Personal Finance

I teach investments, portfolio management, and corporate finance but many people are more interested in personal finance. Here are some thoughts on budgets, using debt, paying off debt, student loans/college, and investing.

Budgeting

Budgeting combines so many personal priorities that one set of guidelines will not work for everyone. I can offer some principles that would benefit most people.

1. Adjust anything necessary to save 3 months of income as soon as possible. This allows you to deal with emergencies that might interfere with your normal income or provide time to search for another job in the event of a layoff.
2. Max out your 401k plan if offered at your company. Company matching funds are lost forever if you don’t qualify and your contributions lower your taxable income. Saving early is more important than paying off your debt because your rate of return will likely be higher on your retirement savings than on your long-term debt.
3. Now we focus on paying off debt. Take a look at my suggestions below. There are no shortcuts but there are more efficient and less efficient ways of getting it done.
4. Identify your life priorities. While steps 1-3 are universal, what comes next depends on what you value. Maybe charitable giving or church tithing is important. Maybe traveling to visit friends and family is essential to your life. Be honest with yourself about “needs” and “wants”. Everyone would prefer not to have a roommate. Maybe this is a sacrifice necessary to afford to visit your family.
5. I find that eliminating “aspirational purchases” is a good start. Do not buy anything where you would change to incorporate the purchase into your life. Only purchase things that fit into your current schedule/priorities. Find self-improvement opportunities that do not require more resources.
6. Find ways of redistributing the things that make you happy. I like good food, but rather than spending money on casual dining, I get more satisfaction from rare visits to good restaurants while eating plain food through the work week. This also helps fight against the hedonic treadmill or the tendency to adapt to lifestyle improvements and receive less satisfaction from things that brought happiness in the past.
7. Consider the life-cycle of the consumer products you buy. Fashion and quality may result in a lower lifetime cost for a slightly more expensive item or it may just be a markup. This can have a big impact on clothing and consumer electronic purchases. Sometimes, the inverse is true. The cheapest option may be good enough. Clothes usually last much longer than you really want to wear them.
8. Constantly reassess your life priorities starting from scratch. This helps to remind you of the importance of your current life choices and to place new choices in perspective.

Managing Debt

Credit cards are not bad if you pay off the debt within the same month. Credit cards often offer good fraud protection and may have features that benefit travelers. However, the interest rates are too high to carry a balance over several months and having multiple credit cards increases the likelihood that you will spend beyond your means. If the psychological pressure is too much to spend within your budget, then get rid of the credit cards.

Debt should not be longer than the useful life of whatever you buy. Most things people buy with a credit card do not have long useful lives which is another reason not to carry a balance on your credit card.

Debt that is tax deductible ends up being much cheaper than other types of debt. Your mortgage should be the last debt that you pay off because mortgage interest lowers your taxable income. Choosing to live in an apartment is often more expensive on an after tax basis but it is easier to move and possibly take a better job. Consider several local career opportunities for you and your partner before buying a house in a new area.

Paying off Debt

There are two dominant factors in finance. One is the mathematics that maximizes your wealth while the other is the psychology that allows you to make good financial decisions. Paying down debt puts these two factors at odds with each other.

Mathematically, the fastest way to pay off debt is to start with the highest after tax interest and longest term debt first and work down to the lowest after tax debt and shortest term debt. This is sometimes referred to as the debt avalanche and it works because of a concept called amortization. Your payments contain both principle and interest but the proportions change over the life of the loan. Early payments are mostly interest with a little bit of principle while the last payments are almost entirely principle with a small amount of interest. Making additional early payments has a larger decrease in the total amount you will pay on the loan because it reduces principle much faster than the amortization schedule.

Psychologically, people need to maintain their motivation over long periods of time to pay off debt. It is easy to become mentally fatigued and to question whether the sacrifices to your quality of life are actually benefiting you. Dave Ramsey has built a massive following by promoting his “debt snowball” which involves paying off small debts first. Many people find this approach useful because of the psychological feedback that provides you with more motivation to continue to sacrifice now for longer-term gain. These two approaches may not even be in conflict if the small debts are credit card debts that usually have the highest interest rates. The problem is that everyone’s finances are different and one approach is not necessarily correct for everyone. Furthermore, using all of your discretionary income to pay off debt may cause you to overlook other financial opportunities such as networking events and the ability to move that can lead to better jobs or promotions.

