Posted in Budgeting, Personal finance, Savings

It is not a good IDEA

There are four aspects of personal finance that we deal with every month, unlike taxes and insurance which are typically annual affairs.

  • Income
  • Debt
  • Expense
  • Asset

Thus the I, D, E, A is what one deals with every month – month after month in that same order.

Typically a household finance (or monthly cash flow) goes like this:

Income (I) -> Pay Debt (D) -> Pay Bills (E) -> If left over, invest in assets (A)

The problem is that the IDEA is wrong. It will never make one financially independent as the Asset part is only an afterthought, and mostly never happens.

This requires a correction in perspective and is much touted by financial advisors as Pay Yourself First, where A should come before D and E.

So the IDEAL sequence is I,A,D,E,L.

Income (I) -> Pay for Assets (A) -> Pay Debt (D) -> Pay Bills (E) -> If Left over (L), have fun. 

The last part if consistently found to generate surplus, can also be adjusted for subsequent months to increase the “Pay for Assets (A)”.

How does one do this course correction? Here is one simple technique.

  • You know how much Income comes in. 
  • Decide a percentage (start a bit aggressive, like 20%) to set aside for A. 
  • But do not invest yet, just set it aside to another savings account. 
  • Pay your debts (D).
  • Pay your bills and monthly expenses (E).
  • If shortfall, pull a bit from the A saved aside. 
  • If not, good news. Invest the 20% into assets (A) and enjoy any surplus (L). 

This habit if done over 3-6 months, will build the automatic flow of savings and investment.

The sequence described above has the following automatic advantages.

  • It starts with an aggressive savings goal of 20%. 
  • As one sees the expenses budget drying up towards end of the month, it encourages one to cut unnecessary spending. 
  • The savings is still saved aside till the end of the month, so can be pulled in if needed. 
  • Pulling in the savings every month however has a mental resistance, hence should be difficult to do month after month. 
  • To make it more difficult, put the A into another bank so that the transfer will take some time and effort to execute. 
  • As one adjusts to a comfortable level of savings (A) percentage, it brings in awareness of how the budget and cash flow works. 

The IDEA is not so bad after all, you just need to fit it in the right sequence to work.

  • No coupon cutting
  • No writing down daily expenses
  • Automatic resistance to debt
  • Steady build up of assets. 
think outside of the box
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Posted in Budgeting, Investing, Liabilities and Debt, Personal finance, Savings, Spending

How to manage your cash flow

A company which is listed in the stock market has to publish 3 essential financial statements.

  • The balance sheet
  • The profit and loss statement
  • The cash flow statement

Briefly, the balance sheet shows the health of the company at the reported time, profit and loss statement shows how much profit the company is making after all expenses and taxes, and the cash flow shows how the company is generating the cash from its operations as well as investments.

Free Cash Flow (FCF) is an important metric that is used by investors to evaluate the real worth of a company. 

In personal finance, while balance sheet (Your net worth) and profit and loss (how much you are making and spending) are important, managing the cash flow is key to achieve your financial goals.

In this blog, we will talk about how to manage your cash flow – no matter whether you earn a lot or earn an average paycheck.

Most people do not manage their cash flow, forget about doing a budget or any other conscious form of tracking.

At the end of the month or year, we wonder where all the money earned went.

Conventional ways of managing cash flow

There are several techniques Personal Finance experts have championed time and again.

  1. Do a budget, track every dollar. 
  2. Create an envelop for groceries, utilities, fun etc.
  3. Use separate accounts. 
  4. New automated solutions like Stash, Digit etc. 

All of these are good methods, but the problem is sticking to the discipline of maintaining it day after day, month after month.

Isn’t that boring and worrying at the same time? Few issues with these approaches are:

  • Writing down expenses every day
  • Stuffing that envelop and counting the money every time before spending
  • Keeping track of multiple accounts
  • Not knowing how much the AI driven savings app is going to deduct next month

So is there a simpler and better way?

Just like most posts in this blog, I seek simplicity and automation.

The simpler way of managing your cash flow

There are 4 goals to managing the cash flow every month.

