Personal Finance 101

According to some relatively recent research, Americans spend 7,000% more time watching TV than working on their finances – which means that, on average, we only spend about 2 minutes per day managing our money (or about an hour per month). While the focus of my research is on when and how we spend our money, clearly this is related to how much we save and how we invest our money – often referred to as “personal finance.”  There are hundreds of books that focus on personal finance, with millions of copies sold each year. I don’t know why there is so much published advice about saving and investing and so little about when and how to spend our money wisely, but that’s a topic for another blog.

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I’ve been meaning to write a basic blog about personal finance for some time now, especially since our oldest son recently graduated from college and is managing his own budget for the first time. What prompted me to finally write this was a recent Freakonomics podcast featuring an economics professor at Yale, James Choi. Dr. Choi recently published an article in which he addressed a really cool question:  what advice do these personal finance books tend to converge on and how does their advice compare with the guidance of economists who focus on household financial decision-making? He found that while there was agreement on some issues, the advice often diverged for two basic reasons. First, the “popular advice” from authors (which wasn’t itself always in agreement) does a better job of acknowledging that people have limited time and experience, and so we tend to rely on decision rules rather than the relatively complex models used by academic authors (mostly economists). Second, popular advice acknowledges that we have limited motivation and that emotions affect our decision-making. So, in a sense, the popular advice takes a more pragmatic approach which to me, as a consumer psychologist, makes a lot of sense. We are human, life is complicated, and sometimes it makes sense to keep things simple rather than overthink (and overstress) every possible decision towards some “optimal solution” that never really gets implemented.

However, I really appreciated the reality check provided by Dr. Choi’s work and thought it would help me draft an even better set of summary principles to share here. To be clear, what follows is not based on my own research expertise, instead, I wanted to summarize the guidance that I have read over the years, somewhat informed by my own personal experience and enhanced by the insight provided by Dr. Choi. Consider this a starting point on your own journey toward personal financial wellness!  And note that there will be a little jargon along the way that I won’t be able to explain in a single blog, so I have embedded a few links if you need more information (Investopedia is a good resource in general).

How much should I be saving?

A common rule of thumb in personal finance books is the “50/30/20” rule. With this rule, you allocate your take-home pay (i.e., after income taxes) to three categories:  50% to spend on your “needs” (rent/mortgage, utilities, groceries, insurance & health care, basic wardrobe), 30% to spend on “wants” (eating out, vacations, electronics, fashion), with 20% left for savings (which could include paying off debt first). While not all personal finance books recommend this specific allocation, most assume that your consumption will change over time in proportion to your income (so you would spend proportionally more dollars in each category as your income level rises over time). Economists, on the other hand, tend to believe that your level of consumption should stay relatively stable over time (in dollar terms) so that your savings % goes up as you move into your higher earning years. With that perspective, it might be just fine to not save anything in your early earning years, assuming that you will make it up down the road with a very high savings rate starting mid-career. While the economists’ perspective makes some sense, it ignores our expectations and motivation. Most of us assume when we are young that our lifestyle will follow our incomes, with the ability to afford more as our incomes grow. Psychologically that sense of progress over time is really important to our well-being – and being able to spend more as our incomes rise is part of what motivates us to excel at work. Importantly, saving money early in life (rather than spending more) also has the clear benefit of your investments having more time to grow in value.

Like most things in life, my sense is that what is “best” is somewhat in the middle of these different pespectives. I have suggested to my son that he save at least 20% now so that he has some money before graduate school, if that is what he ends up doing next. If not, then he could apply it towards a house down payment. Of course, that is only possible because he is fortunate to have a strong starting salary, no dependents, and no debts. If you are young and don’t have the luxury of saving 20%, or anything, take heart that economists suggests you will likely be fine if you don’t ramp up your spending too much as your income increases (a trap that many of us fall into). So, how you apply the rule depends on your situation. But, I still like the 50/30/20 as a starting point.

On the other hand, the best financial advice I ever got was a 5-minute conversation with my mother about thirty years ago. Her advice, likely passed on from my grandparents, was to simply “live within your means.”  Stupid simple, right?  But you’d be surprised how many people don’t follow even this basic level of personal financial management. Here’s a simple thought experiment to put it in perspective. If you are the average American household making $72k per year and you live somewhat below your means, saving just 5% per year, and you invest this in index funds (more on that in a bit), in 30 years you will have over $300k saved up towards your retirement. Conversely, if you spend 5% more than you make, which is easy with credit cards, car loans, house loans, etc., then you will have over $300k in debt in 30 years (likely much more since the % cost of borrowing is higher than the % return from investments). But here’s the real kicker:  you might not get much subjective value out of the extra spending that living beyond your means provides. We are very adaptable, and what feels like a sacrifice at first (like two streaming services instead of four, eating out once per month instead of three times, local trips instead of Disney, etc.) becomes barely noticeable over time. So, when in doubt, do what my mom says:  live below your means and save what you can.

How should I invest?

This can get really complicated quickly, and it’s easy to make bad decisions. So, you might be tempted to hire a professional to manage your investments. But that might not be necessary, or even a good idea. One thing that personal finance authors and economists agree on is that actively managed mutual funds do worse, on average, than passive funds which target a specific investment profile rather than trying to pick winners and losers. Selecting mutual funds isn’t the same as hiring someone to manage your investments, but the idea is the same – nobody has a crystal ball and with so much at stake, the wise thing to do is to invest with the market rather than try to beat the market (and worse, to hire someone to try to beat the market for you – they will get their fee no matter what). If that sounds a little philosophical, then let’s get into some specifics.

