Streamlining Personal Finance

Ideas, comments? lalit@ri.cmu.edu

Warning - This is a point of view and unified towards a paritcular culture

This page describes a few options for highly internet oriented personal finance options and basics of investment for the novice like me.

Money Basics

• Make money always work for you. Imagine a world where everything you spend on or own is making money for you in some way.
• Spread and hedge your money: Never, ever put all your money in one basket or in such a way that one failure will cause its downfall. "One" failure could imply individual stocks (be it your won company), one stock market, gold, cash, land, house, or to a certain extent - one nation. In our own generation, most of these failures have come to pass more than once.
• Same principle applies to your money source: Do not hedge against your job or income source being there for ever. Be comfortable with the job disappearing. Alternatives could be - investments/ assets, other income sources/ revenues (book revenues), or other skills you feel confident about making money from (logging wood, programming, flipping burgers).
• Segregate your needs from wants. Needs include food, well being (health), education. For example, The fact that you want to go to a $25000/yr college does not give you education. I should know. Better to spend a part of that and your time investing in your child so that (s)he stands on his or her feet before college.
• You only live once, there is rarely a need to "tigthen the belt" so much that it hurts. However, i have been amazed at how well some people i know live at how little (for e.g. graduate student couples at student stipends (~1000/month).
• Watch the trends, don't be afraid to make rapid transitions when the evidence is clear. A good trend is the Baby Boomer trend. They are the single biggest demographic force in American economics.

Analysis Basics

There is a lot of advice, software out there. But it all comes down to models people have built in their heads and in computers. Here are basics you need to know to have the right mix of intelligence and skepticism as you encounter advice and computer charts that are only valid so far.

• When you calculate your net worth or money you will make, always take into account the following devaluers. Use one or all of them, depending on which factors apply, usually Taxes and Inflation apply to all. ALWAYS take these factors into account before you plan your future based on numbers, as you read the rest of the page, keep these in mind:
• Tax: Either income tax (Federal + State + city/local), Capital gains or Estate taxes. A lot of seemingly unwise moves (like those huge foundations) will suddenly start making sense.
• Inflation: A dollar bill in your wallet or bank is slowly eroding in value by an estimated 4%-6%, depending on the economy. Use 5-10-20 yr averages to figure out how much a particular asset is worth.
• Estate taxes: When buying property or house, take into account estate taxes/ year, sewer/garbage taxes, neighbourhood fee, ...
• Investment Gain: When evaluating how to invest, make sure you compare how well you will do on average against the Dow/S&P or another index. If not too better, get some sleep and dump into an index account.
• Fees: people charge fee to make/handle money for you, be it stock broker transaction fee, tax preparers, mutual funds, software and bank accounts. Take these fee into account when evaluating your overall (expected) gains, before making choices.
• Balancing your life's money: Note that the flow of money you need is as important as how much you need right now. So carefully look at and analyse current and future expenditures. Draw two curves, one is expected need over time, the other is expected earning, net-worth (and liquidity) over time. If the earning curve rises above spending curve, color the difference black, color it red if it is the other way. If this year, money is good, do not splurge and spend before analysing these two curves. Use the black to invest and cover the red. Red typically occurs for kid's college, after retirement, ... (depending on your level of earning of course).
• Money Desires: Types and nature of money people need:
• "current" expenditures could include taxes (if pre-tax), rent, food, telephone, car, health & other insurance, entertainment cost, regular purchases, retirement investment, other investments, charity. Amounts and categories depends on the personal lifestyle. Spread non-monthly expenses like regular purchases over time, to make it easy on yourself (for that Bose sound system, or dream vacation)
• Future expenditures: To figure out how much money you need over the next 5,10,20,40 years, per year; you need a sense of lifestyle. These are expenses that are not a factor in your life, but will hit you as surely as a train on a track, usually easy to predict. These include - car (more short term), house, wedding, additional cost of married life, children, collegs, parent's retirement/ care, kid's wedding, your retirement.
• Expected Earning: Understanding how much you are expected to be worth. Stock markets do this analysis for companies all the time. This is why a company's stock value is 10-30 times its earning, and maybe this is why it makes sense to go to college. But do the analysis yourself, no idea is sure or sacred. You may be surprised:
• Income profile: When do you start earning, what is it safe to assume your income growth will be over time, when do you expect to retire. Tons of info out there to figure it out.
• Investment profile: Whatever money you choose to save and however you choose to save (Stocks, house, land, IRA, intellectual property, ...) has tangible returns over time. You can change its profile by taking the gains out, taking the capital out, ploughing gains back in and adding more capital. Note some investments like some retirement funds, CDs have less liquidity and very low value if take out early, make sure your charts indicate these and take them into account.

