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Personal finance is complicated. We all know that wealth building requires making more and/or spending less money, but how does one best go about doing that? We know that we need to rid ourselves of debt and also take advantage of compound interest now, but which should take precedence?
We face a multitude of decisions every day that affect our finances, with many of our questions ending in contingent answers.
Should You Learn to Spend Less Than You Make?
Taking that first step toward investing can be overwhelming for many of us. There are over 3,500 publicly traded stocks in the U.S. alone. Should we own individual stocks or mutual funds? There are actually more mutual funds to choose from than individual stocks, currently around 4,500. And what exactly are index funds and ETFs? We haven’t even touched on investing in bonds, international companies, commodities, private businesses, or real estate. Should you be a passive investor or an active trader? Where does one start? Oh, and by the way, is our home a good investment?
Even if we know what we want to invest in, how do we best go about it? Should we use our work-sponsored 401(k), or start an IRA? Is a tax-deferred IRA better than a Roth IRA? What about taxable accounts? Robo-advisors?
The paths are endless, it seems. Andrew is not alone.
Those of us at Dough Roller (as well as writers at many other personal finance sites) do our best to provide accurate and helpful information for those who want to do things themselves. However, the answer to all of the questions and dilemmas above is the same: It depends.
What is great advice for one person may be all wrong for another, depending on their different circumstances. Information is vital, but too much information can actually be even more overwhelming and lead to “paralysis by analysis.”
Many people turn to traditional financial advisors for help. However, financial advisors tend to focus on selling financial products and managing wealth already accumulated, rather than developing the processes that lead to wealth-building success. Unfortunately, all financial advice comes with conflicts of interest.
The options for those starting out with a net worth are particularly challenging. Bad products and advice not in your best interest can haunt you for years due to bloated expenses and adverse tax consequences.
Related: How and Why to Track Your Net Worth
My hypothesis is that any individual interested enough to regularly visit a personal finance blog or listen to a podcast, like Dough Roller, has the ability to be successful in building wealth and managing their own investments. However, in order to overcome the overwhelm that often comes with personal finance — and investing in particular — most people would benefit from some individual mentoring and coaching.
What if an individual was provided individualized education to develop the processes that would make wealth-building inevitable? Rather than encouraging dependence on an advisor telling someone what to do, we could focus on developing processes and a framework, instead. These would allow a person to be independent and confident in making their own decisions while managing their finances.
Andrew happened to be the “lucky” reader/listener whose question caught my interest. We reached out to see if he would be interested in being a “case study,” willing to share some of his personal information in exchange for having this individualized analysis, education, and coaching. He jumped at the opportunity… and thus began The Andrew Experiment.
Andrew is 27 years old and engaged to be married in the coming year. He shared with me his goal of becoming a millionaire within 13 years, or by age 40. In a separate e-mail, he mentioned that his “main goal for these next couple of months is to identify and implement an aggressive savings plan that will set [him and his fiance] up for long-term success.”
Andrew lives in the Washington, D.C. area and recently bought a home with his fiancée.
Like any individual or couple, they have both positive things working for them and challenges they will have to overcome.
In the positive column
On the plus side, due to a combination of hard work, good choices, and circumstance, Andrew and his fiancée have some great things going for them.
- They have above-average incomes to work with, totaling nearly $200,000/year combined.
- They have little debt, consisting only of a reasonable mortgage payment and two small car loans.
- They have no student debt, which saddles many young college graduates.
- Andrew has also received inheritances from two relatives, giving him a leg up in his wealth accumulation.
In the negative column
Andrew has far fewer downsides in his financial situation. In fact, the biggest thing that Andrew has working against him is:
- He is currently living in a very high cost of living area.
Related to this:
- He and his fiance just purchased a home in the past year. For better or worse, this essentially locks him into a certain amount of spending each month between mortgage, HOA fees, and taxes, which could be difficult (and expensive) to try to change.
- His inherited money consists of tax-deferred IRAs which have Required Minimum Distributions, making his tax situation more complicated than that of most 27-year-olds.
Learn All About The Required Minimum Distribution
In order to properly monitor Andrew’s progress, we discussed how we need to have a solid idea of where he is starting. An aggressive savings plan, such as the one he desires, requires maximizing the difference between what one earns and what one spends.
While Andrew was able to provide detailed information regarding household income, he admitted that they had no system of budgeting or tracking their spending. This error of “focusing on what we earn, while ignoring what we spend” is extremely common, even though it misses a full 50% of the savings rate equation!
Andrew starts off with an interesting collection of investments. He inherited several different advisors/brokers, all with differing strategies ranging from passive index funds to an active trading strategy.
He had started a taxable investing account with a robo-advisor. He was managing his own retirement accounts. He even had two different savings accounts. By my count, Andrew had ten different investment and savings accounts, and that’s before even considering the assets that his fiancée was bringing to the relationship.
Andrew has accumulated a collection of accounts that, in sum, represent a substantial nest egg for someone at age 27. However, I could not discern any coherent investment philosophy. He had no tax strategy. He was mostly unaware of the expenses related to his investments or his advisors. There is an old adage that the left hand doesn’t know what the right hand is doing. In this case, it is more like an octopus with eight tentacles at times pulling in different directions.
Andrew is getting married in the next year. While he seems to be very interested in building wealth and investing, I had a difficult time getting a sense of his fiance’s interests or involvement.
