Here’s a real-life fact: You don’t need to be a financial expert to properly manage your money. And you don’t need to hire a personal financial advisor to take care of it on your behalf either.
If you don’t have a disproportionate amount of assets or tax complications, managing your money boils down to knowing the basic principles of personal finance, and then taking action.
However, most people play defense with their money. They know their current situation is not as good as it should be, but they simply accept it as it is. Even though tough times always come, most of your money problems are caused by one person. And that’s yourself.
It’s hard to acknowledge that. But it’s true. According to the Reality Check: Paycheck-To-Paycheck research series by LendingClub Corporation, almost 40% of Americans with annual income over $100,000 live paycheck-to-paycheck. And 12% of these struggle to pay their bills.
Now, take a look at the graph below. It shows the wage estimates for some engineering occupations based on the National Occupational Employment and Wage Estimates, by the United States Bureau of Labor Statistics.
And if you’re in the civil engineering arena in particular, the Salary and Workforce Research by ASCE provides an even more accurate wage estimate for you. According to its 2021 edition, the median annual wage was $63,000 for entry-level engineers and around $123,000 for licensed engineers.
Do you see the problem? The vast majority of your personal finance issues come from managing money — not only making money.
Yes, making more money is always beneficial. In fact, searching for ways to increase your income is a key element in personal finance (more on that later). But if you don’t learn how to manage the “little” amount of money you already make, you’ll only get yourself into even worse financial problems once you increase your income.
Therefore, you need to take control of your financial life now. And to help you with that, this guide will lay out everything you need to know about personal finance.
Once you’re finished, you’ll be able to afford all your basic living expenses, build significant wealth over the years, save for — and achieve — your life goals, and still spend money on the things you simply want to.
What Does It Mean to “Be Rich”?
Simply put, personal finance is the process of planning and managing your financial activities in life. These include generating income, spending, saving, and investing. And why is it important? Because it gives you the best shot at achieving your goals, whatever they may be.
Even though the planning process to achieve these goals can set them up for success, people’s goals themselves are not of much help. Most people say they simply want to “be rich”. But they never get crystal clear about what “being rich” really means to them.
Do you want to own a private jet or travel internationally every year with your family? The dollar amount you need for each is completely different. Instead of blindly chasing the higher dollar amount every single time, you need to be extremely specific about what “being rich” means to you.
That’s not to say you shouldn’t go after increasing your income; just the opposite. A bigger income, when managed properly, allows you to achieve your goals faster. But what are your goals? What’s your dollar amount to achieve these goals?
If you don’t get crystal clear about what you want to do with your money in your life, you’ll tend to copy what others are doing with theirs. So what are the things you value enough to spend your money on? And what are the things you don’t care about?
- Would you rather rent a three-bedroom house or a two-bedroom house that costs $1,000 less so that you can save that one grand to travel more often?
- Would you rather buy the newest model of that car with lots of premium features or an older, completely functioning model that costs $50,000 less so that you can invest that money and let it grow for 30 years to more than $380,000 (without additional contributions) to help you in retirement?
It’s human nature to want the best of everything. So making these trade-offs here and there can be tricky. But it all comes down to one thing: priorities.
Therefore, the first thing to do in personal finance planning is to write on paper all the goals you may want to achieve. If you don’t, you’ll think there are no trade-offs. And that’s why most people get into debt — or end up achieving none of their goals whatsoever.
Here are some prompts you can use to create your own list of goals, but feel free to go further:
- What are your personal goals?
- What are your professional goals?
- What do you want to do for your children?
- What do you want to do for your parents?
- When do you plan on retiring?
- How much money do you want to have when you retire?
You’ve probably written down lots of different goals. But again, you need to prioritize. It’s always easier to plan your future steps when you're crystal clear about what you want to achieve.
So now, separate your goals into short-term goals (up to 5 years), mid-term goals (5-10 years), and long-term goals (10+ years) by selecting 3-5 goals out of your list for each category. And remember the fewer, the better. Why? You’ll be more focused.
Once that’s done, you set a target date for you to achieve each goal. Working backward from this future date, you calculate the amount of money you’ll need to contribute each month (or year) toward that goal.
The image below illustrates what your list may look like once you’re done, as well as some of the goals you may want to consider for each category. If you feel one specific goal is of greater importance than others in the same category, you can contribute more toward that one.
A Better Alternative to Budgeting
Creating a budget is a crucial step in making each one of your financial goals reachable. The basic idea of a budget is to simply lay out all your financial activities in front of you so you know where your money is going and you can make adjustments where necessary.
The problem with simply creating a budget is that most people set very harsh limits on their spending. They try to control where they’re going to spend every single penny. As a result, the system that was supposed to help becomes too oppressive, and they give up on their plans too soon.
That’s not a surprise. Most people are only taught how to save money — not how to spend it. So they end up applying the age-old concept of “do not spend money on that” to everything. But money, for one thing, is all about the great things and experiences it allows you to have.
The key then is to redirect the money to where it should go, and to where you want it to go. Therefore, a much better alternative to budgeting is to create a Conscious Spending Plan (CSP), first coined by Ramit Sethi in his book I Will Teach You to Be Rich.
Based on percentages of your income, a CSP means you decide exactly where you are going to spend your money beforehand. Which frees you from worrying about your minor day-to-day spending. Why? Because you’ll know you’ll have already covered your financial obligations and milestones for each month.