Online Banking and Investment

The first step is to make day to day spending easy and spend the least effort organizing it. The QIF (Quicken Interchange Format) is used by both online Banks and finance software. The following components represent the key software and steps to organizing your money:

• Find an online bank (that is FDIC insured) which offers nominal/no-charge on-line checking. This involves ability to view your account balance and transaction record, download this record into finance software, and pay checks online - wether or not the reciever accepts electronic transfers. Ability to juggle multiple accounts, setup overdraft protection is very useful. Find your favorite bank (use any bank index), some people prefer a local bank and others like national banks (like Bank of America). These banks give free online checking if you direct deposit your pay into them. Major disadvantage is not having free local ATM (except CA, where they are unifying) and not having a personal touch (many offer 24 hr phone assistance).
• Now setup your bill payments, either regular fixed amount, regular variable amount, or occaisional. Once you setup, all you need to do is click- enter amount - click.
• Classify your expenses either in your account or in your personal software so that you can see where your money is going (food, rent, business expenses, ...). A lot of this classification can be setup and automated.
• Find a personal finance software that can work finances and do (or link) taxes, etc. Quicken, MS money and Turbo Tax are popular. These software allow you to track your spending and manage investments (savings, retirements, real estate, college funds, ...) in one glance.
• If possible use credit cards that allow you to download transaction records. Most online banks offer such cards and major cards like AMEX are fast catching up.
• Hand enter any spending outside of checks, ATM use and credit cards. Scan/ save these receipts if using them for tax reasons.
• To invest, find an online investment fund/ broker. Most major ones like Schwab and Fidelity are online. Variables are reliability, transaction fee, facilities (information; knowledge; orders - auto-stop, auto-buy, etc; insurance against insolvancy; advice level and of course fee).

Investment

(at inflation + 10.4%/yr, money doubles every 7 years)

The following categories outline types of saving and investment in increasing risk (i is inflation):

