You can also take the Khan Academy Financial Literacy Course.
Saving money sounds like work because it is. Like flossing or exercising or eating our vegetables it is something we all know is good for us but it just takes a bit of consistency and building the habit. And fortunately for us saving money is a lot less painful than flossing (at least, flossing when you haven't in a long time).
You should judge where you are on the list by your situation in life and if you find yourself near the end of the list you should consider retiring early. Or make a game of becoming frugal and try to decrease your expenses and increase your enjoyment of the basic things in life, saving your money for things like spending time with friends and family and experiencing beautiful places on the planet, or even those things right in your neighborhood. Or move somewhere more beautiful since you're no longer dependent on location for your income.
But we are getting ahead of ourselves. Let’s start at the beginning.
0. Let go emotionally; start growing up emotionally
The main problem with most people's financial approach is emotional, not numerical—even worse if they consider themselves good with numbers or good with money in the first place, yet if they are emotionally insecure with regard to material wealth and unwilling to confront their own relationship to it, especially with how easily or carelessly they part with the money that comes their way, then they are doomed financially. But if people can be dispassionate and disciplined (and reality-based) about money, they will move forward gradually and eventually their money problems will mostly go away, replaced by a quiet confidence in that area of their lives. (Personally, I am a reformed big spender who had the chance to unlearn my entire confused and unhealthy approach where money burned a hole in my pocket, when I learned new habits after graduating college, and I got very frugal and started saving everything I could, when I had the chance.)
The converse of money problems going away with discipline is also true. For people with bad habits, there will always be excuses that things are not going their way financially, and they will make terrible spending decisions (usually spending money they do not have) that dig the hole deeper—even when someone else in the same position could move things forward with just a simple change in strategy and the same resources (with a minimal change in actual quality of life). It's the reason it is not really possible to financially educate people unless they come willingly, and even then it is still really hard! It is just too needlessly political and fraught, and even for people who are motivated, it is an inward journey they have to pilot themselves on.
- Read Status Anxiety by Alain de Botton for more about how people in western capitalist societies seek external trappings to feel loved by the world instead of basing their self image on something more within their locus of control.
- Read Walden by Henry David Thoreau, where he describes how he learned “to live deliberately, to front only the essential facts of life.” “Most men appear to never have considered what a house is, and are actually though needlessly poor all their lives because they think they must have such a one as their neighbors have.”
Since money and its effects can be easy to see and can be a proxy for worldly success, people may seek to buy a status symbol such as an expensive car or too-expensive house, brainwashed and convinced by marketing and advertising that it is OK to do so using credit! Now they are trapped! In a supposed attempt to get ahead, they enslave themselves to their banker instead of actually getting ahead, all to Keep Up with the Joneses, who never even cared anyway. People may grow resentful and start to feel that they deserve to live richly, to treat themselves, and may get pulled onto the hedonic treadmill, never learning to want what they have, never learning to enjoy the best things in life, which are often free—sitting and enjoying nature; going for a walk; visiting local libraries; picnicking at the park; jogging outdoors & doing pushups instead of joining a gym; making something with their own hands; trying a new recipe—instead always assuming some final happiness is but one more purchase away. Economists and philosophers and poets and writers have had this all worked out for centuries now.
If after all of these caveats, you are still open to learning, you may proceed.
1. Budget all expenses by collecting all receipts—no exceptions
Note that you do not have to type receipts in right away but you should begin collecting them and establish a habit of always asking for a receipt. We started collecting receipts in a box long before we typed them into a spreadsheet but we have all expenses tracked since we got married because one day we sat down and typed them in and we always catch up on receipts within a few weeks at the most.
Some people like to use tools like their credit card tracking or tools like mint.com. I'm sure these are better than nothing but if you buy anything with cash it will not show up on your list. And it is helpful to be able to make your own categories. I have seen my credit card put things in totally goofy categories that make no sense.
Quickly you should learn what your monthly and annual expenses are, which can give you confidence in learning how to lower or minimize the things that you don't care about and that are draining your resources. Measure and sum up everything. Do not guess. This is very personal and tracking it makes it much more enjoyable because you get to make the decisions about what you want to worry about instead of being told how to save money or what you should or shouldn't spend your money on. But if you can't measure it, you can't get anywhere financially. You are toast.
2. No new loans
No toys, no restaurants, no new car, no second mortgage on credit.
If you have loans and you are not making your way further down this list, then you have no business taking out new loans. They will just bury you and enslave you to your banker.
If you need to get to work try a bike or take the bus. This will save you a lot of money. And if you have a problem and you need a new car quickly then maybe you should move closer to your place of employment. Save up and buy a car with cash or buy a used car. Or keep your old car.
If you are making your way far down the list, then perhaps getting a modest home with a low interest mortgage and a large down payment can make sense, but having an expensive mortgage is not a badge of honor, it is a badge of helplessness. And yes in many areas owning can be more cost-effective than renting, even including mortgage interest. However understand that a home is in no way an asset because it is a house shaped hole in the ground that you throw money into. Expect your home to cost money and maintenance and repairs even after you own it. And that does not include land tax. Heaven help you if you live in somewhere with a Very High Cost of Living!