  • Invest for the future
  • Save for the short term
  • Pay your bills 
  • Spend the rest

In fact, any wind-fall is also a one time cash flow, and can be fit into the same framework.  Lets say you got a bonus of $1000, for example, the Govt is sending a check to all Americans. And if you want to keep it simple, allocate 25% to all the 4 goals.

  • Invest $250 in your long term (retirement, child education) plans. The market is down and you can invest $250 in a mutual fund or an ETF. 
  • Save $250 for any short term goals that you have. It could be added to your monthly savings goals, towards anything like vacation, buying that new phone, or simply emergency fund. 
  • If you have consumer debt, why not allocate some to pay it off? Use $250 to pay off the highest interest or smallest balance credit card. 
  • Now you have $250 to splurge on. Buy that favorite book, order the special meal or decorate your home. 

But how do we automate and manage the cash flow every month?

  • Invest – Direct deposit investments. In fact most employers have systems to auto-deposit 401-k investments or direct deposit to your chosen brokerage firm. 
  • Save – Auto transfer to a savings account from your checking account. 
  • Pay Bills – Setup auto-pay with your credit card or debit card. Set the bill payments mostly towards beginning of the month. 
  • Spend – Use your debit card to spend – it will tell you when the money runs out. 

Once setup, the only stress you have is the last bullet, where you have to make your spending within the limits, or rather the residue after all obligations are set aside or paid off.

How it can snowball into Financial Freedom

As you get consistent with stashing money away for investing and savings, those may generate additional cash flow or assets which will come back to bolster the spending budget.

Thus cash flow is a virtuous cycle once set up the correct way. Lets take some initials and approach this from a math perspective.

  • J – Job Income
  • R – Retirement
  • I – Investment
  • S – Savings
  • B – Bills
  • E – Expense
  • P – Portfolio Income

J + P = R + I + S + B + E

I can produce P in terms of interest, dividend or rental income.

silver and gold coins

In the wealth accumulation years, the goal should be to increase J, so that I can be increased, which when invested can increase P. P is added to J and a part reinvested, saved or used.

As you reinvest P, it will generate more P till at a point, J becomes less and less important. 

This cash flow situation is called Financial Freedom.

Conclusion

We just presented a simple and fully automated cash flow management system for personal finances. It does not take much discipline and will power to stick to it, once correctly setup.

This is also explained in more detail in the post The SAFE plan – Simple, Automated, Flexible and Efficient .

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woman standing on cliff
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Posted in Personal finance

Five FAQs of personal finance

Throughout my journey with personal finance, and through the mistakes and learning, I compiled a list of Top 5 questions that come to my mind, time and again. 

So I decided to compile these as a FAQ and try to answer them to the best of my knowledge and experience. 

  • Buy vs. Rent
  • How many accounts to have
  • How and where to invest
  • How to save more money
  • How to manage my portfolio

Buy vs. Rent?

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One of the biggest financial decisions in everyone’s life is to buy a house. However there are pros and cons that need to be weighed against renting similar or better homes. There are lots of views and articles on Internet which give both a logical as well as emotional opinion to this question. In my opinion (just another), only You know better whether you are ready to buy a home.

To put it logically from what I know, there are few costs and factors that need to be considered.

  • Save up for a down payment of at least 20%.
  • Consider closing costs, it can easily be in the range of $4000-$5000.
  • Consider any rehab budget if you are not buying a recently updated home. You will pay for it either way. 
  • Aggregate of all monthly expenses of home ownership should be less than the current rent paid. These expenses are: 
    • Mortgage payment
    • Taxes
    • Insurance
    • Maintenance (1% of home value per year)
    • HoA fees
    • Lawn care and utilities
      • if you had paid these apart from rent, you need to make sure the costs are almost identical

Only after you have made the calculation above, and convinced yourself that total monthly housing expenses will be less than the rent, you can consider buying provided there is the cash cushion of down payment and closing costs.

