There are different approaches to saving money. Whether it's saving for a short term goal or saving for your retirement, people go about it in a variety of ways.
I admire those who have a set amount which they put aside each week (or each month) before they spend any money. I call these people conscious savers. It's a regular savings plan. The money is normally deducted from their pay or taken out of their bank account at the beginning of each period.
This sort of approach works for these people because there is a risk that if the money is not put aside immediately, it will get spent. It's a smart move and it lends itself to better long term planning, whether that planning relates to reducing debt or investing for the future or saving to buy a house or whatever.
Unfortunately, I'm not that disciplined. In fact my approach is the exact opposite. I tend to pay all of the bills and spend what I need to each month and only at the end of each month does what's left over get added to our savings.
Fortunately, that works for us. We don't have extravagant tastes and lead a fairly middle of the road existence and our income has always been such that we've been able to add enough to our savings each month to pay off all of our debts, including our mortgage and accumulate a reasonable investment portfolio that will someday become the foundation of our financial freedom.
Despite our success in the past at just following a saving what's left over approach, I do wonder whether a more conscious approach would put us further ahead over the long term. Maybe the extra financial discipline would enable us to save that little bit extra and help us reach our financial goals earlier.
The downside, as I see it, is that we may feel more constrained at living this way. There may also be more stress on our relationship if we attempt a more rigid approach to our personal finances.
You have your budget in place. You're spending less than you earn. You've started to save money on a regular basis and you're starting to accumulate a handy little pile of cash. So what's next? It's time to start thinking about another very important part of personal finance - investing.
Investing is the mechanism by which you will make your money grow. It is the act of buying assets which will grow in value and/or produce income over the years to come. Investing your current and future savings at a reasonable rate of return will help build wealth in order to reach your future financial goals.
But how do you get started with investing? Today I'd like to discuss a broad group of investment strategies which advocate a relatively simple and hands off approach to investing.
While most us us have heard of legendary investors like Warren Buffett, there is a theory floating around which says that the average investor wont do anywhere near as well as Warren Buffett. In fact they will struggle to beat the average because the average itself is made up of a bunch of average investors. Even more importantly, just to earn a return equal to the average should be considered a success.
This is where approaches put forward by The Coffee House Investor and others come to the fore. In a nutshell, they advocate the use of asset allocation and low cost Index Funds or Exchange Traded Funds (ETF's) to build your investment portfolio. Asset allocation is used to diversify across asset classes thereby spreading risk and reducing volatility. Index Funds and ETF's are used as a low cost way of ensuring an investor captures all of the return of a particular asset class - this is the very idea behind index funds.
You can see some of these types of portfolios in action at the Lazy Portfolios section of the Market Watch website.
Or for a more in depth discussion of the Ultimate Buy & Hold Portfolio from the Lazy Portfolios mentioned above, read The Ultimate Buy-and-Hold Strategy by Paul Merriman at FundAdvice.com.
A little while back, in my post about building wealth, I mentioned that I thought it was important to re-invest any income derived from your investment portfolio. It is an example of the compounding effect at work. Today I'd like to share my thoughts on dividend reinvestment plans (sometimes referred to as DRIPs). Dividend re-investment is touted by many a being a great strategy for growing your investments over the long term.
What Is A Dividend Reinvestment Plan?
When a company declares and pays a dividend, investors would normally receive that amount in cash. Under a DRIP, an investor can opt to forgo the cash payment and instead receive the equivalent amount in company stock.
As an example, if you own 100 shares in a given company and that company declares a dividend of $1 per share, you would be entitled to a cash payment of $100. But if that company offered a dividend re-investment plan and you decided to participate in the plan then you could take the $100 in shares. If the company's stock was trading at $50, you would receive 2 shares under the DRIP.
Advantages Of Dividend Reinvestment
Participation in these schemes allows an investor to acquire more stock an a company without paying brokerage fees. This means it can be a low cost way of increasing your ownership of an investment. Even though only a small quantity of stock is accumulated each year, this can add up over a number of years.
