Investing 101: Living Below Your Means
This is the first of a six-part series on investing for beginners. It is designed to help you think carefully about how to build financial security, and to protect you from the many dangers out there. Some of which I learned the hard way!
First, a brief disclaimer: I am not a professional money manager, I am not licensed to give personalized investment advice, and this series will be about general approaches to long-term investing, not get-rich-quick schemes. Obviously, each person’s financial situation is different, and for specific direction related to your assets you should consult an independent financial advisor. This series is merely my thoughts and lessons learned over a number of years of investing my own money, and working as a professional in the financial markets.
Take Care of Today First
The first lesson I’ve learned about investing is: don’t, until you’ve already met all your basic financial needs. You should have a secure housing situation, reliable transportation, no problem paying all your monthly and quarterly bills, and no looming expenses like home repairs, vacations, etc. that you haven’t already saved up for. I know it’s boring, but even careful long-term investing is a lot like gambling, and none of us can afford to lose cash for our immediate needs.
On top of that, don’t even think about investing if you don’t have an emergency fund of cash (not home equity) to get you through a financial rough patch: job loss, illness, or even a happy event like time off to have a child. The general rule is three to six months basic living expenses: less for singles, more for those with dependents.
Again, I found this period in my life financially boring, saving up an emergency fund. My friends were sharing all their brilliant investment tips with me, while I was slowly plodding along, putting cash each month into a money market deposit account. Sexy? No. But it was FDIC insured up to $100,000 and a safe place to put my money for an emergency. Meanwhile, my brilliant friends with their brilliant investment ideas eventually lost huge amounts of money as the Internet bubble burst and the stock markets crashed starting in March of 2000. Quite unexpectedly, I came out way ahead of my friends because I didn’t lose a dime. In fact I was earning 4% a year: nothing to write home about, but better than losing my shirt.
Invest, or Get Out of Debt First?
There’s good debt, and there’s bad debt. Good debt has an actual asset attached to it, like a home which appreciates over time, or even a future asset, like the earning potential of a good education, which will also appreciate over time. I don’t worry about a reasonable level of ‘good debt’ (say, 25% or less of your gross income) as long as you are having no trouble making those payments, and the interest isn’t highway robbery (no more than 6 or 7%).
Bad debt is any debt which you can’t afford, or debt that has a high interest rate (anything above the U.S. federal prime rate, currently 8.25%). Bad debt is especially debt which has no asset attached that can appreciate over time (e.g., debt for vacations, clothing, restaurant meals, most furniture, etc.). It is bad debt because there is little to no long term value to what was purchased, and meanwhile you’re paying interest on it! A more technical term for this is “unsecured” debt because it is not secured by a real asset. This would include credit cards, department store cards, outstanding personal loans, back taxes, etc.
There is no point in starting to invest if you are in ‘bad’ debt. The rule you’ve probably heard is “pay yourself first”, and some people think this means they should invest (paying themselves first) rather than their debtors. I couldn’t disagree more. In this case, “paying yourself first” means pay your way out of debt, and don’t rack up any more debt. You cannot be financially secure when someone else holds your purse strings, and could demand collection on your entire debt any time if you default (read the small print on your credit card agreements, seriously.)
The bottom line is this. Investing requires having extra money each month, and a commitment to sacrifice a little today to reap the rewards in the future. The only way to get ready to invest is to live below our means. When we live below our means, we are meeting our basic financial needs, have saved up an emergency fund, and have retired any ‘bad’ debt”and still have some money left over. That money is ripe for investment, and with careful incubation could grow into a wonderful nest egg over time.
The next article in this series will talk about just that, and how to keep much more of your earnings than the average investor.