One argument which is floated in favor of ownership is that rents are going to increase per year, whereas the mortgage will remain constant. However please consider that Taxes, Insurance and Maintenance will go up too year after year.

On the other hand, the mortgage will get paid down giving a little more advantage to the ownership since you are building equity and hence net worth.

The other factor is how long you are going to stay in the home to recoup the costs of mortgage interest, taxes, insurance, upgrades, maintenance etc. 

One day (in a few years), you may want to move out and convert this house into a rental.

Will the rental numbers in the area completely cover all the expenses? You certainly don’t want to pay for new house as well part of the expenses for your tenant.

All of these factors should be taken into calculation before making the big decision. 

The following post may help in setting up the calculation, but I suggest do your own homework too. 

How to decide on a purchase – the P.V.T formula

If you are interested in scenarios of managing a mortgage or multiple properties, here are couple of previous posts on the subject. 

The Paid Piper of Hamelin

Don’t twist your ARM, fix it !!!

How many accounts should I have?

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There are many banks and financial institutions who are vying to keep your money, earn fees and lure you into a long term relationship. These marketing flyers and lure of higher interest rates or credit offers make us open many bank accounts indiscriminately.

The more you spread out without a purpose to each account, it will become unmanageable and have overlapping features. There are many cases where people (or spouses after the death of one) forgot about their accounts, and the money lies there idle never to be claimed again.

So bank and brokerage accounts all should be tied to specific goals and purpose in your regular financial picture. Typically the following should suffice:

  • A checking account and a debit/credit card
  • A savings account, if more than one, each should be for a specific saving goal
  • A retirement account (typically 401k or IRA)
  • An investment account (outside the 401k/IRA for medium term investments)
  • A special purpose account depending on needs
    • 529 – Kids’ education
    • HSA – Health Savings Account if you have high deductible insurance

Beyond this, it becomes fancy and unmanageable.

The following post shows a step by step guide to open and manage these accounts.

The Starter Kit

How and where do I invest?

One of the main hurdles of personal finance is to find out how and where to invest. There are many risk-return trade-offs from cash savings to mutual funds to real estate, and even exotic investments like art and commodities.

The simplest investment however is a balanced indexed fund, where there is an automatic asset allocation of stocks and bonds and which can vary according to your age and risk tolerance. These are also called Target date funds. Being an index fund, the costs are extremely low (0.0x%) and you get instant diversification.

Most portfolio should not need more that this. However if you are a little bit more knowledgeable, then you can create your own basket of index funds. For example, the three fund portfolio is very popular. Here is a good link: Three-Fund Portfolio

One of my previous posts mentions the various investment accounts that you can setup. 

Investing in the High Five portfolio

Know yourself and your investments

How do I save more?

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This is one of the questions which has many different ways of asking.

  1. How do I spend less?
  2. How do I pay myself first?
  3. How do I increase my income?

The answer lies in all of the above questions. You have to do all to be able to save for emergency, goals, vacations and fun.

The topic on how many bank accounts to have, takes into account this aspect. It is very important to build a cash cushion along with your investments and lifestyle.

See below posts on why and how to do this effectively.

One essential comfort zone

Budget – Grow the tree upside-down

How do I manage my portfolio and reach my goals?

black mazda steering wheel
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Managing your investments and financial system may not be a complex or time consuming task. It needs essentially three things. 

  1. Automation 
  2. Tracking 
  3. Learning

The following post describes a step by step process for managing and growing your personal finance system. 

Five components of a personal finance system

All it takes is to first setup the automatic payments and investments, then a weekly tracking mechanism and weekly reading and exploring more.

With time, you will start flowing like a pro. 

Shun that perfection

Conclusion

While the list of FAQs above is not exhaustive, these are questions that I have seen people struggle with or make irrational decisions on. Or to put it another way, I have done same mistakes and learnt that if you manage these aspects well, you don’t need to worry any more. 

beard cafe coffee shop connection
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Posted in Personal finance

Take off to the aerial view

Today I am flying to India. I am very excited and looking forward to visiting what is my second home now.

As the long flight from US started very early this morning, a few thoughts on personal finance hovered around my mind.

