Financial Stability: 4 Easy Steps to Get Your Finances in Order
by Scott Brown, Advisory Panelist, Investment U
Tuesday, February 3, 2009: Issue #927
The economic depression hit Chuck Smith on May 30, 2008 after lunch.
The 42-year-old father of four was in his small office in a suburb of Dallas when his boss walked in and closed the door – Chuck’s job was suddenly over.
Even so, it took until June before the Smiths finally sat down at the kitchen table to estimate how his wife’s paycheck would cover all the expenses they’d listed on a white legal pad.
But financial stability was a conversation that should have occurred long before that. And like many Americans, the Smiths didn’t see themselves as financially inept.
They weren’t unusually lavish spenders, they didn’t “go overboard” or live outside their means. But the problem was that they never planned their spending. If the money in the checking account didn’t cover it, it went onto the credit cards.
It didn’t have to be that way. With only a few simple steps, they could have been prepared – and with a few more, they can right those mistakes. Here’s how you can do the same…
4 Simple Steps Towards Finding Financial Stability
The Smiths certainly seem normal and intelligent. They don’t do anything that millions of Americans don’t do every day. Unfortunately, they’re no different than unprepared villagers in the path of invading Mongols.
It can be hard to prepare for financial disaster when everything is rosy. It runs against our intuition and our optimistic American spirit. So let’s take just a little time to prepare for the barbarians – or how to defend against the barbarians already at your gates.
Step 1: Figure Out Where You Are Now
No family on the Great Plains in the 1800s would ever have spent the Fall without canning preserved foods for the winter. But, that’s exactly what the Smiths and most families have been doing during the “fat ‘n’ happy” years – before the current economic downturn.
Let’s start with the basics and what you need to get “through the winter.” We can do this by looking at your total annual after-tax income and split it into three parts:
- (Net Income x 50%) = Needs Expense Limit
- (Net Income x 30%) = Wants Expense Limit
- (Net Income x 20%) = Minimum Savings
It can be hard, at first, to separate Needs from Wants, but like many Americans on a forced budget, it quickly becomes very clear.
By restricting your family’s expenses to no more than half your net intake you’re keeping your fixed commitments at a safe level. By not exceeding 30% in spending on anything for enjoyment you are ensuring that you have 20% left over in minimum savings year in and year out.
If you find that your numbers are out of line, then you need to make some tough decisions to bring these back into alignment. That could mean cutting back on wants or reducing needs. Regardless, this calculation will show you very quickly if you are living “above your means.”
Step 2: Save $1,000!
Hopefully, you already have some money saved. You should have at least $1,000 in the bank.
When you have this much money in the bank, many people start planning large purchases or trips. They want that new flat screen, computer, or trip to Vegas. This step trips up a lot of individuals who have difficulty saving. But you must dig in – and resist the urge to spend it.
Do you find that your bank accounts tend to run on empty all the time? If they do, you should consider keeping more than $1,000. It could also mean that you need to review Step 1 again.
There has been some good news lately on the savings front. The economic crunch has encouraged us to save more. The government reported that the savings rate, as a percentage of after-tax income, rose 2.9% in the last quarter of 2008. It’s a start.
But we can and should be doing so much more. If you have, congratulate yourself and move on to Step 3 and start paying off your bad debt.
Step 3: Reduce and Pay Off Bad Debt
Once you save $1,000, you have to focus on paying off your bad debt. It will suck you dry slowly – and the higher the interest rate, the worse it is. Bad debt never converts to value or equity for you – they will never benefit you in any way.
Normally the worst of the bad debts are from Wall Street’s legalized loan sharks. They’re also called credit card companies. You should reduce credit card use to a minimum.
Most people don’t realize that car loans can be bad debts. Many cars drop in value in just a few years, and new cars lose value as soon as you drive them off the lot. But if your car loan payment is only a small part of your needs, you can let it pay off over time without too much concern.
Bad debt is like an anchor, and unless you reduce its impact on your lifestyle, it will constantly be a drag on your finances.
Step 4: Build a Six-Month Security Cushion!
By the time you get here you’ll have made a remarkable transformation in your financial life. First you’ll have completely controlled your Wants spending. Second, you’ll have placed your Needs in balance.
Now you’ll want to put a safety net under your financial “high-wire act.” What if you lose your job, or if have medical issues? What if your car is totaled or there’s a family emergency? There are a number of unforeseen events that can threaten a family’s financial stability. A cash reserve is one of the only things you can do to prepare yourself.
Take your total monthly Needs and simply multiply by six to get the account balance you will need to put away in your own financial bunker. I suggest putting it into a special savings or money market account. Somewhere that you can get to it when you need it, but not somewhere that you will be tempted to use it.
In the coming weeks we’ll continue to add to this. We’ll be looking at simple steps to build a foundation of wealth and how to build a million dollar portfolio from scratch.
Good investing,
Scott Brown
Today’s Investment U Crib Sheet
As the main author of the Investment U course, Scott Brown knows what it takes to build a solid foundation of wealth. His advice fits in perfectly with our 4 Pillars of Wealth:
- Pillar 1: Stick to an Asset Allocation ModelThe only way to consistently beat uncertainty is to asset allocate. No other investment strategy can boast the same. That’s why it earned a Nobel Prize. Following this asset allocation model and rebalancing annually ensures our portfolios will be well diversified and positioned to profit in any market condition.
- Pillar 2: Adhere to a Sell DisciplineEveryone knows you should cut your losses early, and let your profits run. The only way to consistently do both is to use a trailing stop. It defines an exit strategy for all our positions right from the start… and makes sure we have the gumption to stick to it.
- Pillar 3: Understand Position-SizingKnowing how much to invest in each and every situation is crucial to building long-term wealth. Position-sizing ensures that even if a number of our investments turn sour, we won’t lose our shirts. As a guideline, we recommend investing no more than 4% of your equity portfolio in any particular stock.
- Pillar 4: Always Look to Minimize Investment Expenses and TaxesThere’s nothing we can do to affect a stock’s performance once we own it. But there is a way for us to guarantee our portfolio will be worth more 5, 10, 20 years from now. All we have to do is cut our expenses… and stiff-arm the taxman (legally, of course). On the expense side, that means avoiding investments that carry front-end loads, back-end loads, 12b-1 fees, or surrender fees. On the tax side, it means reducing what the IRS is entitled to take. We can do that by avoiding actively managed funds in non-retirement accounts, owning high-yielding investments in tax- deferred accounts and buying high quality investments (high-quality = less turnover = less capital gains taxes).
Any investment contains risk. Please see our disclaimer.
2 Responses to “Financial Stability: 4 Easy Steps to Get Your Finances in Order”
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Really, really good post.
The needs/wants/savings approach to drawing up a budget is one of the best personal finance ideas I’ve ever seen.
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Excellent article.Gives valuable advice to manage finances.Thanks
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