So here’s how it works. Even though you can always change the following percentages based on your goals, a CSP breaks your income into four spending categories:
- Fixed Costs: These are your basic living expenses, such as rent, mortgage, property tax, food, healthcare, house utilities, etc. A good rule of thumb is that this category should never exceed 60% of your income.
- Investments: These are your contributions to long-term investments such as a 401(k), a Roth IRA, and other non-retirement accounts. Here, you should contribute at least 10% of your income. And if you think you don’t have “what it takes” to start investing, you’re wrong. Just keep reading.
- Savings: This category includes the goals you’ve already set that require you to put some money aside every month to achieve them. Whether it’s saving money for a down payment on a house, for your wedding day, or for that family trip, you should be contributing at least 10% of your income to this category.
- Guilt-Free Spending: This category includes the money you’ll spend without worrying about it. Once you’ve already covered the previous, more important categories, there’s no need to stress over a $5 latte. A good rule of thumb is that it should correspond to about 20% of your income, and you should use credit cards to pay for these expenses.
There are other frameworks you can use to help decide where you’re going to spend your money, and how much will go into each category. So do your research and go with the one that appeals to you the most. If you run the numbers and your current spending differs wildly from the framework you’ve chosen, that’s your cue to zero in on your personal finance planning.
And even after you’ve chosen a framework to guide you, the percentages are not set in stone. You can adjust them according to your unique needs, desires, and goals. Whether you’d like to invest more or save more, you simply need to adjust the other categories.
For example, if you’d rather save 20% of your income so that you can travel more often, you can get your Guilt-Free Spending down to 10%. How? Set up an automatic transfer of 20% of your paycheck into a savings account to take place as soon as you get paid. This will make sure you trick yourself into meeting the monthly milestones you set for yourself.
In the Automate Your Money System section below, you’ll learn how to set up these automatic transfers between your financial accounts every month. And most importantly, you’ll see why you need them. Want a hint? To protect you from yourself.
Pay Off Debt
Paying off debt is one of the best personal finance moves you can make in your life. If it’s applicable to you, it should be one of the first financial goals you aim to achieve. If not the very first one.
Why? Because any type of debt is a roadblock to achieving your goals and building wealth. Doesn’t matter if they are long-term or short-term goals, if you have any type of debt, you can’t contribute as much money as you should toward them.
According to Ramsey Solutions, 77% of American households have at least some type of debt, sharing a total debt volume of about $14.96 trillion as of 2021. This figure includes all types of consumer debt, and the image below shows how this total volume is broken into the different types of debt.
Why Credit Card Debt is Your Biggest Enemy
If you look closely at the image above, credit card debt is fourth to mortgage loans, student loans, and auto loans. So you would naturally think it’s not as damaging as the others. And that’s precisely where you’re mistaken.
Credit cards are a credit option widely available to pretty much everybody. They’re significantly easier to get than the others. They can come in handy when used properly. But their interest rates are way higher than the other credit options.
While the interest rates of home mortgages, student loans, and auto loans hover around 2% to 6% (as of 2021), the average credit card APR for 2021 is around 17.50% to 21.89%. Therefore, getting rid of those unpaid balances as soon as possible—and not creating a new one—can really set you up for financial success.
The vast majority of people’s credit card problems grow from their choice of paying only the minimum amount on their monthly payments. However, when you factor in the average APR, it literally “steals” your money.
An example from Ramit Sethi’s book goes like this: If you pay only the 2% minimum amount on a $5,000 credit card balance with a 14% APR, you’ll completely pay it off in 25 years and pay $6,000 dollars in interest alone.
That’s more than you initially owed. And the APR in the example is lower than the real 2021 average. In fact, you would end up paying even more than $6,000 in interest.
So here’s a good rule of thumb: in personal finance, the key to using your credit cards efficiently and not going into debt is to pay your bills on time and in full every month.
How to Get Rid of Debt
If you find yourself among those Americans with some type of debt, don’t do what most of them do: feel sorry for yourself and then do nothing. Instead, acknowledge that you’ve messed up and looked for ways to fix the situation.
Regardless of the type(s) of debt you find yourself in, you should have a plan to pay them all off. Even though you can do fancy things like balance transfer and all that, the time-tested approach to paying off debt is to plan and act accordingly, month after month.
So here go five effective steps anyone can follow to get rid of debt, as presented in Ramit Sethis’s book:
- Lay Everything Out: You cannot plan to pay off your debt if you don’t know its characteristics, such as total balance, APR, minimum monthly payments, etc. So create a spreadsheet like the image below to get to know the specifics of each type of debt you have.
- Decide Which One to Pay First: Here you have two options. You can use the Snowball Method, which consists of paying more on the one with the lowest balance first while paying the minimum amount on all others. Or you can use the Standard Method, which consists of paying more on the one with the highest APR while paying the minimum on all others.
- Try to Negotiate Down Your APR: Credit card companies are always trying to win new customers over their competitors, and keep the ones they already have. So they can lower your APR if you ask them to. It doesn’t always work, however. Especially if you have a huge unpaid balance. But if it does work, you save money.
- Decide Where the Money to Pay Them off Will Come From: Ideally, you would reduce your spending and prioritize your debt, while you keep investing and saving (even if it means a much lower amount) for your other goals.
