“I decided that a part of all I earned was mine to keep” ~ Richest Man in Babylon
The typical view of budgeting is to figure out how much money you “need” to spend, add some for wants, and save the rest. This tends to result in ever more elaborate justifications for what qualifies as a “need”, and keeps the focus on maximizing spending, for good or for ill. Surviving is really just about avoiding dying, and that can sometimes be had at a price of $0, and sometimes it can’t be had at all. Furthermore, correct estimations of the amount of money required to prevent your death are fortune-telling at best. The best solution for your financial health is to set the percentage of money you will save first.
Focus on the percentage to save, rather than percentages to spend
What percentage of your income do you need to save? The answer to that question can be determined by asking yourself what you are saving for? The only sensible answer to that question is financial independence (you are financially independent once your investment earnings can fully cover your spending). If you’re saving for anything else, like a fancy television, you’re simply deferring spending. There’s nothing wrong with spending money on a fancy television, but that should be marked as an expense in your budget as well, money you save is money you keep.
Therefore, in order to determine how much money you should save you first need to know when you want to become financially independent. Financial independence allows you to retire, so many choose a date at which they would like to retire. My recommendation is to set this date as early as you can stand, keeping in mind that the following calculations assume your spending after financial independence and before financial independence will be the same adjusted for inflation:Keep in mind these are after inflation rates of return. While stock market returns have been quite high over the last 5 years, I find it safest to assume a rate of return of 4%. You’ll find that the difference between assumed rates of return become less important as your savings rate approaches 1 (100% that is). Therefore if you’re 35 and want to be financially independent by 50 you have 15 years, this requires a savings rate of roughly 55%. If you’re 20 and want to be financially independent by 50 then you only need a savings rate of 35%, as always starting early helps! This plot assumes that invested capital equal to 28.5 times your annual expenses will sustain you indefinitely. (Why 28.5? Well, that’s math for a later post, but for now it is an amount which has been safe for the vast majority of market scenarios over the last 100 years in the US).
Once you know the savings rate you need then you can worry about how to spend the rest of your money. Suppose I make $4,000 per month after taxes and I have determined that I want to be financially independent in 15. My savings rate needs to be 55%, so I have the other 45% to allocate as I see fit, this works out to $1,800. You then need to split out your monthly bills and your other expenses.
Monthly Bills – Fixed Expenses
This is anything you have to pay every month to avoid a service interruption. For example, your rent. If you don’t pay rent, you will be kicked out of your house. (Same for a mortgage). These are characterized by little variability and are hard to avoid paying in the near-term. It’s important to make sure that your income covers these expenses with plenty of room to spare. This isn’t complicated, usually you know the values of these in advance. They’re also pretty important to pay, no one wants to be without health insurance. As a rule of thumb I want to make sure that my income after taxes and savings covers my fixed expenses by a factor of two at least, most of which will be housing costs. In our example the remaining 45% should cover the fixed expenses twice, therefore the percentage of your budget spent on fixed expenses ought to be roughly 20%. If you make $4,000 per month after tax that means $800. That’s not much when you consider it has to be split up among rent, utilities, health insurance and so on. This likely means that you don’t want to be spending much more than $500 for your housing. That doesn’t get you a lot in some places in the country. Hopefully a high cost of living area means you can pull more income in. If not, get a roommate, or double your working life, doesn’t matter to me, if you intend on waiting 30 years to become financially independent then you can spend 30% of your income on fixed expenses, making $800 for rent more reasonable…seems like not very much benefit when you consider it means working for twice as long.
Other Stuff – Variable Expenses
The stuff here is important too. Food is in this category. You want to be able to eat, it’s bad if you can’t. Fortunately, it’s also a pretty flexible category. Most people can save money on food simply by going out to eat less frequently. The typical cost of eating out is 2 to 3 times greater than eating at home on a per person per meal basis, that creates a lot of wiggle room for most people. Your automobile will probably account for half of the remainder of your budget, 12.5% from the remaining 25% of your after-tax income. This means that you eat, entertain yourself, and cover everything else that comes up in life on $500 for a person making $4,000 per month, intending to be financially independent in 15 years.
