Kill Your Credit Card
The first step along the road to financial independence is to get rid of high interest rate debt. I am staring at you, credit card. By all means put everything that you can on that points-earning Visa, but pay it in full every month. A 1.5% a month is a stupid loan that otherwise smart people get themselves into. There is absolutely no sustainable investment that pays 18% per year. If you are carrying credit card debt, the best investment that you can make is to pay it off before you begin investing.
The second step on the path to a quality-of-life retirement is wrapped up in a little business term: positive cash flow. Simply speaking, that means making more money than you spend. The only way to build up savings is to not spend as much as you make. Obvious, I know, but worth mentioning given the statistics on the overall paucity of savings in the United States.
“Warren Buffett was asked by a friend who had just come into money: ‘Where should I invest?’ The Oracle of Omaha replied: ‘Pay your credit card off. I cannot get an investment to return anything near the 18% per month that you are currently paying in interest.'”
The Path to Financial Security
Whenever possible, you want your money make money. There is nothing better than to deploy your savings so that it makes money while you are asleep. Or on vacation. Watching a movie. Mowing the yard. Teaching your kid the ABCs. Name it, there is nothing sweeter than letting interest, dividends, and capital gains do your work for you.
The path to financial security is perpetually damned by a little thing that physicists call entropy: no matter how hard you try to create a perfect mechanism, chaos has a way of creeping in. Taxes, risk, business cycle, coronavirus, financial meltdown, war, political strife, pretty much anything that you see on the news has the possibility to destroy your nest-egg.
The bad news is that—in the real world—there is no way for your money to make money without effort on your part. Even passive investors need to tune in from time to time. Decisions that you make now have the potential to radically alter your financial condition a decade or so down the road.
As far as savings goes, just about the worst thing you can do is leave it in a cash account long-term. Checking and savings accounts are best thought of as devices to provide for necessary short-term liquidity: they ensure that your bills get paid, that you can put gas in the tank, and that all the normal little things that you spend money on day-to-day gets covered. Once positive cash flow begins to result in balances that are not needed to cover daily and monthly expenses, the first thing to do is to figure out how to make interest on the stagnant money.
In pretty much every business on the planet, one way to increase profitability is to reduce latency: the longer something sits on a shelf, the longer it is at risk of being stolen, or damaged, or lost, and the more that you have to spend in rent and insurance and interest rates to maintain it until it is sold. It is doing you no good until you can turn it into revenue. The money that is sitting in your bank account is no different. For each day that it is not making money, it is losing purchasing power.
Lies, Damned Lies, and Inflation
Time is a double edged sword: spend it well, and you will fund accomplishment. Yet every second that passes is another second closer to death. It is relentless, unstopping, precious, and inescapable. It provides opportunity, but also degrades everything over time. Bury a dollar in the sand, and when you dig it up it will be worth ninety-five cents.
With few exceptions, the cash in your savings account is costing you better than 2% per year. Throughout modern history, a dollar saved is worth less than ninety-seven cents after a year. You are paying interest on your cash, at a historical average of a bit over 3% . That means that every couple decades your cash savings will buy you half the stuff that it originally would have.
The first goal for savings is to ensure that your cash will—at the very least—buy you as much in the future as it would buy you right now. You want to keep up with inflation, at the very least.
Fortunately this is not supremely difficult, nor does it involve very much risk. All you have to do is to get your excess cash into a mix of investment grade and government bonds or ETFs. The potential to lose capital on such investments is very small; the potential to lose capital to inflation on uninvested cash is all but certain.
There is no hard and fast on how to allocate your savings, but there is general consensus that you should have several different layers of exposure to volatility and capital risk. The money that you need for month-to-month cash flow purposes should be held as cash: as long as it is not “sitting on the shelf” for more than a few weeks, you are fine. There is no such thing as a perfectly efficient financial system, so a little dead loss from holding enough cash in order to avoid an embarrassing situation (say, your card getting denied on a lunch date) is perfectly fine.
After that is savings for a rainy day: in case your car suddenly needs significant maintenance; or you suddenly need to cover a 1% deductible for hail damage to your roof. Or if you lose your job unexpectedly and need to float bills for a few months. A savings rule of thumb is six months of basic living expenses.
The thing about this tranche of savings is the requirement for it to be reliable. One of the more likely times to lose your job is during a downturn in the market, so holding these funds in volatile stocks is not a good idea: you do not want to take a 30% capital gains loss the moment that you need your savings the most. A healthy mix of high grade bonds and consumer staples stocks assures returns that will keep you ahead of inflation, while significantly reducing the risk of capital loss during adverse market events.
The third tranche is the long-term horizon. It is the money that you are saving for retirement. Depending on your age, this horizon can be anywhere from a few years to several decades. Success in investing this money is going to be measured over a long period—the longer the period, the less concerned you are with short-term swings in underlying value.
No sane person wants volatility: on good days you have that looming feeling that things are not going to stay good, and on bad days all you can see is hard earned money evaporating. For someone close to retirement, volatility can be devastating. For someone who has decades, it is still unpleasant.
For these reasons, investors will not put their money in volatile investments unless there is an expectation of higher returns. There is no guarantee—particularly on a stock by stock basis—that volatile investments will outperform non-volatile ones, but broadly speaking, over time, the willingness to own a diversified group of investments with higher volatility, generally results in greater returns.
Diversity is the great, universal theme of effective investing. Any one investment can go bad, and if you have everything that you own in a single investment, if it goes bad you are going to be devastated. If you have five percent in twenty different things and one of them goes south, you will have a bad day. If you have a hundred and one goes bad, you will shrug.
Diversity does not only apply to how many different stocks or bonds that you own, but also how much risk and volatility your money is exposed to. Some portion of a long-term investment should be in higher volatility-high return stuff. Rainy-day savings ought to be stable. But all of it needs to be—long term—making money. Holding cash should be viewed as a short-term strategy (you do not necessarily need to rush from one investment to another, and if the market is in decline waiting a bit can be called for; just do not let it sit there indefinitely). At the very least, get into some short-term debt.
Where is the best place to put your investment? A brokerage, or an IRA? An IRA or a 401K? What about a 529 educational savings account ? Click here to learn more about the different options for your savings, and which one is right for your particular circumstance.
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