- Get Started: If you find yourself taking more time to plan and decide than to actually get started paying them off, you’re overthinking. Remember, the longer it takes you to pay off your debt, the longer it’ll take you to achieve your goals since you’ll be contributing less toward them.
A little-known fact about your debt monthly payments is that you can increase the amount you pay each month. This is key to paying off your debt much faster and saving money on interest.
Do you remember the $5,000 credit card balance example above? If you pay a fixed amount greater than the monthly minimum, say $100, throughout the duration of the repayment period, you’d be debt-free in 5 years, paying only $2,000 in interest.
And it can get even better. If you pay a fixed $200 amount every month, it would take you 2.5 years to be debt-free, paying only $900 in interest.
Not only do you reduce the amount of time it would take you to pay it off, but you also reduce the amount of money you lose to interest charges alone. If you want to play with the numbers, check out Credit Karma’s Debt Repayment Calculator.
What About Student Loans?
According to Education Data’s Student Loan Debt Statistics, more than 43 million student borrowers are in debt by an average of more than $39,000 each. But don’t freak out just yet, wondering if your college degree was really worth it.
If you’ve actually taken a look at the first image with the annual wages of some engineering occupations, it’s evident that your college degree was definitely worth it. And it gets even more evident when you get to know that the income of those with just a high school diploma is about $39,000.
Therefore, there’s no doubt your college degree is “worth it”. But from a financial standpoint, the question remains: should you pay off your student loans while you invest? Or should you pay them off first and, only then, start investing?
You basically have three different options to choose from:
- Option 1: If your loan has an interest rate hovering around the average rate of about 5.8%, then you could pay it off as slowly as possible, contributing only the monthly minimum and investing the rest. That’s because you can make an average of 7% to 8% investing—sometimes even more.
- Option 2: If having any type of debt makes you uncomfortable and keeps you from sleeping at night, you can contribute as much as possible toward your student loan repayments in order to pay it off quickly, and only then start investing more aggressively.
- Option 3: That’s a hybrid approach. You pay off your student loan with a portion of your money in your “Investments” category, and then actually invest with the rest.
Getting rid of debt may seem daunting, but it’s not out of your reach. In this episode of the Engineering Our Future podcast, Nicolai Oliden shares great insights into how he got out of $140,000 in debt, and his current work helping others do the same.
Plan for Emergencies
If it wasn’t already clear to you, 2020 proved you need some money set aside to get you covered if life emergencies come up out of the blue. In March 2020 alone, at the very beginning of COVID-19, payrolls fell by 701,000—close to the 2008-2009 financial crisis peak of 800,000.
How would you cover your basic living expenses if you (unfortunately) were part of this statistic? Would you default on your electricity bill to put food on the table for your children? This trade-off cannot even exist, right?
According to a survey by LendingTree, over 50% of Americans can’t cover a $1,000 emergency with their own savings. And what’s more, six in 10 Americans have already had a life emergency that cost them $1,000 or more. The lesson? Only $1,000 set aside is not even enough.
And yes. You can ask relatives and friends for help whenever you really need it. But who likes asking for these kinds of things, right? The better option is to do great personal finance planning and have some money tucked away on which you can fall back in case life hits you.
Therefore, after you’ve paid off your debt, start creating your own version of what’s called an “emergency fund”. It all starts by setting a goal for how much protection you want. At a minimum, it’s smart to have three months’ worth of living expenses set aside; six months is even better. And if you have variable income, 12 months is a better target for you.
Where does the money to create this emergency fund come from? Just like you previously did with your “get debt-free” plan, you would reduce your spending and prioritize the creation of your emergency fund, while you keep investing and saving (even if it means a much lower amount) for your other goals.
The key to feeding this fund every month is to create an automated system that adds money to it on a monthly basis with no input from you at all. You’ll see more on why automation is your biggest ally in personal finance later in this article, but in the meantime, here are some tips you can use:
- Set up a separate savings account for your emergency fund in a different bank. Having it in the same bank makes it easier for you to withdraw for non-emergency reasons.
- Go for high-yield online savings accounts. Accounts like Capital One 360 Savings and Ally Online Savings Account are high-yield savings and let you set up automatic transfers to take place each month from your checking account.
- Don't you dare let this money sit in your regular checking account. If you do, the temptation to use it for non-emergencies will build up and you’ll probably spend it.
While it may take you longer to reach your other goals since you’ll be contributing less towards them, the silver lining here is that you’ll be covered in case something happens. Depending on how much protection you’ve accumulated, an emergency fund gives you enough time to get back on your feet after you’ve been knocked out by life.
Invest for Retirement
In personal finance, most people phrase it like this: “You should save for retirement.” However, this implies that simply sending some money into a savings account for many years gives you the returns you need to land in retirement in good shape. But it doesn’t.
According to Bankrate’s January 5, 2022, weekly survey, the average Annual Percentage Yield (APY) of savings accounts across all US banks is 0.06% per year. You can find banks, especially online banks, offering high-yield online savings accounts whose APYs range from 0.40% to 0.55%.
When you run a compound interest calculator like Bankrate’s supposing a starting balance of $0, a monthly contribution of $400 over 40 years, and using the higher APY of online savings accounts of 0.55%, you’ll have a total of $214,740 down the road.
However, when you run the same calculation just changing the rate of return from 0.55% to 7% (10% average stock market return per year minus 3% due to inflation, according to NerdWallet), you’ll have about $994,207 after 40 years. That’s a difference of $779,467 that you would lose!