Student Loans

Let me first explain my college experience and then offer some general advice. I could not afford college after high school. I joined the Marine Corps initially to get money for college and stayed for an additional few years to increase my savings. When I was ready to leave active duty and go to school, the government involuntarily extended my contract due to the 9 / 11 terrorist attacks and subsequent war in Afghanistan. Nearly two years later, I was permitted to leave active duty. I joined the reserves, used my weekend reserve paycheck, my G.I. Bill benefits (before the revised G.I. Bill), and got a part-time job at Starbucks in order to receive healthcare. (At the time, Starbucks was one of the few companies offering healthcare to employees working at least 20 hours per week.) This allowed me to afford to attend Rhode Island College on a full-time basis.

I decided to study finance rather than music because I knew I needed to support myself after school and I didn’t have the option to go live with my parents. I attended the state college for 3 semesters and I took as many general education classes and introduction classes as I could that would easily transfer to another university. I maintained a 3.95 / 4 GPA which I used to apply to the local private business school, Bryant University. Bryant offered a $10,000/year scholarship and I was able to graduate after 4 semesters at Bryant with a double major in finance and economics in the honors program while taking two years of Chinese.

Despite the academic scholarship from Bryant, I used my entire G.I. Bill, Marine Corps Reserve paycheck, my Starbucks paycheck, and still needed student loans. I understand that I was lucky to have those opportunities and everyone cannot possibly repeat my experience simply by working harder. I should also note that despite my academic achievement, many companies did not want to hire me because they were concerned that I would be deployed. I received many opportunities to interview but my peers that I had tutored received multiple offers while my first offer only came after I separated from the reserves. I believe that the attitude towards veterans has improved in corporate America but there is a substantial difference between the “Thank You for Your Service” platitudes and the actual hiring practices.

I could have decided to stay at Rhode Island College although the opportunities and quality of education were not equivalent to Bryant University. Opportunities are only valuable if used and I believe many other students at Bryant would be better off going to the state college. At the time I did not intend to get a masters degree. A better path would have been to graduate from the state college and go to a better university for my masters program although it is uncertain whether I would have been accepted in the same masters program.

What should you do? First, identify whether you simply want a college degree or whether you need a marketable skill to survive. Americans do not like to talk about class because it conflicts with our ideal of equal opportunity and meritocracy. Be honest with yourself about what you need to survive and what you are willing to sacrifice when you choose a college major. Every program at every college has alumni that they can use as examples of success. What you need is hard data on the percentage of students for a given program that get entry level jobs that pay enough to pay off student loans in a few years (not 10 years) and provide a minimal standard of living. Unfortunately, this eliminates many liberal arts programs at non-prestigious universities. You should also utilize data such as the U.S. Department of Education College Scorecard.

As a college professor, I would also suggest that you consider not going to college. Watch this video by “Dirty Jobs” host, Mike Rowe. I don’t mean to in any way minimize the value of learning but universities are not the only places to learn. Get a library card and read. Consider certificate programs but only if they have a proven career benefit. (There are lots of useless certificates and online programs out there.) Professors do not have a monopoly on knowledge but they usually know the best sources of knowledge and the most efficient way to acquire knowledge. Search for syllabi (course outlines) on subjects that interest you and read the book on your own. A well-read tradesman (electrician, plumber, etc…) may be wealthier and more knowledgeable than a college graduate.

Personal Investing

The goals of investing (more return, less risk) are same for everyone but the tools are different for various levels of wealth. Someone with $1mm to invest should not be doing the same things as someone with $100k to invest. Investing is a scale business which means that some expenses are worthwhile for large portfolio and a waste of money for small portfolios. I suggest using a robo-advisor like Wealthfront or Betterment unless you have more than $100k. The reason is that the fees are low and lowering expenses is more likely to benefit you than hiring a personal financial adviser. You should not be buying any fund with an expense ratio greater than 0.25% (Yes, that is a quarter of 1%). Most people should be investing in index funds and these types of businesses make the process relatively cheap and simple. They also automate the process of rebalancing your portfolio which minimizes your interaction with the portfolio. Behavioral Finance is an entire field dedicated to studying why people make foolish financial decisions. In long-term investing, most people are better off doing as little as possible.

For the ultimate in cheap, DIY investing, I recommend using a pair of Vanguard funds like the Total World Stock ETF (ticker: VT) and the Total International Bond ETF (ticker: BNDX). For those that want to stay within the U.S., you can use Total Stock Market ETF (ticker: VTI) and Total Bond Market ETF (ticker: BND). The proportion of stocks and bonds depends on your level of risk. If you have more than a decade to invest, hold all stocks. Something less, or if market changes concern you, hold more bonds. You only need a pair of mutual funds or ETFs.

A final word of warning, do not use apps like Robinhood for serious investing. The reasons are more complicated than I can include here but one reason is that the service is not free and they count on people not recognizing where the money is coming from.