No discipline is complete without principles. The more time I spend thinking, writing, and working around the financial space, the more it has become apparent to me that people are not successful based simply on luck or talent.
It seems like people are financially successful because they have created a simple, repeatable framework that they consistently are able to follow. Sometimes this is as simple as saving a portion of their paycheque every month. Other times it is based more on creating a repeatable investment strategy.
I’ve spent a lot of time thinking about the framework I use to work towards my financial security. Along the way, I’ve gathered my thoughts into these ten guiding principles of personal finance.
1. Spend substantially less than you earn.
This principle is inarguably the single most important thing you will ever read about personal finance. So important, in fact, that you will see it on almost every finance blog there is – with one small variation.
Almost anyone in personal finance will say “spend less than you earn”. I have added the word substantially because in order to accumulate any significant wealth, it is important to spend MUCH less than you earn, especially when you are young so that you can reap the rewards of many years of compound interest. For the average single individual with no children, I recommend at least saving 20% of your after-tax income if growing your wealth is a priority in your life.
Sounds easy, right? Unfortunately, it isn’t. Let’s consider some statistics. According to the Credit Suisse 2015 World Wealth Report, the median (half have more, half have less) Canadian net worth in American Dollars is $74,800.00. At today’s exchange rate, that translates to roughly $94,996.00 Canadian Dollars (Google quotes today’s rate at 1.27).
If we compare that to the median 2013 Canadian income of $76,550.00 according to Statistics Canada, we notice that half of Canadians have saved just over half of the median income. With most advisors recommending having retirement cash flows of 70-80% of income, clearly we have a long way to go. Many people could benefit by saving more money.
Now obviously there will be exceptions based on what your income is. There’s no doubt that it’s definitely easier to save $100,000 if you make $500,000 than to save $4,000 if you make $20,000, even though it’s a 20% savings rate in either case.
One last thing – as you save, remember to be grateful for everything you have. When I was doing some research for this article, I was reading the Credit Suisse report I mentioned earlier. I was absolutely floored to see that a net worth of $3210.00 American Dollars is in the top half of the world’s wealth ranking. This really struck me and reminded me how fortunate I really am!
2. Maintain a moderately diversified portfolio.
Having diversified investments has two main benefits. First of all, you are more likely to strike financial gold and generate massive returns if you have eggs in many different baskets. Conversely, the second benefit is you are less likely to be ruined by a drop in any asset class if you are invested in many classes simultaneously.
While this may seem like a no-brainer for anyone with some financial education, it always has surprised me how many people will keep 50% (or more!) or their portfolio in a single asset class. This seems to be particularly common among two types of people. The first are those who are afraid of complicated investments, or what I call “paper investments”. Examples are stocks and bonds, the bread-and-butter of any modern investment portfolio. Thus, they invest all of their money in tangible investments such as property, rental homes, and precious metals. When I worked in banking in rural New Brunswick, I saw plenty of these people every day.
The other type of person who tend to have simple portfolios are those who have an extreme aversion to risk. Therefore, they only invest in risk-free investments such as guaranteed income certificates (GICs) and bonds. While these people will be safe from any drastic volatility in the marketplace, they are drastically limiting their potential returns with their narrow-minded investing attitude. With risk comes reward, thus it follows that no risk means no reward. Most GICs return at sub-inflation levels in today’s low-interest rate environment. This means that even though your nominal portfolio increases in value, you are still losing purchasing power over time.
Clearly I think diversification is important. However, notice that I included the word “moderately”. – there is danger in over-diversification. As we will see, the reduction in risk for diversifying past 6-8 investments is small when compared to the reduction in potential returns.
Warren Buffet, one of the world’s most iconic investor’s, famously said “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” While Buffett is clearly an anomaly in terms of his investment returns, his approach of “focus investing” has been picked up by many other successful investors and definitely is worth considering. If you want to read more about Buffett’s tremendous financial success, I wrote a review on “The Warren Buffett Way” that might be worth a read.