Therefore, you’re free to phrase it “save for retirement” if you wish. It doesn’t matter. But what you should actually be doing is investing this money in the stock market over the long term.
And don’t wait to get started. The best time to start investing for your retirement years was yesterday. The longer you wait to take action toward this big personal finance goal, the more you’ll have to contribute each month to be financially safe down the road.
Don’t you think so? The chart below from U.S. News shows the impact of starting investing as early as possible.
There’s no single rule for how much you’ll need to have in retirement. You can even set your own unique retirement goal. If you want to meticulously plan your contributions, returns, and specific milestones, you can use Personal Capital’s Retirement Calculator to help you out.
If you’re not that meticulous type of person, this doesn’t mean you should not invest. A solid guideline that’s been around for quite some time, and that you can use to point you in the right direction, is to have a specific multiple of your income set aside at different ages. That is:
- Age 35: Aim for two times your income in your retirement balance.
- Age 50: Aim for six times your income in your retirement balance.
- Age 60-70: Aim for 10 times your income in your retirement balance.
If you’re already in your mid or late 20s, you probably panicked a little bit after reading this, didn’t you? But don’t worry. The second best time to start investing for retirement is now. But the question remains: how do you get started?
You Don’t Need a Financial Expert
When it comes to investing, it’s super easy to get overwhelmed by all the options out there. Should you buy individual stocks and bonds? Which ones? Small-cap? Large-cap? Federal bonds? Private bonds? And how much money should you have in each asset class?
These types of concerns cause people to think the only way they can invest in if they hire a financial expert or adviser to pick their investments for them. But the thing is, you don’t need to. And here’s why.
Nobody can predict where the market will go in the near future. Many financial experts, especially portfolio managers at mutual funds, love to give reasons for their predictions of where the market will go tomorrow. This is called Timing the Market. But the truth is, it’s extremely difficult to predict how high, how low, or even in what direction the market will go.
This doesn’t mean financial professionals are not good at their craft. Don’t get it wrong! The financial world has had countless exceptional investors that consistently beat the market by large margins year after year. And there are a lot more out there.
However, these people are outliers. Their livelihood depends on being exceptionally good at investing. They study it every day. They work with it every day. For the average person (read: you), on the other hand, the best strategy is to focus on time in the market — not timing the market.
And as an individual investor, one of the main things you should be aware of about investing is that fees are your biggest enemy. And that’s why you should know the difference between active and passive management.
Active vs. Passive Management
Active management means that a portfolio manager tries to pick the best individual stocks to make up your asset allocation and then give you the “best” returns. This is the method used by mutual funds, which was still perceived as the best way for the average person to invest until not so long ago.
The problem with actively managed mutual funds is what they charge you in exchange for picking the stocks on your behalf. In order to pay all the staff and the expensive portfolio managers every month, they charge you a fee called an expense ratio. For mutual funds, it’s typically 1% to 2% of assets managed (the total amount you have invested in the fund) per year.
Then, in 1975, John Bogle pioneered the idea of passive management with the world’s first index fund. At this moment, mutual funds started to lose their status as the best way for the average person to invest. Why? Their fees.
Passive management replaces portfolio managers with computers. And the computers do not try to pick the “best” stocks. They simply and methodically pick the same stocks that an index holds in an attempt to match the market. That’s how index funds and ETFs are managed.
And since there’s no more expensive staff and portfolio managers to pay, their fees are considerably lower — around 0.1% to 0.3% of assets managed per year. This means two things:
- You keep more of your own money to yourself than when you invest with mutual funds.
- In the long term, you can beat the vast majority (75%) of actively managed mutual funds.
According to the Survivorship Bias described in Burton Malkiel’s book, A Random Walk Down Wall Street, a financial complex may start a number of different mutual funds and wait for their results. After some time, they start heavily marketing only the handful of funds that produced great returns, while killing the dozens of others that did poorly and burying their records.
A 1% to 2% expense ratio may not sound like much, but the table below from Ramit’s book will shed a different light on it. You can even use this expense ratio calculator to run the numbers yourself and compare how much you’ll pay in fees over the lifetime of your investments for different funds you may be considering.
If nobody can predict the market, the only solution to investing for the average person is to keep doing it regularly and contributing as much money as possible into low-cost, diversified passively managed funds — even in an economic downturn. In the long term, the market has historically generated extremely good positive returns.
The Best Investment Accounts for Individual Investors
By now, you know what investment strategy you should go for: passively managed, low-cost funds over the long term. But that’s just the theory behind investing for the average person. And as previously mentioned, money management is all about action.
It’s common to hear a lot of people complaining about how difficult it is for them to make ends meet, much less invest. That's a real situation for a lot of folks. But you should not let this helplessness set the rules you’ll live by. Go after increasing your income (more on that later) and start investing. Whether that’s $50 per month or $500 per month.
Remember this: investing is the most effective and sure way to get rich over time. However, you don’t need to become the next Warren Buffet or Peter Lynch. It’s all about giving your hard-earned money a better destination. One that will benefit you down the road.
For the average person, the best way to invest is to use special accounts that give tax advantages. This includes employer-sponsored retirement accounts like 401(k)s, or even your own individual retirement account (IRA). These are called “retirement accounts” because they give you huge tax benefits if you agree not to withdraw the money until you’re a certain age.