Putting it together
You should keep in mind that savings or retirement accounts count as working years. If you save $25,000 per year and your net worth is currently $75,000, you get to count that as an additional three years. Thus, if you want to be financially independent in 12 years and have three years worth of savings you can use the savings rate of someone who desires to retire in 15 years. Keep in mind however that you have to continue to live on the same amount of money post financial independence if you lose your original source of income.
15 years to financial independence
After-tax income: $4,000
- Savings $2200 — 55%
- Fixed Expenses $800 — 20%
- Housing $500 — 12.5%
- Health Insurance $150 — 3.75%
- Car insurance $50 — 1.25%
- Utilities $40 — 1%
- Internet $30 — 0.75%
- Cell Phone $30 — 0.75%
- Variable Expenses $1200 — 25%
- Car $500 — 12.5%
- Food $300 — 7.5%
- Entertainment $100 — 2.5%
- Books $50 — 1.25%
- Gifts $50 — 1.25%
- Haircuts/Clothes/Home supplies (other) $200 — 5%
This is an example budget and simply represents a baseline. Surely you’ll find that you want to spend less money on a car and more on housing, or vice-versa. (Keep in mind to account for depreciation as part of your car expenditure). Maybe your health insurance is covered by your work.
I realize this isn’t the standard 15% savings rate that is often advocated by personal finance experts. They assume retirement at 65, a fixed social security payout and then they assume death. Part of the benefit of financial independence is simply having to worry less about what happens. Depending on social security being unchanged in forty years sounds about as fun as hoping that I don’t accidentally outlive my money at 85 (that being said, I’ll happily choose outliving my money over the alternative). Seriously, boo to having four years left on the actuarial table, and having four years of savings left, there is nothing fun about that math.
I’m just starting out in my career and I think I’m ready to start investing. I really expected Hillary to win the election. Now that it’s Trump I don’t know if I still should. It looked like when Trump started winning the market dropped a lot.
Well, when you boil this down, what this question seems to really be is: “Should politics impact my investing decisions?”. Short answer, no. If you owned a successful car-wash would you sell it because Trump was elected?
I voted against Trump. Specific to the matter at hand, I think Trump’s economic proposals are bad ideas. The main planks of his economic platform seem to be a mercantilist view of the global economy, that trade agreements make winners and losers of countries. This is coupled with a restrictive view of immigration. The global economy would like roughly double in size (Clemens, 2011). This would likely double average real incomes. (That’s an after-inflation doubling folks!) Yes, the middle class in the US has not seen a lot of the benefit of free trade, in part due to increasing healthcare costs, and in part due to competition from foreign workers. If Trump does not approve the Trans-Pacific Partnership, if he cancels NAFTA, or if he reduces incoming immigration, I expect the economy to suffer.
My Bias and My Investing
I have not changed anything about my investing process to take this into account. It is very important not to let your political bias effect your investing. The fact that my above bias is based on, what I believe to be, sound economics, doesn’t make a difference. When you’re investing you want a mechanical and rational process, or a process that is based on analyzing individual companies for obvious mispricing and exploiting it. There is very little rational and nothing mechanical about politics. The vast majority of people should put 20 to 50% of their income into an appropriate asset allocation split between bond and stock index funds. They should do it every month, rain or shine, and wait.
That means each month that you’ll accumulate a growing share of the world’s productive assets, this means that you own a larger and larger share of the world’s businesses. These businesses will probably make profits in the future, and you’ll have a right to an increasing portion of those profits. The important thing is that you don’t sell your share of the businesses for any reason except that you need the money.