Before the flight takes off, there are a number of events that take place more like items in a checklist. As the plane’s technicians go through their routine yet stricter checks, as a passenger we too go through some disciplined steps like reaching the airport on time, checking in, clearing though security and finally boarding in a queue. All of these steps are important and must be done in sequence.

Then as I put on the seat belt and the plane takes off, the mind switches off from the low level sequence to a higher level composure. The plane rises above the clouds and I can see the world top down.

Personal finance is also the same. As you go through the low level details of controlling your expenditures, paying your credit card on time, automating a few bills on the way, you slowly but steadily reach the state of composure as if your financial life has taken off the grounds.

You no longer worry about petty coupons and discounts, or avoiding the crave for that latte, or even recording each transaction in your budget app.

Instead, now your systems are automated and you have a pretty good idea of how much is spent every month and how much you can invest.

Now your focus shifts to the clouds and you need to only take a top down view of the financial landscape. You start learning more about various investments, real estate, taxes and start strategizing on how to grow all areas of your personal and financial life.

You can now see personal finance is not just about money but when managed well, can allow you to cruise in other areas of your life as an aircraft in a turbulence free sky.

For example, this holiday is completely planned and paid for and I do not need to stress about credit card balance to afford the cost of the trip.

Complete the ground steps in a defined sequence as the suggested posts below, and then focus on the bigger clouds.

Budget – Grow the tree upside-down

One essential comfort zone

Investing in the High Five portfolio

The clouds that you can focus on once done with above are:

  • Taxes and how to find tax efficient investments
  • Insurance
  • Estate planning and wills
  • Passive income generation
  • Career goals
  • Your potential for earning more
  • Having fun

From time to time you do need to come down and go through the low level steps again, as I am in transit now in JFK airport.

I will be flying to my destination in a couple of hours again.

At the end the sequence matters. You can imagine how chaotic it would be to rush through security without checking in your bags first.

The cruise comes later when you are a disciplined traveler and follow the steps.

Posted in Budgeting, Investing, Personal finance, Savings

The Starter Kit

If you are just starting off with organizing your personal finance, or restarting from scratch, here is a step by step way to get started.

Most of the times, we get started haphazardly, the first account in the local bank or the ad-hoc insurance policy or even the next stock tip forces us to open a  brokerage account.

However there is a need to get started in a more planned way.

When I moved to the US couple of years back, the below is how I setup my money system. I had a similar one running in India for a long time and it has given me very good results.

Here is the starter kit that you need to get organized and get started. 

Since it is built in a systematic manner, it will help you automatically organize and keep your finances in order.

A checking account

This is the first step as you need a place to deposit your income, be it direct deposit from your employer or you get checks at the end of the month.

Get a simple checking account at a Credit Union which provides you with a basic ATM and Debit card. Try to find a credit union or bank which has very low fees. Obviously they will have some like overdraft fees that we will anyway avoid, but others like ATM access are something unavoidable, so shop around a little.

This is where all your income will come in and get deposited. 

A credit card

We are going to be responsible spenders, right? If not, do not get this and use your debit card from your checking account.

The key to being a responsible spender is to make a budget, stick to it and pay off the credit card bill in full every month. Lets just assume you agree to all of this. 

There are many credit cards in the market with various features like cash back, travel rewards etc.

As a starter kit, you will just get one from the same bank or credit union where you hold your checking account. The reason is ease of payments and setting up automatic transfers from your checking account to pay it off at end of month. 

The bonus will be of course if  the card also has generous cash back benefits or other similar perks. But get a free one and not one with annual fee loaded just for extra perks.

The credit card will be your main expense vehicle. It gives you automatic fraud protection, insurance and easier account tracking. 

Budgeting

If you do not do any further, you have setup the very basic system. You earn money which get deposited into the checking account, you spend with your credit card (on a budget!!) and your checking account pays it off every month.

But this sounds like living paycheck to paycheck or Living on the Edge, right?

We are going to do better – save and invest. 