A 401(k) is a type of retirement account offered to employees by some companies. Depending on how much you make, you can or cannot use this account. And if you can use it, there’s a maximum amount you can contribute every year. Here you can find the contribution limits for 2022.
You can open a 401(k) account with your company’s HR department. And it should be the very first place you consider when you start investing. Here’s why:
- Automatic Investing: The money goes directly from your employer into your 401(k) account and does not show up in your paycheck. This tricks you into investing since you’ll learn how to live without that money.
- Using pre-tax dollars means growth acceleration: The money you invest is not taxed until you withdraw it many years later. So you have much more money compounding over time.
- Your employer can match your contribution up to a certain amount: This screams “FREE MONEY!”. And if your company offers a 401(k) match, you should take it.
- Your employer’s match doesn't count toward your contribution limit: This means you can go beyond the limit set by your employer in order to get their match. And if you can contribute more, you should.
Individual Retirement Accounts (IRAs)
A Roth IRA is another type of retirement account. Here you contribute after-tax dollars, but your withdrawals in retirement are tax-free. And you can even withdraw your earnings — not the principal — tax- and penalty-free before retirement.
As with a 401(k), it also has a contribution limit depending on how much you make per year. Here you can check the numbers for the upcoming year. And you should treat a Roth IRA as you’d treat a 401(k): long-term investments.
On the other hand, a Roth IRA differs from a 401(k) in the sense that it’s not employer-sponsored. That is, you’ll need the discipline to contribute to your account every single month.
And you don’t open a Roth IRA with your company’s HR department. Rather, you need to open an account with an investment company. A really good choice for you is M1 Finance. With their IRAs, you can build your own retirement strategy, and most importantly, easily maintain it over time.
Another difference between a 401(k) and a Roth IRA is the investment options you have. A 401(k) only has an array of funds for you to choose from. But a Roth IRA lets you invest in pretty much anything, from individual stocks, index funds, and ETFs to bonds and mutual funds.
A 401(k) and a Roth IRA are the two accounts that will set you up for success in the long term. Tax advantages and benefits mean you keep more of your money to yourself. So whether or not you have already started investing, you should highly consider these two options and contribute as much as your annual limit allows you to.
If you still have money to invest after reaching your contribution limits on both your 401(k) and Roth IRA, you have a third option at your disposal. And that’s to open a non-retirement, taxable account with an investment company.
This account also lets you invest in basically any asset class in the market with the money you still have leftover in your “Investments” category. The only difference is that it doesn’t offer you tax advantages and benefits as the previous two accounts.
And before you choose your fund for your 401(k) and/or start buying individual stocks like Amazon ($AMZN) with your Roth IRA and non-retirement accounts, you first need to know what investment options are best suited for the average investor. And here’s a hint: it’s not individual stocks.
What Individual Investors Should Invest in
Most people think that investing is all about picking winning stocks. You’ve already seen that even portfolio managers fail to beat the market, right? So it’s evident that the average person whose profession has nothing to do with the financial market cannot pick winning stocks by him or herself.
Fortunately, you don’t need to. Again, individual investors should use a time-tested, low-cost investment strategy that is easy to maintain, and consistently contribute as much as possible to their accounts over the long term.
Investing Options for 401(k) Accounts
When it comes to the money you’re putting into your 401(k), whether your employer matches your contribution or not, you don’t have too many options. Typical 401(k) accounts only offer an array of funds that range from conservative (mostly bonds) to aggressive (mostly stocks).
If you’re young, you should go with the most aggressive fund available to you. And regardless of your age, steer clear from what’s called “money market” funds. This terminology is simply a fancy way of saying that your money is basically uninvested. That’s not the goal of contributing to a 401(k), is it?
Finally, depending on the financial company your employer is using to offer 401(k) services to its employees, some of the funds may come in a little expensive. Their expense ratios can reach about 0.75%. But don’t forget you're getting huge tax benefits down the road and possibly your employer’s match. So the fees are somewhat worth it.
Investing Options for Roth IRA and Non-Retirement Accounts
After your 401(k), the next best place to invest is your Roth IRA. As you’ve seen, this account gives you huge tax benefits. And if you still have money to invest after you’ve maxed out your Roth IRA, then you can also invest that money with your taxable, non-retirement account.
The catch here is that, differently from a 401(k), when you send money into these two accounts, it just sits there. You need to personally plan, pick, and buy your investments for them to start generating any returns. So for you to set yourself up for success with these accounts, you need to know the basics of the options you have.
The Pyramid of Investing Options below shows the options you can choose from. These options decrease in complexity and maintenance effort required as you move up the pyramid.
The bottom of the pyramid is made up of stocks, bonds, and cash. This will require the most effort and time from you since you’ll be in charge of coming up with your own asset allocation by choosing individual stocks and bonds, as well as rebalancing your portfolio fairly often.
As you’ve seen, it’s very hard for portfolio managers to pick stocks that will outperform the market — nearly impossible for the average person. Therefore, this bottom section of the pyramid is for those financial experts, advisers, and stock market aficionados. The average investor would be much better off by investing in passively managed, low-cost funds.
Going up, you have mutual funds, index funds, and ETFs in the mid-portion of the pyramid. While mutual funds hire a portfolio manager to pick your investments for you (active management), index funds and ETFs simply try to match an index of the market with no “experts” (passive management).
