Sunday, May 13, 2012

Personal Finance Overview

It has been a little more than a year since I first started this blog, and I think it would be appropriate to summarize the main takeaways from all the information I have so far compiled on this site.  The overarching problem I try to address is that we are going to need money for our entire life over our entire life.  The problem is that the time when we earn money isn't as evenly spread out with most of us earning a lot more in the middle of our lives rather than near the beginning and end.  When we are kids, our parents help provide for us but when we grow old, we will rely on our middle-aged selves to push some of the income into retirement through saving.  And we look at the process through the lens of personal finance.

The core of personal finance has to be the budget.  Everything always boils down to the simple relationship between what you earn and what you spend.  What is the key insight to stay financially healthy?  Spend less than you earn.  That's it.  Obviously, this is oversimplifying the issue since there are different degrees of how much less than your income you should spend, but if there is one takeaway I had to give anyone, it would be that.  I give many recommendations about getting credit cards but those only net you a gain if you can control your expenses and spend only what you normally would with cash.  Especially for college students getting credit cards for the first time, know that you are still paying for whatever you buy, even if you don't see it leaving your pocket right away.  And if you don't pay off your bills immediately, you will also be paying your credit card company for their services.

The budget is used to segregate where your income goes.  The easiest way to think about the budget is how much of your income goes to necessary expenditures or your "needs," special treats for yourself or "wants," and your savings for future consumption.  If you wanted to see it as a mathematical equation, it would look like this: Income = Needs + Wants + Savings.  A good percentage to allocate to your savings is 20-25% of your income, but this number will vary from person to person depending on your goals and discipline.  Anytime your savings is 0% or negative, you are in a very dangerous situation financially since you are spending more money than your income can support.  Take a look at how your budget balances to make sure you are on track to avoiding many problems associated with getting trapped under debt.  As your income increases with your career, try to put as much of your salary increase into savings and needs and limit your increases in wants.  Your needs and wants give you current satisfaction and gratification, but in order to secure a decent standard of living for your future self, you will need to be able to delay some of your consumption though saving for the future.

There are a few smart things you can do to lessen the burden of saving a lot through investing what you do save and growing your wealth.  The biggest threat your savings faces is inflation (aside from a person's own reluctance to save).  Over time, the value of your cash saved for the future will drop in value because of inflation.  The amount used to buy a year's worth of gas in the mid-1900s can probably buy only a few days' worth now.  To protect your savings from inflation, you can try to invest your money into something that increases in value as inflation increases.  Stocks are a good example since as the economy improves, inflation increases and the value of the stock market as a whole increases.  Inflation protected treasuries known as TIPS are another example from the fixed income side.

On the other side, sometimes what you want to focus on is not growth but liquidity of your savings.  You will need money throughout your life, but sometimes the issue is that you won't know when you will need it or how much cash you will need.  You want to try to keep your expenses steady over time to prevent any unexpected need for cash.  Emergency savings are a good thing to keep on hand in a checking or savings account somewhere.  Insurance can also help spread out the cost of emergencies over time at a small premium cost.  With good control over your expenses and risks, you should be able to limit the cost of getting money to pay for emergency spending on health bills or home repairs, especially since these risks tend to grow as we age.  It is often difficult to strike a fine balance between protecting yourself against inflation and protecting yourself against a shortfall of cash, but it is important to take the time to think about these issues early on.

It is sometimes hard to think about saving since you won't really need the money until you retire.  You will have income from your job to support whatever consumption you need until you decide to stop working, but depending on your lifestyle, it is never too early to begin preparing.  Opening an IRA now can help you save thousands or tens of thousands of dollars in taxes by the time your retire.  Minimizing your tax liability lessens the burden to save and gives you the option to spend the money on current consumption or saving it anyway for extra security.  There are other ways to supplement your savings and income like through cash-back programs with credit cards or finding the bank account that offers the highest interest rate.

What is most important is to prepare yourself early on and learn as much as you can.  Making mistakes are great if you learn from them, but it is important to try to learn from other people's mistakes when you can. I have seen that a lot of young adults don't seem to care too much about managing their money or discount the importance of learning these skills.  It takes a lot of practice and discipline to become financially independent and secure, and the earlier you start, the easier it will be down the road.

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