To make it more attractive, some companies offer stock in their DRIP's at a discount to the current market price (around a 5% discount or so). This can make the plan an even more cost effective way to add to your holdings.
Disadvantages Of Dividend Reinvestment
The main issue I have with these plans is that you may not necessarily be investing your funds in an investment which represents the best value at any given time. I like the idea of re-investing the income from my stock market investments. It creates a compounding effect whereby the amount reinvested increases the income the following year and so on. But I like to choose where I invest my hard earned cash. I prefer to take all of the income received over a given period then plow it back into the opportunity which represents the best value at that time, or perhaps even invest in a new idea.
Another thing to consider is the additional paperwork required. You will need to track each purchase for tax purposes. As your portfolio starts to grow and the number of holding increases, you will need to track the issue of shares twice or sometimes 4 times per year for each holding.
I know that get rich quick schemes are enticing. The lure of making money fast is too tempting for some people to resist. Maybe there are some methods out there which you can use successfully to generate significant wealth over a short period of time. However, I suspect there is either a certain amount of luck, a large amount of risk involved or both. In fact the cynic in me suspects that the only people getting rich from some of these schemes are the promoters.
My plan to build wealth is simple. Spend less than I earn, save the rest and invest my savings in quality investments. I said the plan was simple not easy. And I can't claim it as my own either. It is essentially the story laid out in George Clason's personal finance classic, The Richest Man In Babylon. If you haven't read this book, I think you're missing out.
This deceptively simple formula does take considerable commitment though. Obviously it helps if you can maximize your earnings. This might be through developing your career or maybe via a more entrepreneurial approach.
Controlling expenditure is where most of us run into trouble though. A budget is one of the tools which is critical for managing money in this context. Knowing where your money goes is the first step to controlling your expenses.
Then, by putting a savings plan in place, ensuring that cash is being put away out of harm's way on a regular basis, you'll start to build up some capital to start up your investment portfolio. Untold numbers of books have been written on the subject of investment but the main point I want to make here is that you should strive to re-invest any income derived from your investment portfolio. Use the power of compounding to your advantage.
Are you trying to get your personal finances organized? This article will help get you started.
Lots of people have good intentions when it comes to personal finance - they just don't know where to start. And it's not always easy. Everyone's situation is different - there's no one-size-fits-all solution. You may be in a situation where you have trouble making ends meet from week to week. Or you may have a decent income coming in each week but never seem to have any money left at the end of the pay period. There are even those among us who have managed to save a little money but are not sure what to do next.
Take Stock Of Your Personal Finances Now!
The first step you need to take is to work out where you are now. This is essentially establishing what you financial position is now. What are your assets and liabilities? How much income do you have each month? How much do you spend?
What Are Your Assets?
This can be a tricky question. How do you work out what an asset is? The simplest asset to identify is cash in the bank. Next will be any investments you have - stock market, real estate, retirement fund and so on. Then, if you own (or have a mortgage over) your own house you might like to include this next.
Now comes the gray area. Some personal finance books will tell you that lifestyle purchases like cars, boats, televisions and stereos are not assets. They argue that these "assets" wont appreciate in value and in many cases will have very little resale value. And in the worst case scenario, they may have high maintenance costs associated with them. I'm not going to say whether or not you should include these things in your list. I tend not to include them, but it's up to you. You should be going though this exercise (establishing your financial position) on a regular basis and the most important thing is to be consistent over time in what you record.
For each of the assets you've listed, assign a dollar value. For financial asset (like cash, mutual funds and stock market investments for example) this will be easy. For other things you may like to record the purchase price. In cases where the monetary value of the asset diminishes quickly over time, you might like to allocate a value based on how long you've had it and how long you think it will last. Better (and easier) still, just don't include it as an asset. Consider it as an expense - like a night out or a weekend away.
What Are Your Debts?