It might be appropriate for some people to take a more active approach to their investing. Here you analyze a companies, balance sheet, income statement, and other financial documents to determine it’s intrinsic value. (The value of all of the money that can be extracted from the business ever, discounted at a fair interest rate to the present). You then compare the intrinsic value to the market value, and buy shares of the business if the market value is substantially less than the intrinsic value. This is much harder than it sounds, as it involves some prediction of the future. It’s easier if you look at businesses that are simple and easy to analyze, crucially the market also has to be dumber than you about analyzing them.
The best investment I ever made was probably in Sitestar, the dying dial-up company. The reason it was a good investment is that it owned a bunch of real estate, and you could buy shares in the company for less than the value of the real estate. Shares were cheap because to the casual observer, it simply looked like a dial-up company, and who wants to invest in a dial up company?
Nowhere in that story did it matter who the president was, nor did it matter what the economy was doing (frankly I was probably helped by the poor economy if anything). So there you have it. If you’re a mechanical investor, keep doing the mechanics as normal. If you’re an active investor your investments probably have more to do with your research than who is in the White House. Everyone’s politics are tied very tightly to their emotions. Emotion is an investment killer.
There’s an old investing joke: Tell me tomorrows news, and I’ll still lose money trading on it. That seems to apply strongly with politics! If I had a crystal ball that told me in advance Trump would win, I would have bet a bunch of money that the stock market would go down after his election (assuming that Trump’s impending win wasn’t generally known already). Stock market went up the day after his election. The stock market is still up since his election. I would have been very wrong, I would have lost a lot of money. The reason I didn’t place such a bet is that I didn’t know who would win the election, but I assumed my reasoning would turn out correct. Trump fans shouldn’t think the lesson from this is just that my politics is wrong, and that you’re safe trading on your politics if you’ve just got the right politics.
The bottom line is that you should probably go ahead with your original investing plan
The answer to this question is complicated and gets to the root of psychology and money. If you’re about my age, probably the best thing for you to do is to set your money in a total market index fund and ignore it until roughly retirement. This is very probably the best effort-to-reward ratio. The problem is that most people are not psychologically prepared to watch half their money evaporate in the stock market.
Why a Dividend Reinvestment Plan could be worth it
Let me give you a hypothetical. You have a retirement account. If you want to spend $40,000 per year when you retire you’ll need $1,000,000 to do so safely. Include inflation and both of those numbers are potentially much larger by the time you retire. So let’s say you’re 50, still 15 years left until you plan on retiring, your retirement account has more money in it than it has ever had (if you’re contributing constantly, most years should be record setting years for your retirement account balance). You have $2,000,000 in your account. One month later the market has taken a nose dive, you’ve just lost $1 million dollars.
Try to imagine that.
What it feels like over the course of a month to lose 40 to 50 thousand dollars day after day.
Sure, there are occasional up days, even days where you make $60,000, but you’re still down 100K overall, then 200, 300. The financial news is calling this the worst stock market crisis in 15 years, and things seem to be getting worse. Really try to imagine how you feel at the end of the month. You’ve lost a million dollars, does your spouse know? Does losing a million dollars of your shared retirement cause any marital strife?
Really close your eyes and try to imagine the stress and the fear. Then suppose that there is another big up day. Seven days where you’ve made $40,000 or more have happened in the last month. Every one of them has been followed by even bigger losses, it’s put your account just a little ways above a million dollars again. Be honest, what do you think the chances you sell your stocks to prevent more losses are?
If you tell me that the chances you sell are less than 20% and you’ve never been through a bear market, you sir, are a liar. People have extreme levels of difficulty predicting how they will react when they’re emotional state is different from the one they are in now, this is a type of hot-cold empathy gap.
So where does a dividend reinvestment plan come in? While an index fund might be optimal if you really would buy it and sit on it for 40 years, it might be easier to buy and sit on a dividend reinvestment plan instead.
How does a dividend reinvestment plan work?
Company’s sometimes offer DRIPs (Dividend Reinvestment Plans). The deal is that you buy some of the company stock from the company rather than a broker. The dividends are then paid either to you (often by direct deposit or check) or reinvested in fractional shares of the company’s stock.