• Savings (i + epsilon return): Advice is not to use this except to store cash buffer, since such accounts allow ~6 transactions/mo without charge and better keep cash in savings than in checking.
• CD (i+1-3%/year): These are federally insured, with deposit durations of 6 months to 10 years. Not sure why i would use them.
• Money Market (i+2-4%) - Fidelity/Vanguard: Very low risk, higher return over CDs, higher liquidity (3-5 checks/year allowed). Less convenient than a bank CD, but online makes it all easy. So always money market over CDs.
• Bonds (i+4-5%): [Not insured, variable rates, but like CDs]: Possible earnings tax exemptions with government bonds (e.g. Muncipal bond earnings are exempt from Federal and i think State).
• Annuities: Deposit now and withdraw and fixed "income" later. Possible tax benefits.
• Index Funds (recommend Vanguard): A special class of mutual funds (see below), that have low load (0.1 - 0.2%) and essentially emulate the stock protfolio of S&P 500 or Wilshire 4000, ... The advantage is that you are betting on the growth of the economy, and can turn on the TV and mentally calculate your worth; you will also do better in the long term than most mutual funds.
• Mutual Funds: Over the long term, 75% of funds do not do better than S&P 500, so watchout. The winning game here is S&P + 2%. If you can do that consistently, you are in fat city. Watch for well managed funds (they grow fast and saturate, you may want to get in when they are not - risk). The dimensions of mutual funds are:
• Load: What % do they take away of your investment, buy only if less than 3% (that too for good funds). Watch for 2B1 fee, something they take away yearly instead of upfront.
• Diversification: How many stocks is this fund comprised of (10 - 100)
• Income level: Growth (no income or dividend), Growth and income, pure income. Risk progressively reduces as income stocks are less volatile
• Stock Size: Size of companies the mutual funds invest in; metric is cap size (small, medium, large). Small is new startup or success (~100 million), medium is ~Billion+, large is Coke/IBM - can buy a country.
• Sectorization: Some funds focus on particular sectors like bio-tech, info-tech, asian markets, etc. Sectorization can be by product type (energy), geography or technology (silicon).
• Evaluation Metrics (Check Morning - Star ratings for indices. )
• Yield: Percentage growth after accounting for load and other costs to you. Look at 1 yr, 5 yr, and 10 yr numbers. A good normalization technique is to see how well a fund compares with your favorite index (S&P, Dow, ...). For your own purposes don't forget to take inflation numbers into account.
• Size: What is the total size of the mutual fund? The lower the size, the more careful you need to be. $100 Mil - small, $500 M+ - medium, $1500 Mil+ large.
• Volatility: What is the % Standard Deviation of this stock. 12% is nominal, 6% is very good.
• Buy your own Stocks: Highest risk, heady game, never invest what you will lose sleep over, for it is only a matter of time. See wisdom below Rhetorical question - what makes you think you know better than the thousands whose job is to do this? If you do want to go this route, do background research, even try to play a simulated stock game by buying and selling virtually and tracking (i am sure there is software out there with such a game, AT&T used to have a stock game). Typically, do not buy your own until you reach 100,000 investment level as you need the numbers for diversification. Don't let this stop you from buying stock options or your best friends start-up company you know will succeed (hopefully based on evaluation rather than emotion)

Retirement Planning

Most people invest 6% as savings. It looks like you would need to save closer to 9%. Be safe in retirement investment, especially if you do not track it closely. Look at funds, factors like

• Watch out for conventional IRA mania:
• Good News: IRA accounts allow you to invest upto 2000/yr (i think) tax frree.
• The money is of course taxable as income when you cash out. Major penalty (tax on principal) for taking it out before retirement (~60), but exceptions are allowed (health emergency, college?).
• Bad News: 2000/yr deduction is only for income below 28000/yr (individual) or 40000/yr (joint)
• Bad News: The tax on IRA gains is at "income tax" levels when you take it out (~30%). But if you had invested the same money in regular, taxed investment, the gains are taxed at "capital gains" level (~28%, may soon go to 20%!!)
• 401(k) plans are often offered by employers, where upto a certain amount can be put into retirement funds (6500/yr?), where the employers matches some fraction of your contribution (...,x1,x2,...). Recommend invest (at least) upto maximum amount that employer will match, it is unbeatable.
• Life Insurance: 

Investing Wisdom

• Invest well for the long range (college, retirement), and minimize risk (e.g. mutual or index funds). Start investing early, for starting at 20-25, even a 2000/yr IRA account will make you a millionare (in todays money). Recommend investing full IRA amount due to tax break (~30%, does not get better).
• It is OK to take some risks in the short range, especially when you are young. For when you are young, the earning potential is high.
• Time Average Investing: Invest the same amount every month or so. For if you miss, you can be awfully wrong. And the advantage of picking the best peaks/valleys vs. uniform investing over a long period (years) is not that much.
• Read good books:
• "One up on Wall Street", Peter Lynch (Magellan fame): Insights on how to do better than the indices. Essential insight is "Buy a stock from a company you know and understand" - need unfair (not illegal) advantage. Might be a company you work for/ know well, a product line/ technology you know well or use extensively.
• Book by Markiel on efficient market theory. How stock market works. The other extreme of "One up on Wall Street"