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Personal Finance 101

November 24, 2014

Stock options, derivatives, arbitrage, foreign exchange markets, liquidity traps… confused?

Whats superannuation? Um… Ah… I haven’t been saving. What? “Lets just… see what happens man.”

Student, these are two different types of misguided people. The first is completely baffled by complex terms and ideas beyond the comprehension of mortal men. The 2nd is a person who might end up in debt, be shackled by credit cards etc.

Student, you need to learn. This Personal Finance 101. Listen up!

The Goal of Personal Finance is…

… To get rich, right?

No.

The goal is financial freedom. What is financial freedom? The capacity to be able to spend money without having to worry about the consequences. For example, you’re financially free if you have 6 months worth of savings. In such a situation you have the freedom to pursue a side job, hobby, or consider giving up your job for some other growth opportunity. The aim of personal finance is to build your wealth. That is, the stock of assets you own.

Some people consider high wealth to be ‘rich’ . Perhaps that’s the case. When I think of ‘rich’ I think of ‘lavish’, or notes being able to be frittered away. Rolling in money. But I also think of high income earners who spend a lot. And here’s the secret – it doesn’t matter if you earn a ton if you spend it all! In that case you’ve been able to buy stuff, but you’re still chained to a job, and every paycheck. If some emergency occurs you’ll panic because you’ll be in trouble. If you lose your job you’re screwed. Even when these things don’t happen, you’re stressed out because you know you couldn’t handle them if you did. There are shackles holding you in place, bars surrounding you. And you’re tired, scared and stressed at the guards sending you out to a stay of execution.

We want financial freedom, and to build wealth.

Core Rules

The world is a complex place today, and the financial architecture is as complex as its ever been. But let me give you the 2000 year old financial secret guaranteed to build wealth.

Spend less than you earn. Invest the difference.

And there you have it class, your goals to riches. At heart, that’s all you have to do to become wealthy over time. You want more wealth or to achieve greater freedom or get it faster? Increase the gap between spending and saving (in favour of saving) and invest it better. That’s it.

Does that sound too simple? Okay, there are 3 pillars to wealth creation, in order of importance:

  • CORE RULES
    • Maximise income
    • Minimise costs
    • Invest the difference

Let’s break these down.

Maximise Income (Y)

When people think of ‘rich’ they think of high rollers raking in tons of money. They have a point. The most important way to create wealth is to maximise income. Why? Because though being frugal is important, there’s only a limit to which you can cut expenses – to $0, and more in real life. Theoretically though, your capacity to heighten Y is unlimited. And in practice it’s a lot easier to increase Y by $5000 than minimise costs of $5000.

So, how do you maximise Y? Here’s some key ideas:

  • Start a side hustle or second job. (Join the Army Reserves!)
  • Expand your hours at your current job is possible
  • Improve your qualifications / get educated / improve your skills. The more you know, the more you’re worth. It also opens new doors.
  • If you’ve improved qualifications, negotiate for a salary raise
  • Sell whatever you own
  • Pursuant to these – build connections

Minimise Costs

Often people will say “if only I had that much money, I would be fine”. Yet high earning lawyers can be just as ‘tight’ for cash as a low earning waitress. Why? Because they spend all their extra cash. Okay, they get experiences and material objects in abundance, maybe a nicer house, but they still have the same ‘problems’ with money – stress, making ends meet etc.

The reason this happens is “lifestyle inflation”. You increase your lifestyle to match your Y. Which is fine – you do want to make use of the extra cash – but not if all your extra cash goes towards it!

Minimising costs means eating out less. It means maybe not buying a massive television. It means holding off on a new smartphone. This may sound boring. It is. Luckily, minimising costs doesn’t mean just that. Some advice:

  • Buy a small house
    • Housing is the most significant cost you’ll have. You want to minimise regular interest repayments as much as possible! Play hardball on interest rates, regularly renegotiate, increase repayment costs early in the loan… and reduce the debt!! Seriously, if you get this under control you’re acing it!
  • Reduce use of motor vehicles
    • Its cheaper to walk. No parking fees… Keep upkeep costs low if possible. Watch car loan rates.
  • Prefer used instead of new more often (see above)
  • Cut unnecessary insurance
  • Spend purposefully – know what you want to buy. Have a budget, and track spending to make sure you meet that budget.
  • Minimise tax (legally!!)
    • Salary sacrificing, tax deductions, shading schemes to reduce taxable income… Stay on the side of the law please.
  • AVOID DEBT
    • Debt will shackle you. Debt grounds you from achieving flight into financial freedom. If you must take on debt, ferociously fight on interest rates. A 1% difference over 30 years is a LOT of money.
    • Don’t get me wrong, borrowing is a powerful way to realise current goals. Just realise that you want to pay more than ‘minimum repayments’, and you want to aggressively reduce debt. Debt decreases at an increasing rate. In short, the start is very, very painful. Do all you can to expedite repayments.

Ultimately, cutting costs isn’t about being a scrooge. Its about 1 or 2 compromises in areas of large payments, and purpose led purchases to find what you really want and need, not whims of the moment. People would tell you to save 10% of your income on top of super. If your costs are low, you can look at saving maybe 30% of your income. It depends on your costs (Sydney housing anyone?).

Don’t underestimate the value of saving costs. Be frugal.

Investing

Making money and saving lots and not spending much? Cool. Now… what do you do with it? If you sit there it decreases in value due to inflation. If you invest it in a savings account or something similar, you get minimal returns.

There’s a phrase that goes something like “making the first million is bloody hard. Making the second million is easy” . Money can breed money. Here’s investment advice:

  • Make use of *any and all* government contributions
    • Governments may encourage saving or have tax loopholes. You want to exploit these (legally). Eg. Government co-contribution for super
  • When young, invest in high growth options. Ignore the news, keep investing regardless of the market. You have times to ride the ups and downs.
  • When older, be more conservative
  • One of the big aims of investment is to build PASSIVE INCOME. What this is is money that flows in without you doing work. Rent from a property (lets leave gripes about rent seeking for some other articles) , commissions from product sales, advertising revenue etc. The point is that if you’re investing in items that build you a passive income, then you are reducing your dependence on a job and other income to fund your existence. Passive income is VITAL to achieving financial independence.

After this investing, just remember a few basic ideas. Review investment, income and savings every few months. Reevaluate your items. Align spending and income with your financial goals. Be cognisant of your situation.

Conclusions

The world of finance is complex. The world of personal finance is simple at heart. The basic principles I’ve discussed today are all you need to know to succeed, build wealth and achieve financial freedom. Is there more to know? Yes. Could it help you? Yes. But that is all quibbling at the edges.

Build your foundations first. Remember today’s common advice. And you shall succeed.

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