3. Emergency cash fund
Save up six months of expenses. So for example if you are out of work this will cover your expenses for six months. Note that this requires knowing how much your average expenses are for a month, which requires tracking your expenses as above. The emergency cash fund is only for that—emergencies. If you are lucky then you will die with your emergency cash fund untouched. In the end it is not that much money because you plan to be so rich that the small pile of cash will not be tempting to spend. Another way to look at the emergency fund is as insurance against having to take out loans (unpaid credit card balance!) for important things like food and shelter, a new pair of glasses, tires for your car, or a mattress to sleep on.
4. Pay off loans as fast as possible
Start with the highest interest loan first and pay that off as fast as possible. Then pay off the next, etc. If you have extra money you should split it up between building a tiny emergency cash fund and then focus on paying off loans as fast as possible. Having a loan is being enslaved. You need the enslavement to end so you can start making your money turn into more money for you instead of for someone else.
Pay off credit cards as fast as possible and always pay them off every month—no exceptions. Credit cards are okay especially if they give you cash back but they should not be used to buy things that you do not have the cash to pay for. Use credit cards to pay for your regular expenses and if you like having your expenses centralized in one place that can be useful too.
5. Always max out 401(k) (403(b) for non-profit) if employer offers one, or Roth IRA if not
(For those who cannot contribute to a Roth IRA, consider learning about the back-door Roth IRA through an empty Traditional IRA. Check with your tax accountant.)
The tax savings from a 401(k) or Roth IRA make this one of the best places to put your money and there is no excuse not to max it out every year. If you start a new job a simple rule of thumb is to set your contribution to 60% or 75% so that you fill up your annual contribution limit as fast as possible—this lowers your tax burden and still leaves room for you to pay your payroll taxes (social security, etc.) and ensures that if you lose your job or find a new job without a 401(k), then you have already maxed it out for the calendar year. And of course this will not be a burden because at this point you have no loans and you have an emergency cash fund. Get that money saved as quickly as you can and then worry about saving even more money in other ways. See below.
Your goal is not to “save some money,” pat yourself on the back and then spend the rest, your goal is to save as much money as possible for some years until you have saved up so much money that you can do what you want with it in the future. Remember: figuring out how to spend money is easy, but saving money is a bit more work and takes more discipline but always pays off more than you can imagine.
6. Start buying mutual funds
I will let you in on a juicy secret. The rich do not want you to know this, but making money from money is as easy as opening an account online. (No I do not mean a stupid savings account at your bank which pays you nearly zero.) The secret is called buying assets. No they are not guaranteed to make you money, but on average over time they will make you money. That is why they’re called assets. It is like being the owner of the casino. The odds are in your favor and over time you will have a small but steady pay out.
Early in your saving journey, save as much money as you can in the stock market. Go to vanguard.com and open an account. Buy mutual funds such as Vanguard S&P 500 Index or Vanguard Total Stock Market Index. This is very simple. You are avoiding portfolio risk by diversifying broadly and you are saving a lot of money by having very low expense funds (low expense funds are very important). These are not managed funds and you are only paying taxes on the gains and dividends that you make.
Don't worry about watching the stock market price go up and down. Stocks generate dividends and pay them out to you on a regular basis. Unless you are living off of your portfolio you will not be selling stocks so low prices are not a bad thing, they are a good thing and a signal to buy more, just like when you see a loaf of bread for sale at the grocery store. Not a bad thing, just a signal to buy low. See below.
In addition you won't have to worry about reaching into your stock portfolio in order to pay bills in an emergency; that is what your emergency fund is for. And by the time you get to the end of this list you will understand that even in the topsy-turvy world of the stock market, you will not retire until your savings are sufficient to get through even the worst crashes in history. (Which by the way are often followed by some of the best steady gains in history.)
7. Dollar cost averaging
This is a simple way of saying that you should put money into mutual funds on a regular basis. Instead of saving up a lot of cash and then buying stocks once a year or all at once, you transfer money from your bank account to your stock portfolio in reasonably consistent intervals of both time and money.
What this does for you is it helps you avoid the tendency of watching the market for lows and highs. When the market is high you buy the same amount of dollars of stock and you get fewer stocks. A higher market is more risky so you are naturally buying less.
When the market is low you are buying more stocks because they are cheaper and it is less risky to get in at a lower price. Over time this will smooth out the bumps and on average will give you higher returns. It is a simple matter of mathematics.
A caveat to this is that you should not hold on to a large chunk of cash in order to put it into the stock market in small pieces. The opportunity cost is too high. You should also not try to time things. Just put excess cash in as quickly as you can and consider that your “dollar cost averaging” strategy: you are planning to save continually, in other words, not save up and buy a year’s worth of stock all at once.
8. Bonds and the 40% / 60% rule
Buying just stocks as mutual funds is not necessarily the best way to maximize your returns and minimize your risk. It is simply a smart way to get things started, especially early on, long before you retire and you do not need quite as consistent of returns.