These two options are better for the average investor when compared to buying individual stocks and bonds. But index funds and ETFs still win the battle against mutual funds due to their extremely low fees. Meaning you keep more of your money to yourself.
The only downside of index funds and ETFs is that you have to own several of them in order to have a balanced and diversified portfolio. And while they are extremely easier to maintain when compared to individual stocks, you'll still have to do some portfolio rebalancing to keep it fine-tuned to your theoretical asset allocation.
Finally, the very top of the pyramid is made up of target-date funds. If you know you’re the type of person who will never get around to doing the necessary research to come up with a good asset allocation, or even take the time to rebalance your portfolio at least once a year, then this is the option for you.
Target date funds are simply funds that automatically diversify your investments for you based on the year you plan on retiring. Instead of you having to research, come up with an asset allocation, choose your funds according to it, and rebalance your portfolio as you get older, target-date funds do it for you — automatically.
A target-date fund is actually what’s often called a “fund of funds”. That is, your target-date fund owns many other secondary funds, which in turn own stocks and bonds. You only have to own one single fund, and all the rest will be taken care of. The only work you do is send money to your target-date fund.
What Investing Options Should You Go With?
As you know, there’s not too much to do regarding your 401(k). You have to choose one fund from the options your employer provides. Your choice will depend on your age and risk tolerance. But again, if you’re in your 20s, it’s advisable to pick the most aggressive fund possible.
When it comes to your Roth IRA and non-retirement accounts, the easiest option you can go with is a target date fund. You just pick one fund and all you do is send money into it on a regular basis. No need to research a reasonable asset allocation. No need to rebalance. It’s all automatically taken care of.
And you can choose any target-date fund available based not only on your age but also on your risk tolerance. That is if you’re young but you’re pretty risk-averse, you can choose a target-date fund for someone older (retirement year not that far away). That will give you a more conservative portfolio.
If you want more control over your investments with your Roth IRA and non-retirement account, you should then go with the option of index funds or ETFs. Here, you’ll need to do your research, come up with a diversified asset allocation, search for the index funds or ETFs that match that asset allocation, and rebalance your portfolio over time.
Yes, this may sound like a lot of work. And in fact, it is. But it’s also a one-time thing. Once you have a list of the different index funds or ETFs you’ll own, you’ll just keep buying them repeatedly according to your asset allocation.
And to help you come up with your own asset allocation strategy, you can use David Swensen’s strategy below as a guideline. Then you would just pick the index funds or ETFs that match each asset category in his model.
Creating your own portfolio of index funds or ETFs is not simple. It takes significant research. So here go three things to consider when choosing a specific fund or ETF:
- Minimize Fees: Look for funds and ETFs with low expense ratios. Anything around 0.1% to 0.3% is fine. Remember, fees cost you a ton of money over the lifetime of your investments.
- Personalize Your Asset Allocation: Use Swensen’s model just as a guideline, but tweak it whenever necessary. For example, if you're in your 20s, you probably do not need to own inflation-protected securities just yet and can be much more aggressive with stocks.
- Past Performance is No Guarantee of Future Results: Looking at how well your chosen index funds or ETFs have done over the past 10-20 years is highly advisable. But remember that good past performance doesn’t necessarily mean good future performance.
Automate Your Money System
Now that you’ve mastered the basic theoretical principles of personal finance, your next best move is to make the money management process as hands-off as possible.
Why? Because you need to create a system that acknowledges your natural human behavior of wanting to spend money once you have it, and that uses technology to make sure you don’t.
You’ve probably already created your CSP and decided how much you’ll spend on each category. But that’s all still very theoretical. Now you’ll create an automatic money flow that makes sure you contribute the exact dollar amount you previously determined for each category.
It’s all about linking your accounts and setting up automatic transfers so your money goes where it needs to go every month. That is, you won’t need to open your bank app, log into your account, and do the transfers yourself every single month. Which would increase the likelihood of you contributing less than what you set out to. Instead, the system will do it for you.
The only catch is that it’ll require some time at the outset to set everything up correctly. But once you’re done and your accounts are all linked, it’ll run on autopilot. Meaning each dollar that comes in will be routed to the right account according to your CSP with no input from you.
First, get all the basics done. Put together a list of all your accounts, their details, and your login information for each of them. This will make the setup easier since you’ll be asked for this fairly often. A great platform to help you get all this together is Personal Capital.
Second, link your accounts so that you can set up automatic transfers between them. The basic links you need to make are outlined and illustrated below:
- Connect your paycheck to your 401(k);
- Connect your checking account to your savings account;
- Connect your checking account to your brokerage accounts (IRA and non-retirement accounts);
- Connect your credit card(s) to any bills that can be paid on credit;
- Link regular bills that cannot be paid on credit to your checking account using the bill-pay feature (widely available and free with nearly every account today);
- Set it up so that all your credit cards’ bills are paid on time and in full from your checking account every month.
Third, you log back into your accounts and automate all the transfers and payments for the amount and date you want. But be cautious! Here you need to pick the right dates for the transfers. If you don’t have the money in your checking account on the date a specific transfer or payment is supposed to happen, it won’t go through.
So gather all your monthly bills and verify their current billing dates. A good rule of thumb here is to switch all your billing dates to be around the time of the month in which you get paid.
The image below illustrates how this automatic money flow would work. Here, the person gets paid on the first of the month and makes the necessary transfers and payments soon thereafter.