First what we need is a planner. As the above system of checking account and credit card gets working in a flow, you will start getting an idea of how much you are spending every month.

For the next 2-3 months, track your spending to categorize your money into only 4 parts.

  • Food and Dining
  • Utilities and Transportation
  • Clothing and miscellaneous
  • Surplus

You will automatically get motivated to squeeze the first 3 categories and increase your surplus every month. 

Check out this post on how to budget: Budget – Grow the tree upside-down

The above technique will help you generate surplus for both savings and investment, make it your goal to only increase it and not fall back to paycheck to paycheck cycle.

Savings Account

There are unexpected events or expenses that will always come up. You need to be prepared for it and the only way is to build up a cash cushion.

One essential comfort zone

This is similar to Dave Ramsey’s first 3 baby steps, where you start with saving $1000, then get out of debt (hopefully you have none if you started with this) and finally build a cushion of 3-6 months of expenses.

I use an online savings account like CapitalOne 360, Ally Bank or Synchrony. There are many others, and online banks provide little more interest on your deposits than brick-and-mortar banks, or the one where you have your checking account.

Setup an automatic transfer of your Surplus from your checking account to this Savings account. Set this up for beginning of the month, so that your budget works with just the right amount needed (to pay off the credit card at end of month). 

Investment Account

Get to this step only when you have a running budget, able to generate surplus consistently and stacked up 3-6 months of expenses in your savings account.

From here on, you become a pro in personal finance as you are about to invest and grow your net worth. 

There are two main investment accounts, a retirement account and brokerage account.

Contact your employer for a 401k (Pretax or Roth) account and contribute to it, if there is a match. If this exhausts your projected surplus, no worries you have got started.

If there is still surplus, good news. Open a brokerage account in one of Schwab, Vanguard or Fidelity. Preferably open a Roth IRA account if your income is within eligible limits.

Roth IRA rules

Then invest in one or two broad index funds with very low expense ratio (< 0.05).

Here is a classic 3-fund portfolio from Vanguard index funds.

  • Vanguard Total Stock Market Index Fund (VTSAX)
  • Vanguard Total International Stock Index Fund (VTIAX)
  • Vanguard Total Bond Market Fund (VBTLX)

Similar portfolio can be constructed from Schwab Funds too.

https://www.wallstreetphysician.com/three-fund-portfolio-using-schwab-index-funds-etfs

Managing and growing the investments

You have done a great job in the above steps and at par with average disciplined investors.

In investment world, “average” is what wins. If you get average returns of 8-9% over a very long time (decades), there is nothing more you need to do. 

To know how to structure and maintain your investment accounts, read this blog post

Investing in the High Five portfolio

Conclusion

The above is a simple 5-step process to take you from a personal finance newbie to a disciplined investor and saver. Taking action in a systematic way is the key to financial bliss.

If you need motivation to get started, read this:

Shun that perfection

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Posted in Personal finance

Shun that perfection

One of the lessons we learn in our early childhood is to be perfect in whatever we do. We were told if you are not perfect, you will not be able to compete in the real world. 

While it may be true for some disciplines like music, medicine and mathematics (the only subject in our times in which we could score a perfect 100/100), personal finance needs an opposite attribute.

There is nothing perfect about investments, budget and savings.

Things change rapidly like the stock markets fall when a leader in some nation sneezes, or unexpected events in life happen.

While the perfectionists among us keep waiting for the sun, moon and the earth to align to begin to invest or budget. Some of the common quotes which I am guilty of uttering at many times in my financial life.

“I will invest once I get the next raise” – when and who guarantees that today?

“I will save from next fiscal year” – hello, which fiscal year and which month does it start?

“I am too scared as the markets are going down”  – which means I will invest when they are up, exactly at the wrong time.

The end result is that the perfectionist gets a perfect ZERO in his/her investment and savings goal. 

You have to unlearn the perfections and not apply them at all in personal finance.

What is important is to get started and be consistent. 

Anyone who has not yet started or planned own finances should do this in below 3 steps.