Another example of an example of a successful investor who preaches the benefits of a focused investment porfolio is Joel Greenblatt, who wrote the book “You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits”. His book contains the following quote: “ After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small.”
Another way to think about overdiversification is this: your largest holding is likely your best investment idea. Your second largest holding is your second-best investment idea. The trend continues, until you are diversified over 30 stocks and taking potential money away from your best idea to put into your 30th best idea. Seems illogical, doesn’t it?
3. Take only risks that you can manage and understand.
Personally, every time that I undertake a financial risk I try to list out my expected return (estimated conservatively – see #9), my best case return, and my worst case return. Once I am able to visualize these three things, I ask myself three questions.
“Will I be happy with the maximum possible return?”
This should always, always, ALWAYS be an automatic yes or you should obviously not make the investment. This goes without saying.
“Will I be happy with my expected return?”
Again, you should always be answering yes to this or you shouldn’t be considering the question at all. If the expected value of the investment is not worthwhile, stay away.
“Will I be able to handle the worst case return?”
If there is any hesitation to answering yes to this question, there are two possible reasons why. Either the investment is outside of your risk tolerance, or the chance of the investment producing at it’s worst rate of return is incredibly small. (For example, index funds rarely return at terrible rates but when they do, the numbers can be very scary, like during the financial crisis of 2008 or the dot-com bubble burst of the early 2000s.) So if the worst-case return of an investment is very scary but it is balanced out by a very small probability, you might still be looking at a worthwhile investment opportunity.
4. Understand your tax basis.
This could be a whole article in itself, so I’ll try to be brief. There are two main reasons why this is important. First, it will save you TONS of money – taxes are the biggest expense we occur in our life. Not your house, not your education, not your car – the hidden cost that we spend the most on is taxes, so knowing how to minimize them is very helpful. Understanding the tax benefits of being an incorporated business vs an individual employee is one popular example. This is why medical doctors fight so hard to retain the right to become incorporated – they are typically employed as a professional corporation (for example, Dr. John Doe Professional Corporation).
The second way understanding your taxes will help your finances is by saving you money that you would otherwise spend on an accountant. Understanding the rules of Canadian taxation yourself will allow you to do your own tax returns. And trust me, accountants can be incredibly expensive if you aren’t careful – I know one small business owner who spends tens of thousands of dollars on accountants each year. Performing your own tax return also lets you understand how your day-to-day financial activities effect your tax basis, which allows you to alter your behaviour throughout the year to further save on taxes.
Don’t think doing you’re up to filing your own tax return? Warren Buffett filed his first personal tax return when he was 11. That was the fact that inspired me to start learning about my taxes and filing my return myself!
5. If you are going to get a university education, try to come out with minimal or no debt.
When I was in high school, I was fortunate enough to land a full scholarship for both my tuition and dormitory fees. That is perhaps the single biggest thing that has helped me to grow into the person I am today – I was able to spend time doing what I wanted during university, without having to work at petty jobs just to get by. While I did still work part-time throughout my university years, it was only at jobs that truly interested me or I thought had important career benefits.
It also had another important consequence. Obviously, I graduated debt-free. This kind of financial beginning can have tremendous implications later on in life. For example, if someone can graduate at 22 with $100,000, and that money grows at an 8% annualized rate, it will add a whopping $2.7 million to their net worth when they retire at 65 ($100,000×1.08^(65-22)). Don’t underestimate the power or compound interest – coming out debt free can be much more valuable than the apparent cost of your education because it happens so early on in life.
6. Buy just the right amount of insurance.
Needless to say, insurance is very important, but some people go way overboard. It is extremely important to understand that insurance companies make their money because the vast majority of policies run to maturity without any claims being collected.
Important examples of unnecessary insurance include:
Extended warranties. Being a mathematics & statistics major in university, I have the tendency to look at everything from a numbers point of view. And statically speaking, the extended warranty is highly likely to be unnecessary. How else would the issuing company make any money by offering this service?