For example, with the Exxon Mobile dividend reinvestment plan you fill out a couple forms, buy some starting stock, and you’re off to the races. For the Proctor and Gamble DRIP you can set any number of whole shares worth of your dividends to be reinvested vs direct deposited to your checking account. For example, when I had a XOM DRIP I had roughly half of the dividends reinvested and the other half direct-deposited to my account. It wasn’t super simple to see the current balance of the P&G shares I had, this meant that there was only one thing I could focus on: the income stream coming from my P&G shares.
The DRIP plan
The theory is this, rather than buying an index, instead invest in 15-20 DRIP plans of megacapitalization blue chip companies in various sectors of the economy. Probably your money won’t grow as fast as in an index fund. Your money will probably experience volatility similar to the index fund (perhaps it will be somewhat better). However, since your focus is on the number of shares you own and the profits generated by those shares, rather than their quoted market value, you are somewhat less likely to make a serious mistake, you just slowly accumulate ownership of these companies over time and collect steadily growing quarterly dividend checks from them.
Why do I worry so much about mistakes rather than just explaining the optimal strategy? The return of a total market index fund is about 10% annually. The return of the average investor is about 3% annually. Typically the gap between an investor’s return and the return of the funds they invest in is 6.5%. Basically this comes down to investors buying and selling too often and at exactly the wrong times. If losing out on a few percent of possible gain can keep you focused on the right things, and avoid the much more common 6.5% drag, it’s money well spent.
My Favorite DRIPs
Exxon Mobile – No comment about the future of oil, or if the stock is reasonably priced, but this is my very favorite DRIP. Oil can be very volatile. Hiding this volatility from yourself behind incoming reinvested dividend checks seems good. The Exxon Mobile DRIP is delightfully cheap as far as fees go. They only hit you when you’re trying to sell, but the plan here is that you never sell. If you’ve got a long time horizon this goes from being good to being very good. If you think oil is going to die a painful death, then maybe not, probably shouldn’t be your only investment.
GE (General Electric) – A relatively low fee DRIP. There is a $7 or so initial purchase fee, and a small fee for automatic investments. However, there is no fee paid for dividend reinvestment. There is a fee if you’re trying to sell, but you aren’t trying to do that, right?
DRIPs with fees
Coca-Cola – Minimum manual purchases are $500. This isn’t terrible, but note the dividend reinvestment fee of 5% up to a maximum of $2. In order to hit the maximum fee and therefore for the reinvestment to stop sucking you need to have a quarterly dividend of $40. The current dividend on Coke shares is 35 cents per share, so you need about 100 shares. That requires about $5,000, really though you want to get the effective fee down to 1%, that means an investment of $25,000.
Proctor and Gamble – Same deal as Coke, more or less, only the fee caps at $3.
Tradeking – If you look at anything with a reinvestment fee, you’re probably just better off shoving it into a tradeking brokerage account. If you intend on reinvesting your dividends this is probably the way to go.
Loyal3 – This would be my favorite solution to the high-fee DRIPs, however the selection of stocks is very limited, and they don’t currently allow for reinvestment. Psychologically, it seems like one of the best options. No fees (more or less at all) and the default view doesn’t show when you are losing or making money. You just focus on the cash building up in the account from the incoming dividends. This is a good way to pick up positions in available companies with expensive DRIPs like, Coke, Disney, and Intel.
Sell your extra stuff. If your in credit card debt, sell everything you reasonably can. There are all kinds of cognitive biases (loss aversion, the endowment effect, and post-purchase rationalization) working together to make you want to keep stuff that you wouldn’t buy today, even at the price you could get selling it used.
You’d be happier with the cash than some of the random things you’ve managed to pick up throughout your life. Usually this means, donations, craigslist or E-bay, but sometimes you need to sell something and eBay or craigslist just doesn’t make a lot of sense. In that case you might want to sell it on consignment.