  1. Budget – Keep it simple by following the methods described in : Budget – Grow the tree upside-down
  2. Invest – Slowly build the 5 account portfolio. Start today with at least one of the accounts : Investing in the High Five portfolio
  3. Save – Save for your important goals even if you allocate just $50 to one goal today : One essential comfort zone

Perfect plan? Now execute it imperfectly by just getting started.

Write one goal each of budgeting, saving and investing for this week. 

notebook
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Posted in Budgeting

Budget – Grow the tree upside-down

Many people cringe at the thought of a budget. Budgeting sounds like nit-picking about finance and a lot of work to keep tabs on expenses, planning etc.

It sounds highly restrictive in the traditional sense. However there are ways to simplify it and make it automated, so that once you set it up correctly it works by itself.

There are many books and resources on the internet on budgeting techniques. Some of them ask you to be mindful of every dollar while others are more liberal in that they talk about setting and adjusting ratios (30% invest, 40% expenses and so on).

In my experience, a simpler technique worked wonderfully and nicely adapts to changes in income and lifestyle choices.

I call it the repeated divide into 3 parts and allocate.

To keep this short, lets take an example and work this budget out.

  • Income = $50,000/yr [Average range in America, taken just for illustration]
  • Taxes = $12,500/yr [It will vary based on filing status etc. average 25%]
  • Take home = $36,000/yr [$37,500 reduced by 401k contribution etc.]
  • $36000/year = $3000/mo

The first divide and allocation goes towards 3 main goals. 

  • Investment – Remember the Pay Yourself First?
  • Expenses – You have to live, don’t you?
  • Housing and Miscellaneous – Typically for most people, this takes about 30%

So from our example, now you have 3 categories – $1000 to invest, $1000 to live on and $1000 on housing.

This automatically challenges you to live within your means, invest and allocate money to whats important. And yes, without a ballooning credit card debt.

Now lets apply the next level division on each of them.

First we will take the Expenses. 

3 major categories are Food, Transportation, Utilities. I know there has to be the fun part too, but we will come to that later.

Here for simplicity or to start with, you can equally allocate:

$300 for Food, $300 for Transportation and $300 for Utilities.

Keep $100 for variation in any of these.

Over time, the ratios will be adjusted as you learn the spending pattern more. The reward – $100 towards fun if you are able to discipline yourself to keep the 3 categories within $300 each. More rewards follow, read on.

Next is Investing. Again we may divide by 3 into the simplest asset allocation. 

$300 – Stocks, $300 – Bonds, $300 – Cash

[Keep $100 for variations] 

These can be varied based on your risk profile, age etc. but to keep things simple or to get started, what works is an equal emphasis to all. The cash component is for safety factors (towards your emergency fund) or you can invest in REITs (Real Estate Investment Trusts), if you already have a safety cash cushion.

The last $1000 is for housing and miscellaneous. 

Now here there can be multiple scenarios. Lets consider some, or you can be creative applying the divide-by-3 rule according to your situation.

$400 – Rent or mortgage. 

$300 – savings for other goals – vacation, maintenance, taxes

$300 – Flexible. This is the amazing part – you have just budgeted yourself for free money.

I don’t care what you do with this, but having this is a huge peace of mind.

It is a reward for sticking to the divide-by-3 rule and making it work.

Conclusion

The budget grows like a tree upside-down. You can grow it as you further divide your categories. For example, Transportation can be broken down into gas, insurance and car payments.

Similarly savings can be broken down into vacation, maintenance or down payment for a gadget/car/home.

This model of the budget also adapts to raises year after year. All your branches will increase enabling you automatically to invest, save and spend more.

The more money you put on the top, the richer it makes you at the lower nodes, and improves your lifestyle, savings and investments. It directly encourages you to invest in your talent, increase your income and enjoy that dinner out.

A-labeled-ternary-tree-for-labeled-k-ary-trees-is-the-same-as-a-power-series-as-the

Plant your budget tree today. Water it, grow it and enjoy the fruits at the leaf nodes.

Information : We computer geeks call it a Ternary Tree. 

https://en.wikipedia.org/wiki/Ternary_tree