Special Cases for Your Automatic Money Flow
If you don’t receive a stable income every month, or maybe your employer pays you twice a month instead of just once, don’t freak out. The automatic money flow outlined above can still work for you. You just need to take a slightly different approach to it.
For those getting paid twice a month, which is fairly common today, you can cover two categories of your CSP with one paycheck (e.g., investments and fixed costs) and the other two with the next paycheck (e.g., savings and guilt-free spending). Just set up the transfers and payments accordingly.
If you have irregular income, on the other hand, you have to set up a buffer in your checking account to simulate a stable monthly income. Just calculate all your monthly expenses for all four buckets and keep six to 12 times that amount (i.e., a 6- to 12-month buffer) in your checking account. Then you can just use the system as outlined above.
Key Elements in Personal Finance
#1 – Make More Money
If you’ve set up your CSP and realized your income is not enough to cover all four categories, then you’re not alone. Most people cannot really afford to cut more of their spending in one category to redirect that money to the others. Or maybe they simply don’t make enough money to contribute as much as they’d like to each category.
If you find yourself in this position, setting up a beautiful CSP will be more of a goal for you to achieve than a plan for you to follow. Here you have much more important concerns. The most important of them: Making more money!
Most people complain their jobs don’t pay enough for them to make ends meet, let alone invest and save every month. While there may be some truth to this, especially with today’s skyrocketing inflation, that’s the total extent to which they go when addressing their income problem.
This approach is simply playing defense. But remember the very introduction of this article: when it comes to money, you should always play offense. Therefore, if you find yourself unhappy with the amount of money you make, then start looking for ways to make more money.
In personal finance, monitoring and reducing your expenses is crucial. But increasing your income becomes, as Ramit puts it, “superlinear”. You truly need to internalize the fact that there’s a limit on the amount of money you can stop spending (i.e, you still need to pay rent, buy food, etc.), but no limit on the amount of money you can start making.
And in today’s tech-driven world, it’s never been easier to make more money. Especially online. The best way to eventually have an extra income is to start a side hustle and build it up gradually, while you still have the safety of your full-time job to cover your living costs.
Whether you sell your services as a freelancer or start an online business to generate that extra income you want, you need to understand the fact that you can — and should — always make more money. Even after getting every aspect of your personal finance right and on autopilot.
If you need some encouragement, according to a study by LinkedIn ProFinder, more than 331,941 professionals in the U.S. are already freelancing on the side of their day jobs. These people understood that making more money is the No. 1 thing that can exponentially change your financial and personal life for the better.
To help you follow in their footsteps, here are a few things you could consider to help you make more money:
- Negotiate a Raise: While the negotiation process is a whole different matter, this is a really neat first step you could take. After all, you could earn more for the same type of work you're already doing.
- Get a Higher-Paying Job: If you find that your current company doesn’t offer you growth potential, you can always look somewhere else. And during the hiring process, that’s when you have the most leverage to negotiate a bigger paycheck.
- Do Freelance Work: Think about the interests and skills you already have that others would pay for. These skills don’t even need to be heavy technical skills that require an undergrad degree. It could be video editing, graphic design, or even writing services that other people would be extremely happy to pay for in order to free them from having to do it themselves. Busy people need others to help them with their lives.
- Entrepreneurship: The idea here is to start a business (especially online) on the side of your day job that can potentially generate passive income down the road. This one can give you the best return on investment, but it’ll take much more time to materialize — if it ever does. Some options you could consider include starting a YouTube channel or a blog, creating and selling online courses or physical products, etc.
These options work for everybody. You just need to find something that you’d be excited about and go for it. And if you think you’re not cut out to be an entrepreneur, check out this episode of the Engineering our Future Podcast with Stephanie Slocum.
She’s a structural engineer, turned author of the book She Engineers, turned entrepreneur. She scratched her own itch and founded an online business called Engineers Rising aiming to help women engineers succeed in the male-dominated field of structural engineering — just as she did.
#2 – Take Care of Your Credit Score
One crucial aspect of personal finance you probably overlook (like many others) is your credit score. It’s simply an easy-to-read number between 300 and 850, that represents your risk to lenders. And establishing a good credit score is a huge step towards achieving your financial goals and living your rich life.
Why? Your biggest purchases are made on credit (e.g., a house, a car, etc.). And those with a good credit score save a lot of money on interest while also having lower monthly payments. That is, you can contribute more money toward your other goals.
If you still don’t think your credit score matters when it comes to your financial life, then take a look at the table below from Bankrate. It shows the monthly payments you’d have, the APR you’d be charged, and the total interest you’d pay for a 30-year mortgage loan depending on your credit score. As you can see, the higher your credit score, the better.
Your credit score is made up of different elements with different weights. They are payment history, amounts owed, new credit, length of credit history, and credit mix. When combined and weighted accordingly, the final result is your magic 3-digit number.
However, one specific element is worth noticing. And that is your payment history, which represents 35% of your credit score. This means you need a very long history of paying back your duties and not defaulting on your payments for you to have a good credit score.
Even though there are many ways of getting credit today, the most widely available is via credit cards. While they can be a convenient payment method in the short term, their misuse has hurt more credit scores than any other mistake ever will.