What is consignment?
E-bay is in fact a good way to think about selling something on consignment. Basically, you’ve got something you’d like to sell, and someone who owns a store allows you to use their space to sell the thing. If it sells, you get some of the money but the store gets a cut. You only get paid after the item sells, but you still own the item until it sells.
When to sell something on consignment?
Basically, sell on consignment only when you think you’d end up with more money than your alternatives, a garage sale, eBay, or craigslist. When you do this with eBay they take a cut (10% last I checked), but it is generally smaller than if you wanted to sell the thing at a physical store.
Generally when you sell something on consignment you can only expect to get 50-60% of the sale value of the item. At first glance it might seem that eBay is the better deal, and quite frankly for most things it is; it has a broad reach, it has relatively low fees, and turnover is fast. However, you need to account for shipping costs.
If you have a really big heavy item, it probably doesn’t make sense to sell it on eBay, because shipping costs will eat substantially into what you might have gotten out of the item otherwise. An obvious example is furniture. So that gives us reason #1 to sell something on consignment:
It’s too big to ship economically.
The other major reason is that it is an item that people are reluctant to buy online. Some of these might be collectors items, or other things which have value that can vary wildly based on the condition. For example musical instruments can be tough to sell online because it can be hard to tell the quality of the instrument without actually giving it a test play. So reason #2:
People feel more comfortable buying this item in person.
The last major reason is perhaps especially rare. Any item that needs to be purchased right before it is used. Here you’re looking for normally people think of impulse purchases, but really what you want is emergency items. If you need a some kind of specialized pump for your pool because the last one broke, you probably need it today. You’ll have best luck with tools and some specialized hardware stores are willing to sell tools on consignment. That gives us reason #3:
The time between when you realize you need it, and when you must use it is short.
How to sell something on consignment
After you’ve figured out what to sell you need to find a shop that will sell the item. You have basically two choices for this, specialized consignment and second-hand stores where nearly all the items are sold on consignment, and a store that sells the type of item you’re trying to sell. It’s worth asking around for the commission that the store will take on your item.
Generally I find that commissions are 40 to 50% of the total sale price. All things being equal you probably want to sell the item on commission at a store that specializes in that particular item, not a consignment store. For example, if you have a grand piano you would like to sell, consider having a piano store sell it rather than a consignment store. The clientele at a piano store is looking to pay retail for a piano, the clientele at a consignment store is looking to get a good deal on something. You’ll probably get a higher overall sale price at the retail store.
Major Caveat – Time
Selling items on consignment can take a long time. For expensive items it can sometimes take years. You may also need to keep an eye on the store owner to make sure that they don’t forget that your item was consignment and not part of their regular inventory, so check back every six months or so, and make sure you get some kind of receipt.
This is also one of the major benefits. You don’t need to wait for your item to sell on ebay, you drag it to the store today, and then it’s one less thing cluttering up your life.
So, you own a car.
You’ve heard that sometimes these things don’t run in perfect condition forever. Go figure. So how much should you budget for auto maintenance?
The answer is: about 15% of your income.
So how much should you budget? If you make more money you could certainly spend more, but I suggest prioritizing financial independence over bonus cars. Certainly your car budget shouldn’t exceed 15% of your income. I would recommend also checking out what vouchers you can get online to save you extra when you are purchasing basics like oil. Companies like Halfords often have many deals view them here.
Stuff Everyone Needs
As a rule of thumb you should count on changing your oil one to three times per year – you can do this this yourself to save money. This usually sets me back roughly $40. Every five years or so you should probably replace your tires, this sets me back roughly $500. Buy good tires. They’re worth the cost. Cheap tires just need to get replaced more often. In this case, I recommend Michelin’s. There are more incidentals, like coolant, fuel filters, and so on, but I think it’s often easiest to take a look at your spending on maintenance over the last 5 years and average it. All in all I figure about $50 per month ought to be about right, based on my average spending.