This should be a little easier than the assets - as most lenders will remind you frequently of how much money you owe them. Write them all down. Include any money owing on your mortgage, personal loans, car loans, credit card debt, student debt, store cards and so on. Now write the amounts next to them.
Do You Owe More Than You Own?
The next step is to add up all the values you allocated to all of your assets and write down the total. Now add up all of your debts and write down the total. Now the moment of truth - subtract your total debt figure from your total assets figure. What do you get? Is it a positive number or a negative number.
If you got a negative number, don't panic. At least we know where we stand. You should be happy that you now have a basic idea of your personal finances and how they stack up. Knowing how much net debt you have will give you something to focus on. Each month, you will want to try to reduce the deficit of assets to debt. You may not improve every single month, but overall you want to see a steady improvement over time.
If you subtracted your debt from you assets and got a positive number, well done. Don't become complacent, but you must be doing at least something right to be in that position. Either though hard work or maybe just good fortune you are ahead of the game - but by how much? Or maybe a better measure would be to look at the total interest you are paying on any debts you may have, then compare this to your income. You may have more assets than liabilities, but are you moving in the right direction?
In my next article I will be looking at what our next step should be. How does our income stack up against our expenditure? Please come back tomorrow to read the next article in the series on personal finance basics.
How does budgeting apply to personal finance?
Budgeting is one of the most basic personal finance tasks you can undertake. A surprising number of people have never even given this subject any thought and fewer still have even attempted to prepare one. So I have deciding to write a series of posts on personal finance budgets - what are they, why do you need one and how do you create one?
Today I will answer the questions - what is a budget and how does it apply to your personal finances?
So What Is A Budget?
A budget is generally a plan which is financial in nature and which maps out expected income and expenditure. Governments have budgets as do corporations. Governments need to understand how much expenditure is planned in what area and when the expenditure is due to occur. This then allows the government to plan what income is needed to cover these expenses. They then have the choice of adjusting taxation policies and debt levels in and effort to match expenditure against cash flows. In a similar way, corporations of all sizes will undergo similar activities to ensure continuing operations and profitability.
A personal or household budget is essentially to same as a government or corporate budget except that it is done on a smaller scale and at a micro level. Granted, an individual wont have the same financial resources as a government does, but the principle is the same.
So a budget is all about understanding what your expected income is over a given period and what your planned expenditure is.
Income could be salary or wages from paid employment. It could be interest on a bank deposit, dividends from stock market holdings or some other form of investment income. Income could equally be a government benefit, pension or other allowance. If you are helping your children set up a simple budget, it could just be their pocket money. Income could even be your regular winnings from the blackjack table or at the racetrack (only joking - nobody wins on a regular basis playing blackjack or betting on the races do they?).
Expenditure is anything you spend money on. This will be things like food, fuel, utilities, clothing and medical expenses. It also includes things like credit card payments, mortgage repayments and other debt servicing costs.
The other items that will appear in the outgoing section of your budget will be things like savings and investments. By this I mean the money you want to put aside each month to contribute to savings and investment plans. It's important to include these items in your personal budget so that they are part of your plan. Planning to save money is the first step on the way to saving money.
How Has A Budget To Do With Personal Finance?
A budget is one of the fundamental building blocks of your personal finance plan. It helps you to understand where your money is coming from and where it is going. You will use it to determine how much excess cash flow you have available each month (or maybe even how much shortfall there is). You can then put the excess towards debt reduction strategies to help you get out of debt. Alternatively you can put the excess to work in the stock market, a mutual fund, a real estate investment or any other type investment that will help you to grow your wealth.
And if you budget has a shortfall, you'll be able to identify it then take steps to address it. Maybe that car loan is too expensive. Maybe you need to re-think your personal loan rates. or you may just be living beyond your means.
Your budget doesn't have to be complex - a pencil and paper will do. However I suspect that excel spreadsheet budget planning is probably the most common method. In an upcoming article I will describe the process of actually preparing a budget.
For now, start thinking about where your money comes from and where it's going. Then keep an eye out for my upcoming article on how to prepare a personal finance budget.