So do you remember the rule of thumb for efficiently using your credit cards? Yes. It’s all about paying your credit card bills on time and in full every month. This will automatically set you up for success. But here are five more credit card rules you should know:
- Try to get fees on your card waived: If you think the fees you’re paying are not worth the perks your credit cards offer, then you can try to get them waived. Especially if you’ve been a great customer who pays your bills on time and in full.
- Negotiate a lower APR: Basically, APR is the interest rate on your credit card usage. If you can get them to lower it, you’ll pay less in fees (when applicable).
- Keep your main credit cards active for as long as possible: Lenders like to see a long credit history to “trust’ you with their money. The longer you hold an account, the better.
- Get more credit: This helps with your credit utilization rate, which is the ratio of how much you owe to the amount of credit you have available. If you increase your credit, you lower your credit utilization rate. And lenders don’t like high utilization rates because it increases their risk.
- Use and abuse your credit card secret perks: Most credit card companies offer services the vast majority of people are not aware of. This includes trip cancellation insurance, car rental insurance, etc. Just reach out to your company and ask them which services they offer.
There are many good rewards credit cards out there that offer you really great things, from cash back to travel rewards. Do your own research and pick the one that offers what you prefer. Two great options to consider are Chase Sapphire Preferred and American Express Cash Preferred.
Did you get interested in checking out your own credit score too? Well, regardless of how good (or bad) it currently may be, you can get your credit score at MyFICO after choosing one of their subscription plans. Or once a year at Annual Credit Report.
If you want to really dive into the nitty-gritty of credit scores and learn how to increase yours, check out this episode of the Engineering Our Future Podcast with Danielle Schroeder. Her first experience with personal finance was in college, taking out loans to pay for housing and meal plans. But she has now come a long way to building an impressive 800+ credit score!
#3 – Choose the Right Banks
Another important aspect of personal finance is the banks and financial institutions you choose to work with. You probably already have your checking and savings accounts set up. But the bad news is that they are probably from one of the big-name banks out there, which are huge traps for the average person.
Why? Because they will always find a way to get as much money out of you as possible. And to do this, they have many other strategies that go way beyond the usual fees. This includes many of the so-called “value-added” services, which trick you into paying for something you’ll never really need, much less use.
Just as an example, this article from U.S. News reports on Wells Fargo fraudulently opening more than three million accounts without customers’ authorization. And this article from The New York Times states that 85,000 of these accounts generated more than $2 million from fees people had to pay for those accounts.
Therefore, you need to be very cautious about the banks you choose to work with. Yes, it can be their job to profit off you. But it’s also your job to make sure they don’t. Good banks offer you better services and charge you no fees, while bad banks have low-quality services, ever-increasing fees, additional fees, and different ways to get money out of your pocket.
Always try to find banks and financial institutions that will really make your life easier. That is, find a cheaper, better bank that also offers better rewards, such as no fees, no charges for money transfers, no charges for ATM withdrawals, good and fast customer support, etc.
Here’s a shortlist of the things you should consider when choosing a bank:
- You should be paying no fees: Essentially, banks make money by lending your money to other people at a much higher rate than the rate they pay. If they’re already profiting off of your money, there’s no reason to pay any additional fees.
- You should not be required to keep a minimum: A minimum is a specific dollar amount you should always have in your checking account to avoid additional fees. This is another way big-name banks found to get money out of your pocket and into theirs. Just look for another bank. There are many other options that require no minimums.
- Trust: When you visit the bank’s website, check if the information about all their services and fees is straightforward. If it’s not, they are not trustworthy because they will probably use these hidden technicalities to fool you later on.
- Convenience: The bank’s services need to allow you to easily receive and transfer money, withdraw money, pay bills, etc.
- Features: The bank’s interest rate should be competitive, transferring money should be free (you’ll do that a lot), the bank app should be easy to use, their customer service should be good and fast enough, etc.
In his book, Ramit mentions his personal recommendations for the banks you should consider, and the ones you should definitely avoid. He goes even further to suggest his top picks for the best checking and savings accounts, as well as the best brokerage institution for your long-term investments.
Here are the best and worst banks, as well as the best brokerage, according to Ramit:
- Best Brokerage: Vanguard
Here are the best checking and savings accounts for you to consider, also according to Ramit:
- Checking Account: Schwab Checking Account
That was a long journey. But there you have it. This is the only personal finance guide you’ll ever need to take control of your money and make it work in your favor rather than against you.
Internalize the concepts and take the pieces of the advice laid out in this guide. But remember, money management is all about action. You can read everything available about money, but if you don’t put the principles into practice, they’re useless.
And once you have taken full control of your money, the next step is living your life the way you want to. Do you want to have kids? Do you want to take a one-month vacation every year? Do you want to live in a specific house in a specific neighborhood?
Sure. More money will always allow you to do more things. Or even achieve your goals faster and set new ones. And you should always be on the lookout for ways to increase your income. But what’s your dollar amount, at least for the time being?
Remember, you need to get really specific about what “being rich” means to you. Otherwise, you would just be blindly seeking more and more money while your life is passing by and you’re not living it.
If you’d like a quick walk through the five basic principles of personal finance, this episode of the Engineering Our Future Podcast got you covered. It’s an audio-version summary of this article, touching on some key points and giving real-world examples based on Luis’ financial life.
*Disclaimer: Some links on this page are affiliate links and Engineering our Future received a small commission when you purchase through them at no extra cost to you (some of them even include discounts to save you money). Thank you for your support.