Money is frequently cited as one of the top causes of divorce. While cause/effect relationships are difficult to prove, it is indisputable that money is an incredibly powerful tool in our society. After all, it is intertwined in nearly every decision that we make. Therefore, it is vital to get on the same page with your significant other.
Learn More: 9 Things to Consider When Combining Finances
It is easy to see why people become overwhelmed. I have greatly edited down our conversation, and even within that there are many actions that could be taken. I advised Andrew to take three key first steps, that will help all future decisions and actions to fall into place.
1. Determine true goals
Andrew’s goal of $1 million by age 40 has most of the elements of a good goal, including being specific, measurable, and time-sensitive. However, the arbitrary numbers meant the goal was lacking a few things.
It lacked emotion, which could make it easy to abandon. It also lacked meaning, though. This means that it would be easy to spend a lot of time working toward the goal, only to be left disappointed upon finally reaching it.
I recommended that the first thing Andrew do was sit down with his fiancée. He needed to bring her on board to discuss mutual goals and plans. Rather than working toward an arbitrary number, I recommended that they think about what they wanted their lives to look like in 5, 10, and 20 years. Then, they could begin working to reverse-engineer their finances, in order to provide the lifestyle they want to live.
This would add emotion and meaning to their goal, making it more likely that they’d stick to the process. It would also give them a joint purpose, rather than being one person’s vision — which could be potentially divisive to the relationship over time.
It would also allow them to develop a more purposeful goal. For example, let’s think about what Andrew’s desire to become a millionaire means, using the 4% rule. For starters, a $1 million investment portfolio could be expected to produce $40,000/year of income to support lifestyle. With no fixed costs, this could allow a person a lifestyle of perpetual world travel, if they so desired.
On the other hand, a $1 million net worth — consisting of a paid off $250,000 home and $750,000 portfolio — could produce $30,000/year. For someone who has built a low-cost, mortgage-/rent-free lifestyle, this could mean being financially independent.
To confuse the situation even further, the same $1 million net worth — this time, consisting of a $500,000 portfolio and $500,000 tied up in home equity — would produce only $20,000 in annual income. This may or may not even cover the fixed expenses associated with such a home, let alone allowing freedom for travel and whatever else they desired.
In any of the above cases, the person would have achieved their goal of being a millionaire but their lifestyle choices would be very different. Which of these scenarios does Andrew want, or is $1 million by age 40 really the goal at all?
Resource: 6 Keys to Setting Financial Priorities
2. Develop a system to budget or track spending
We discussed several options for tracking his spending, ranging from paid programs such as You Need a Budget (YNAB), free online tools like Mint.com, or getting really basic and simply using a spreadsheet. While there is no right or wrong system, I emphasized that there needs to be some system in place, to know what he spends.
This has two key effects. First, it is difficult to improve and virtually impossible to quantify progress if you don’t even measure what you want to improve upon. Second, it is difficult to set an appropriate saving goal if you don’t know the cost of the lifestyle you want to support.
When increasing savings, it is fairly easy to make a few big changes and take away things that are not even deemed a sacrifice. To start, I asked Andrew to figure out the exact expenses associated with all of his investments. I also requested that he figure out exactly what he paid in taxes in 2016, in order to get a baseline and see where he could potentially optimize.
This could allow for some very big wins, with no real sacrifice. In fact, he can likely save thousands of dollars a year by better controlling these costs, while simultaneously improving his investments’ performance.
Related: Best Budgeting Tools
3. Gain an understanding of investing principles
In our conversation, I discovered that Andrew is very interested in learning about investing. However, he admitted that he had never read an investing book. Most of his information had come from a variety of financial blogs and podcasts, as well as advice from the different advisors with whom he is working.
I advised that he stop flooding his mind and lay off the blogs for a while (yes, even ours!). We also talked about halting any new contributions to investment accounts for a short period. We discussed simply putting money into savings or using it to pay off auto loans until he came up with a comprehensive investing plan and strategy.
My recommendation was that he first establish some principles that would then guide all future investing decisions. These include:
- understanding exactly what he was investing in and why,
- knowing historical returns and all of the ways he could make or lose money on a particular investment,
- understanding the difference between a diverse portfolio and one that is unnecessarily complex,
- having exit strategies for any investment, and
- understanding the tax consequences associated with each investment.
This would allow him to develop an appropriate asset allocation to meet his needs and risk tolerance. It would also allow him to develop a plan to hold his investments in the most tax and cost efficient ways.
A Rare Glimpse Into Warren Buffet’s Allocation Plan
There are many great investment books, but I advised Andrew start with two that would meet his specific needs. The first is JL Collins’ Simple Path to Wealth. (You can also read our full review of the book.) It is written for beginners to be simple, entertaining, and easy to read. It simultaneously contains some very profound insights into building wealth, as well as technical and behavioral aspects of becoming a do-it-yourself investor.
The second book was Rick Ferri’s All About Asset Allocation. The value in this book is that it gives an excellent overview of virtually every asset class in which you could invest. The pros and cons of each asset class are clearly laid out. This level of understanding will make Andrew much less susceptible to every “next big thing” that he hears or reads about.
Andrew has agreed to work with me periodically over the course of the next year and allow me to document his journey. Can anyone really become an expert on their own financial situation and be a DIY investor? My hypothesis is that you absolutely can.
Join us in following the “Andrew Experiment” as we monitor the impacts of his individualized educational and coaching program.