that's the worst thing you could do.
The more you talk about things, the better you understand them, the more you know, the more you can share. Successful personal finance is about following sound principles and cultivating them as a way of life, a manner of living. You can enjoy financial security, even if your earnings are modest.
But it will involve both planning and commitment. Develop your plan today and resolve to maintain it throughout your life. Your future self will thank you.