In order to take advantage of swings in the stock market, you have to have money in something else so that you can sell that something else and buy stocks when they're cheap. Or you need to be able to sell stocks when they are expensive and put it into something else. This something else is called bonds.
Bonds are simply IOUs issued by corporations or states or municipalities to fund whatever they need to fund. They borrow money at a certain rate and then pay out at the rate. Bonds can be bought and sold with the prices going up and down so there can be risks and in addition some bonds payers may default, that is not pay on time. You can think of bonds as sort of like being a banker without all of the crazy headache of tracking down people and making them pay, breaking their kneecaps, etc.
If you felt like doing a bit of math you could compare the current stock market rate of return with the current rates on bonds and based on their price difference allocate your portfolio proportionally. So for example if bonds are earning 8% and stocks are earning 12% then your non-cash portfolio would be 60% stocks and 40% bonds. However you might have to do too much buying and selling for this to be reasonable and you can instead use a historical rule of thumb which is just to balance your overall (non-cash) portfolio at 60% stocks and 40% bonds. You only need to rebalance your portfolio every few months or quarterly. And if you are still actively saving money from wages then you can simply rebalance by buying bonds when your stocks are high or buying stocks when your percentage of stocks is lower.
Vanguard has a number of bond funds available. In addition you can buy the Vanguard Balanced fund which is already balanced at 60/40. Another actively managed fund that balances bonds and stocks is the Vanguard STAR fund. Past returns are not an indicator of future returns but in the past this fund has done very well in up and down markets.
9. Buy and Hold
Your goal of keeping your money in mutual funds is not to obsess over returns or try to optimize or max out your returns. You will hear a lot of advice about how the market is efficient and is basically random and you should not try to beat it by timing individual stocks, etc. The efficient market hypothesis is pretty much false—simple calculations based on fundamentals like cash and revenue often show that many individual funds can be over- or undervalued in very obvious and dramatic ways—but the advice is still good advice. Do not try to beat the market; simply understand the rules and try to maximize your average returns. Prove to yourself that you have the discipline to avoid selling off when the market goes down and avoid buying into the hype of the market and overbuying when it is too expensive.
The other part of buy and hold is that you should understand that the stock market pays dividends. All of these companies are working hard and trying to turn profits, which they then write as checks to you, which you then reinvest. As an owner of these companies you get to sit back and enjoy the dividends however high or low the price of the company goes. In addition a lot of selling incurs a lot of extra taxes. So “buy and hold” is both pragmatic advice to avoid fees and taxes, and to avoid costly mistakes from guessing wrong as a day trader; and philosophical advice to help you be a more patient, long-term investor. You are not trying to buy something that you know is overpriced in order to sell it to some greater fool at a higher price. You are trying to get a good value on a pile of honest companies turning out consistent profits over a long period of time.
10. Watch and Wait and the 4% Rule
An important part of investing is patience and goal-setting. If you are not buying shiny or tasty things with your money and you’re not letting your money sit in your checking or stupid savings account, then you should at least get some enjoyment out of counting your money. Develop spreadsheets and charts (mint.com? YNAB?) that help you track your net worth and use this to set goals for however you plan to use your money. As you invest for longer you will diversify and have more accounts to keep track of. It is nice to be able to see everything in one place and get a bird's-eye view of where your portfolio could use more work or where you are insufficiently diversified. (And as you diversify more broadly you can try small experiments on more risky ventures, also called speculation, which will likely have a very small impact on your overall returns, unless you are very lucky.)
If you hear about the 4% rule, just know that it is a simple rule of thumb that tells you when you have enough money to retire. Simply take your annual expenses and multiply by 25 (same as dividing by 0.04). So for example if you spend $24,000 a year then you only need to save up $600,000 before you can live off of interest and dividends. The mathematics is incontrovertible.
At this point you are only working because you want to, not because you have to in order to pay the bills. Or perhaps you are working because you are trying to meet other savings goals, such as paying off all of the principal on a mortgage in order to lower your expenses in the long-term, or you are getting involved in saving up to buy a rental property, which might produce income in the long term as well.
The 4% rule of thumb is based on the idea that you can safely withdraw a fixed amount of money per year with the gains that you make replacing that amount on average every year. This rule of thumb is very conservative and based on worst-case scenarios of thirty-year periods of the United States stock market. (The rule also accounts for inflation.) In all likelihood this “maximum withdrawal rate” will not prove to be a problem in practice, especially if you end up retiring early, because you can always find other sources of income or live more frugally, etc. You can also pick more conservative numbers, like 3.333% or 3% or 2.5% (30x or 33.3x or 40x your annual budge) if you want to be able to weather any storm.
The 4% rule of thumb can also be looked at as a way of making sure you have enough to retire for a quarter or third of a century, with compound interest turning this into retirement for longer than you will ever live.
Using this math, $100 saved is one penny earned, every day for the rest of eternity. Or $10,000 saved is one dollar earned, per day, every day, forever. Or, if your daily expenses are around $60-$70 ($24,000/year), then saving around $600,000 will pay your expenses every day, forever.