Too many people suffer from a lack of financial education. In school, the average student learns nothing beyond the art of simple accounting and the proper way to write a check. It is ridiculous to assume that some basic math is enough to prepare someone for real world personal finance and investing. But if schools aren't providing the proper education, who can we turn to for financial lessons? How about a whip-wielding archaeologist with a knack for getting into trouble? Whether he's negotiating his fees with buyers or scrapping it out on a conveyor belt leading to a rock crusher, you can be sure that Indiana Jones always takes care of himself. If you're going to take control of your finances, you will have to do the same.
The road to personal financial security can be a perilous adventure - so let's take some cues from this courageous movie hero.
Look Out for Number One
A good first step toward ensuring future financial stability is to establish the 10% rule - one of the oldest and most efficient ways to find your financial footing. In simple terms, it comes down to this: you must pay yourself 10% of your paycheck before you do anything else. Then you use that money to invest.
There are several good reasons for this rule's popularity. First, taking 10% off your monthly income will not make a significant dent in your lifestyle - it is an achievable goal for everyone. Second, it is a percentage, so it adjusts to any change in income you may experience, be it a pay raise or a pay cut. This takes away the common excuse of "I'll put away $200 when I have it". When people say that, it often means that they (subconsciously) make sure they never have money to put aside. Finally, it is an action that you can take immediately - the first step toward effective financial planning and overall personal financial health.
Attack the Big Guy First
When confronted by a gang of armed guards, Indy instinctively follows bar brawl rules: take out the biggest guy first and work your way down from there. The idea is to remove the most dangerous enemy while you still have the energy. Your approach to debt should be the same: prioritize and then eliminate. How do you decide which debt goes first? Follow these steps:
- Eliminate the high-interest debt first, such as credit card debt or any other high-interest loans.
- Pay off the non-tax deductible debts. These can be lines of credit, bank loans, car loans - any debt that doesn't allow you to write off on the interest.
- Attack the debt that has tax write-offs; student loans are good examples of this type of debt.
- Get rid of that mortgage. Even though people are constantly talking about leverage and investing via your mortgage, a paid off house offers all of these advantages and more. (To learn more, see Debt Consolidation Made Easy.)
It is not advisable to invest before you have eliminated high-interest debt. Let's consider a simple example to illustrate this:
You have $5,000 in your savings account. Unfortunately, you owe $10,000 on your credit card. What do you do with the cash? You can invest it in an index fund or a bond and receive a 6-12% rate of return on it at year's end. However, your credit card debt (assuming 13% interest in an industry that can charge as much as 28%) costs you $108 that month! If you don't pay it down, it will cost you the same next month as well. In other words, your investment cannot outpace the loss you are taking on your credit card debt. If you use the $5,000 to pay down the credit card, you'll only pay $54 the next month. If you invested it in the index fund or bond we spoke of, you may only earn $25-$50 (assuming 6-12% rate of return).
Debt puts undue pressure on your investments. If you have a debt that is at 8% interest, you have to get an investment that returns significantly more than 8% to make carrying the debt worthwhile. Some people have trouble finding an investment that returns 8% consistently. The debts described as priority No.1 and No.2 are significant obstacles to investing. In many cases, high-interest debt precludes any chance of making a profit investing. (For related reading, see Invest In Spite Of Debt.)
Ducking Arrows and Dodging Boulders
When the arrows are flying at Indiana Jones, you might wonder why he looks worried - they're not nearly as deadly as a gun or a rolling boulder. A person can probably take a couple of arrows without being killed or permanently injured, whereas getting shot or crushed is often fatal. However, the more arrows you're pierced with, the slower you'll get, and the easier it will be for your enemies to catch up to you. Therefore, it is logical to fear the cumulative effect of small damages as much as more devastating events. So why do we ignore this common sense thinking when saving our money?
There are two fatal finance mistakes that people often make. We are all familiar with the first - purchasing debts. People tend to buy things that cost them and continue to cost them for years. Sadly, we are not as good at acquiring assets as we are at collecting debts. A good example of this is cars. Cars are one of the worst expenses you can incur. Not only do they rapidly depreciate in value, but the more you pay for the car, the greater your monthly insurance is likely to be. Carmakers often present their cars as "investments" or "assets", in much the same way that real estate agents present homeownership, but a true investment shouldn't lose value when you go to sell it. (For more on this, read Wheels Of A Future Fortune.)
Having said that, it's not always the big expenses like cars that drag people down. The second equally fatal mistake people make with their personal finances is not controlling their lifestyles. It's the small expenses that add up: buying a lunch instead of packing one, attending the latest movies, drinking specialty coffees, and so forth. People who receive raises or bonuses often fail to save or invest more than they did before the increase in income. In short, if you are not disciplined with your money, your standard of living adjusts upwards to your income level. All those small expenses that make up your lifestyle are arrows slowing you down.
Together, these two mistakes can be fatal to a person's financial well-being. An increasingly demanding lifestyle accompanied by purchased debts is that rolling boulder that we can't seem to escape. Got a better job? Time to get a better house. Boss give you a raise? Time to get that new car you've had your eye on. And so on, until you end up with a monthly balance of zero again and again. How much you make doesn't make a bit of difference if you don't save any of it - broke is broke. We have to be like Indy and avoid being pierced by those flying arrows - if you get hit too many times, you won't have the strength to jump out of the way when a boulder comes thundering toward you. In other words, you need to be disciplined and work to minimize the little expenses that eventually drain your net worth.
Walking Off Into the Sunset
When you have eliminated high-interest debt, minimized your expenses and started to pay yourself every month, you may feel you've earned the right to walk off triumphantly into the sunset - just like Indiana Jones. But life is not exactly like the movies. This is just the beginning of your grand adventure in the world of investing. Keep your mind sharp and always be on guard against the dangers to personal finance discussed in this article. These pitfalls don't disappear; they just get easier to spot. (For more personal finance tips, see Seven Common Financial Mistakes.)