Stuff that depends
Additionally, you’ll need to set aside money for repairs as well as routine maintenance. This is a little trickier, as you don’t know in advance what the repairs will be or what they will cost. There are basically two components to saving for this: possible accidents, which you may have insurance for, and part failure, which generally is not covered by insurance.
You have two options here. Either carry comprehensive insurance, so that if your car is damaged you need only pay the deductible, or self-insure. The rule of thumb that I use is simply, could I cover this unexpected expense without causing a significant financial issue, ie having to take a payday loan, or end up paying interest on credit cards.
This means I don’t carry comprehensive insurance for my car. I have a cheap car, an emergency fund, and a high savings rate. If any of these weren’t true I’d strongly consider comprehensive insurance. If the car isn’t cheap, then replacing it at a moments notice is hard. If you don’t have an emergency fund, you don’t have money to replace it. If you don’t have a high savings rate you don’t have the capability of replenishing that emergency fund.
In order to make sure that I’m setting aside the right amount of money month-to-month in case of an accident I simply get a comprehensive insurance quote and set that money aside rather than purchasing the insurance. Yes, that does mean that month-to-month I don’t come out ahead of owning insurance, but in the long run the expected gross profit will accrue to me rather than the insurance company, for my car this works out to be about $40 per month.
If you have a warranty on your car you might not need to worry too much about much of this for the first few years. That being said, if you have an inexpensive used car you need to count on making the occasional repair. As a rule of thumb I figure that the expected repair cost annually is half of the depreciation. Another rule of thumb is that a car loses 25% of its value annually to depreciation. Therefore, if you have a $6000 car, then the depreciation is about $1200 for this year. Half of that would be $50 per month.
You can get a reasonable guess of the depreciation of your car by going to the Kelly blue book calculator to get the current value of your car. Then use the calculator again, only change the model year and the mileage so that the car is 1 year older. The difference should be a reasonable estimate of your car’s depreciation.
For example, my car from 2008 with 80,000 miles on it is worth $3000. I go ahead and check the blue book value for my model of car from 2007 with 90,000 miles on it. The calculator gives me: $2500. Therefore, I expect to lose $500 to depreciation over the course of the next 12 months. I therefore set aside $20 per month for repairs.
Adding it up
Altogether I budget $110 in maintenance a month for my car. I also budget the amount of depreciation I expect from my car, that way I’ll have already budgeted the replacement car on a month to month basis when it comes time to replace my old car.
For me the total monthly car budget adds up to $250 include gas, insurance, depreciation*, and maintenance. This is the third biggest line item on my budget, and it’s one that it pays to keep a careful eye on, it’s less than 10% of my take home pay.
So how much should you budget? If you make more money you could certainly spend more, but I suggest prioritizing financial independence over bonus cars. Certainly your car budget shouldn’t exceed 15% of your income.
*A rant on depreciation
Many people will ignore depreciation because it’s not a cash expense. This is bonkers. Depreciation is a real cost. You have a net worth, and every month it goes down by an amount equal to depreciation. In order for you to keep your net worth flat, you need to put the same number of dollars into a savings account to keep your net worth flat.
Alternatively, look at it this way. If you don’t budget depreciation, how does the cost of your car get put into your budget? If you pay cash for a car you probably aren’t just taking one months worth of excess cash to pay for a car. (If you can do that, great! But the situation is atypical.) That means that you’re going to blow up the budget for one month (the month you replace your car) in a weird way. This will result in significantly overestimating your savings rate! If you get nothing else out of this article. Budget the depreciation of your car.
An exception to this is that, if you have a car payment you can budget the depreciation plus the interest in the car payment or the car payment! If you budget for both depreciation and the car payment you end up double counting.
Will Forex Trading keep me excited? Some people shy away from Forex because they think that it will take a lot of boring, high-level mathematical calculations. While this is true, the modern Forex Trading platform has numerous features to keep you interested, entertained and fully invested. You will never get bored with Forex Trading.