Life insurance for anyone without dependents. Life insurance is designed to allow people with children or other dependents to have peace of mind, knowing they will be taken care of if the insured individual passes away. It is not designed for young people with no dependents.
I think that for some parents, it is appealing to know that if their child passes away there will be some financial consolation. As a result, they encourage their children to buy life insurance, or if their child is still young the parents buy it themselves. In my experience this does nothing to soften the blow of the child’s passing. As well, the vast majority of children grow up to be both happy and healthy so I think the money would be better put to use in a Registered Education Savings Plan (RESP), or anywhere else to be honest.
Credit card insurance. This one is a no brainer in my eyes. Buying insurance to cover credit card bill that you cannot pay is akin to buying medical insurance in case you shoot yourself in the foot. In both cases, it is better not to do the offending action in the first place. DON’T buy things with your credit card that you can’t pay cash for. If you have trouble with this, cut your card up before reading any further
7. Understand that a large net worth is more valuable than a large income.
There are many reasons why this is true. First of all, the Canadian government’s progressive tax system targets those with high incomes, not those with high net worths. So, having a large income is more costly tax-wise than having a large net worth, and as you readers know, taxes are the biggest expense we will incur over our lifetimes.
As well, a large net worth is much more important when it comes to retirement. When we retire, it doesn’t matter what our income was while we were still in the workforce – what matters is how much we have stashed away. Once your net worth becomes large enough, you can even chose to live modestly off of investment income without touching your principal nest egg. For example, someone who has 1 million dollars invested at a very reasonable 7% rate of return will be making $70,000 per year off their investment income alone, enough to live very comfortably in mostly all parts of Canada except maybe Vancouver or Toronto.
8. Be modest when estimating the expected rates of return of your investments.
Here I’m going to use myself as an example. I have a diverse portfolio that, if recent trends continue, should easily return at a rate between 7.5% and 8%. However, when planning for the future, I always assume a 5% annualized rate of return. Why? Because being conservative in your estimations forces you to be aggressive in your saving. For obvious reasons, this is very useful and sometimes helps me to meet my goals sooner than anticipated.
Another thing to consider is that using this strategy will help you to survive unexpected downturns in the market. If you are pacing yourself to meet financial goal and you returns are higher than what you are counting on, you will still be able to meet your long-term goals if there are temporary dips in the market.
9. Increase your savings rate each pay check until you find that you are truly having trouble making ends meet.
Once you have found your rate where it really begins to hurt, pull back a few percentage points and stay there while the savings grow and grow.
A valued friend suggested this when I was 19 and I have been using it ever since. I consider this to be an incredibly valuable technique to save money. If you employ this method, my experience has shown me that you will eventually find your “magic number” that will meet your needs depending on your personality and spending habits. So go ahead – find your magic number and reap the rewards that come from saving a sizeable portion of each pay check.
Another suggestion is that if you are fortunate enough to receive a raise from your employer, save all the money from the raise so your cost of living doesn’t change. For example, if you’re currently saving $2000.00/month and you get a $500.00/month raise, immediately start saving $2500.00/month. Easy enough!
10. Understand the concept of “Time Value of Money”
To put this concept simply, a dollar now is worth more than a dollar later. This is due to two complementary forces. First of all, money obtained now can be invested for gains that can be benefited from later. Also, money will always be worth less and less due to the powers of inflation.
In my third year mathematical finance course, I remember my professor writing on the whiteboard during our first lecture that there were four fundamental problems in finance that can be solved with math. You can dress them up, combine them, and make them as difficult as you like, but mathematical finance problems always boil down to one of the four following problems:
- Current value of money in the future
- Current value of a sequence of cash flows
- Future value of money in the present
- Future value of a sequence of cash flows
These concepts all relate back to the time value of money. This is a pretty rigorous topic, and I plan on writing a full article about it sometime in the future. Stay tuned!
So there we have it! My ten guiding principles of personal finance. I hope you’ve enjoyed your reading and any feedback you have would be appreciated.