First, your investment options depend on where you have the money saved. If you have money saved in a retirement account with your employer, you likely have a reduced set of options for investing. However, the principles that follow will probably still apply. If you are investing money in a simple brokerage account, rather than in a retirement account, then you will have many more options – but that isn’t really needed.

The advice that most personal finance books will give you is to invest in low-fee “index funds” that track a specific segment of the investment market. For example, the Vanguard fund VTI tracks the US stock market. In other words, investing $1000 in VTI is like buying a very small share of all of the stocks in the US stock market which, by definition, gives you very high diversification (versus the volatility of individual stocks which can be big winners – or big losers). VTI has a very low management fee, especially compared with actively managed funds, and has earned about 9% on average per year over the last 20 years (or about 6% per year factoring in inflation). So, one simple approach would be to just invest your savings in VTI and to hold on for the long term. And don’t sell during downtimes, like right now!  6% may not sound like a lot, but over 30 years that $1000 will become $5,743 – and this is real value appreciation, adjusting for inflation. That’s the power of compounding interest.

However, that alone might be too risky an approach, and most personal finance authors would recommend diversification in at least two dimensions. First, the US market is only about 40% of the global stock market, so many authors recommend investing some of your money outside the US market. However, rather than the 40:60 ratio that this would imply, a commonly recommended ratio seems to be 60:40 of US stocks to foreign stocks (although that overweights US stocks). Personally, I like the idea of owning global stocks for diversification, and I do maintain about 40% of my stock portfolio in global stocks. That hasn’t been great over the last few years with the US stock market on a tear (well, until 2022), but I am in this for the long run. So, in addition to VTI to cover the US stock market, you could buy VXUS to cover the global market (non-US market). VXUS also has a very low fee.

Second, in addition to stocks, most authors say that you should also invest in bonds which historically have been less volatile and tend to move in the opposite direction of stocks (which helps to smooth value appreciation over time). This is a tricky one lately since bonds have had a rough few years. But if you are planning for the longer term, then the standard guidance likely still applies. So, what is the standard guidance?  One common rule of thumb is that the % of your investments in stocks should be (100 – your age). If you are 25, then 100 – 25 = 75% of you investments should be in stocks. Fortunately, it is very easy to invest in a “basket” of bonds, similar to the index funds that I mentioned above. Two of the more popular are AGG and BND, which have had similar performance over time, and both have similarly low fees.

However, both the personal finance authors and economists suggest that this rule of thumb might be too simple (although their rationale is somewhat different). On the one hand, it makes sense to decrease the % of your portfolio in stocks over time towards lower risk bonds. On the other hand, early in your career and investing life you may need to spend your savings on things like a home or graduate school – meaning that you might not want most of your money in relatively risky, volatile stocks. So, the best advice from both camps seems to be that you should follow a “hump shaped” strategy, where you have moderate risk in your early years (say, 60:40 stocks and bonds), then higher risk in the middle years when your lifestyle is stable yet retirement is not yet in sight (say, 80:20 stocks and bonds) and then back down to a lower risk profile as you approach retirement (say, 40:60 or even more in bonds).

To summarize. Don’t play the market with individual stocks unless you are willing to do worse than the market. Also, don’t pay someone else who, on average, won’t be any better at picking stocks than an algorithm. Instead, invest in low-fee funds, including both stocks and bonds. For stocks, invest in both US stocks (using VTI) and international stocks (using VXUS). A common ratio is 60:40 US to international. Then, keep some of your portfolio in bonds (like AGG or BND) and adjust the ratio over time to fit your risk profile – with the idea that you should be more cautious as you approach retirement, and possibly early in your savings years as well. For a 25 year-old, it might look like this: 60:40 (US stocks:foreign stocks) with 60:40 (stocks:bonds) = 36:24:40 (US stocks:foreign stocks:bonds). You could get fancy and split the bonds between US and foreign bonds, but there is no clear guidance on this (I just stick with US bonds myself).

How much do I need to save for retirement?

Until recently, most of us could approach this question by considering what some have referred to as the three-legged stool of retirement:  social security, pension, and retirement savings. Unfortunately, pension plans have been watered down significantly over the last few decades, even in traditionally pension-friendly jobs like government and academia. For most of us, instead of “defined benefit” pension plans, we now have “defined contribution” plans where our employers contribute a percentage of our salary to our retirement accounts (usually in the single digits). This is helpful, but won’t be enough to retire on. So, how much you save and invest on your own really matters a lot. Specifically how much you will need when you retire depends on a variety of factors. But early in your career (or even mid-career), I think a simple rule of thumb is enough of a guide. Fidelity completed an analysis several years back that I think provides a great set of benchmarks. They suggest that you should save at least 1x your salary by age 30, 3x by 40, 6x by 50, 8x by 60, and 10x by 67. This assumes that you retire at 67 and that you plan to maintain the same lifestyle in retirement (most people spend less, but some of us have travel dreams). You can use their widget to play with these assumptions and customize your own target. As life gets more complicated (kids, college savings, dreams of a second home) you may want to use a software program to do some more sophistical planning, but for most of us, a rule of thumb like this could be enough.

There’s certainly more to saving and investing than this – hence the millions of books on personal finance out there (literally). But, the guidelines above should get you started both in terms of how to approach this and some of the specifics as well. I really appreciate the work that Dr. Choi did in highlighting where personal finance authors and economists agree and where they disagree. My sense is that both perspectives are valuable, but that economists make assumptions about how we think and feel that work on paper but not always as well in the real world. This is why my mother’s simple advice years ago to “live within your means” has been some of the wisest advice I’ve ever received. Thanks, mom!

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