What is the definition of personal finance?
Personal finance is a remarkably broad subject. The simplest way to define personal finance might be to take a look at each of the topics which come under the personal finance umbrella.
Record Keeping.
One of the fundamentals of personal finance is record keeping. It provides the foundation for everything else to build on. Keeping records means keeping track of all of your financial transactions. This includes what you earn, what you spend, what and where your savings (if any) are, insurance, and the list goes on. Record keeping can be as simple or as complex as you like. Some people will be thrive on tracking every individual cent that gets earned, saved and spent on a daily basis. Others will find this way too much overhead and will instead record approximate figures on a weekly or even monthly basis. Most people will find a working solution somewhere between these two extremes.
However you decide to do it, the main thing is to keep at it. Record keeping will enable you to understand what your financial position is now and how you've progressed over time. It will also provide valuable input into the planning process.
Budgeting.
Budgeting could be considered the counterpart of record keeping. The two go arm in arm. Budgeting is the practice of estimating future income and expenditure. To create a budget you would normally offset your expenses against your income month by month for the next year (and beyond). That way you can see what the surplus or shortfall is each month. This can help with planning your investments or by identifying where your future cash flow problems might lie.
Financial Position.
Another key area of personal finance is your financial position. Knowing this is key. When used in conjunction with your record keeping and budgeting, your statement of financial position is a key tool in meeting your financial goals. In it's simplest form, it's a document which lists your assets and your liabilities and which will hopefully show a surplus on the asset side. Even if it doesn't show a surplus of assets, it will provide you with a starting point on your road to freedom from debt.
Credit and other forms of Personal Debt.
And speaking of debt, this is another broad topic within personal finance. Not many of us can go through life without resorting to some sort of debt. Whether it's a mortgage to fund the purchase of a house, a personal loan to buy the car of our dreams or credit card debt to be used for day to day living and the odd larger consumer purchase, most of us will be in debt at some time or other.
But there are different types of debt. Borrowing money to finance investments can be a powerful wealth generating tool. However payday loans and other forms of cash advance are normally to be avoided if at all possible.
Saving and Investing.
Saving money is something we should all aspire to. It could be saving enough money to put aside in an emergency fund to provide a financial buffer in unforeseen circumstances. Or it might be saving for the kids' education or maybe even an overseas trip. And saving ties in nicely with budgeting. Saving is what we can do what the money which our budget tells us should be left over each month.
Then once you've accumulated some savings, you may look at how to invest them. Investing is a complex area with many complex investment products available. You might buy shares, real estate or a mutual fund. You can even invest in non-financial asset like art or wine providing you know what you are doing. Investing is how you take your accumulated saving and put them to best use to grow your wealth over the long term.
Insurance.
What does insurance have to do with personal finance? Well, what's the point in doing all of that hard work to get your personal finances in order just to see some catastrophic event wipe it all out? That's why insurance is such an important part of personal finance. Whether it's your house, your car, your income, your health or even your life, you need to make sure you have enough insurance for the worst case scenario.
Tax.
Nobody likes paying tax, but with some careful planning and good advice, you can at least minimize the amount of tax you need to pay. I'm sure most people would agree that we pay more than enough tax already. And by organizing our personal finances better, we may be able to reduce our taxes freeing up more money to save and invest.
Retirement Planning.
For some people this is what it's all about. You need to make sure that nest egg has grown large enough to support you once you stop paid employment. By putting the right strategies in place earlier in life you can help ensure you have a comfortable retirement.
Mastering each of the above topics should put you well on the way to living large in retirement.
Estate Planning.
They say that death and taxes are the two certainties in life. While nobody likes to think about their own mortality, it's important to consider your estate. How should it be distributed? Do you have any special wishes? Is your will up to date? A little planning and forethought may at least remove some of the financial worries from this difficult time.
I think the topics above cover this broad subject area reasonably well. In future posts, I will refer back to this "What Is Personal Finance" post often as I drill down on each of these topics.
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