The ingredients for a successful financial life are easy. The chef and the recipe create a lot of non-value add, behavioral complexity which leads to a less than desirable meal.
The concept of investing for the long-term in a low-expense, tax-efficient, diversified portfolio so that compounding can take over is easy to understand. However, humans are impatient creatures that compare and feel the need to tweak things that don’t need to be tweaked like a Major League Baseball manager running through his bullpen.
There is an expression in investing – “Don’t just do something, sit there.” We suck at doing nothing. We suck more when we do something. The key is to find the right amount of “something” that balances the risk of loss and opportunity cost, when dealing with heightened uncertainty.
Markets don’t care about you. Neither do traders, hedge funds, robo-advisers, or mutual funds. They have no clue what your goals, time horizons, and risk tolerance are.
So what rules would I offer a public in need of a balance between structure and freedom that provides the emotional relief valve to investing? I would start with savings.
“Save like a pessimist, invest like an optimist.” – Morgan Housel
Savings Rules
Savings rate is the crown jewel of a successful financial life. True wealth originates with the absence of spending in the form of savings. I really believe this starts with a mindset. Spend what you don’t save, rather than save what you don’t spend.
· The more you save, the more you have to compound.
· The less you spend, the more you realize how little you really need
· It is more fulfilling to attempt to save more rather than attempt to spend less
· Savings goals, unlike many other elements of investing, are completely in your control
Savings goals are more forgiving than spending goals. Once you miss your spending goal, you can’t really go back and “unspend” money. However, with savings, if you have a short-term headwind that may make that savings goal less likely, you at least have the chance to save more later to offset the savings speed bump.
There are three levels of savings that everyone should automate and aspire to achieve.
· Level 1: Save enough in your 401k to achieve the maximum matching amount.
· Level 2: Save enough to fully fund all retirement and Health Savings Accounts. Work with your advisor to determine where your next dollar of savings should go.
· Level 3: Save beyond retirement accounts so that you pay yourself as much as you pay in taxes. I call this the Personal Freedom Index.
If your Personal Freedom Index is greater than 1, then you are investing more in yourself than in the government. Who wouldn’t want to do that? By doing this through your working life, you should also avoid unsustainable lifestyle creep. If for every $100 you make, $24 goes to taxes, and $24 goes to savings, that still provides a nice percentage devoted to paying off debt or spending on today. If you don’t do this, your savings rate necessarily decreases and you will have a harder time making things work financially as you age.
Saving is the short-term intensity that takes out market volatility. Investing is the long-term consistency that leads to the benefits of savings through compounding. People underestimate the impact of these two forces because it happens too slowly for them to notice and seriously consider.
Whether it is savings, diet, or health, you pay for your good habits now, you pay for your bad habits later. The cost of those bad habits compound. The benefit of those good habits compound as well.
One disclaimer: In any event, spend less than you earn doesn’t mean to skip out on purchases you can afford as a result of guilt, but recognize when you have approached mastery of savings, spending isn’t as fun.
If you are interested in calculating your Personal Freedom Index or other Financial Diagnostics, please reach out to me and let’s see if I can help. In the meantime, check out this table I created to give you an idea of how many months it takes, with a given contribution and return of 5% to reach various benchmarks. Here you can get a feel for the impact of compounding.
