Americans love slogans.
In 1928, the Republican Party distributed a circular claiming a Herbert Hoover presidency would result in “a chicken for every pot”. Bounty paper towels have been “The Quicker Picker Upper” for decades. A sea of red baseball caps emblazoned with “Make America Great Again” flooded Trump rallies during the 2016 presidential race.
The list is endless. Hope and Change. Just Do It. Melts in your mouth, not in your hands. Social media has only made our short attention spans even shorter.
Finances
When it comes to finances, many of us are trapped in our own personal wild west. Only five states require at least one semester of personal money management. That means the vast majority of Americans aren’t taught how to handle money or manage debt. Too many wait too long or save too little to be prepared for the curve balls life throws at us. It’s little wonder why 60% of us cannot cover a $1,000 emergency from savings.
You’re forgiven if you embrace the modern sound bite culture — most people do. With respect to finances, however, you cannot afford to take the same distilled approach.
Irrational Exuberance
The etymology of the term irrational exuberance originated with former Federal Reserve Chairman Alan Greenspan during a black-tie speech before the American Enterprise Institute on December 5, 1996. Fourteen pages into his remarks, the Fed Chairman posed the following question:
How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
Despite his warnings, stock speculation continued for 51 months until the NASDAQ peaked at 5,132.52 during intraday trading before market fundamentals took hold. Shortly thereafter, the markets began to crash, and the dot com bubble spectacularly burst.
The moral of the story is this: embracing the herd mentality is a losing strategy. An even worse approach is having no strategy at all with respect to your finances.
You, Inc.
So how does You, Inc. get on top of its finances? Start by thinking of finances in three basic ways:
- Net income
- Liquidity
- Equity
Although they are all critical, I’d rank them in this order. Positive net income leads to liquidity and ultimately equity. Let’s break them down.
Net income
The building blocks of You, Inc.’s finances are anchored by personal net income. Much like a business, put together a personal profit and loss statement by listing monthly income and subtracting monthly expenses. If the net number is positive, congratulations — You, Inc. is profitable. If the reverse is true, you’ve got work to do. Profits can be spent (material acquisitions, vacations, etc.), saved (investments, 401k, traditional savings) or a combination of the two. Losses must be covered, all too often by taking on additional debt.
- Monitor expenses, and make sure they are consistently lower than income
- Do not allow credit cards and consumer debt to creep up. Increasing credit card balances are a sure sign that You, Inc. is not profitable.
Liquidity
Liquidity is the ability to generate cash quickly. It’s powerful: an unexpected expense will not force You, Inc. into selling assets or borrowing money in order to cover the bill.
- Start early and save money on a regular basis. If You, Inc. is profitable, that won’t be a problem. Make it a habit to put money aside for a rainy day. The U.S. household savings rate is a mere 4.65%, among the lowest in the world. Put 5% of your income away in short-term savings, and strive for 10%.
- Pay down credit cards and short-term debt as quickly as possible. Better still, pay them off every month
- Do not overly concern yourself with how much money the savings accounts are earning. It’s more important to have quick access to cash than it is to earn a few additional basis points.
Equity
Equity is the difference between assets and liabilities. Negative equity — debts exceeding assets — bodes poorly for You, Inc.’s future. As a rule of thumb, assets should be at least twice as much as liabilities.
- As mentioned above, pay off credit cards monthly.
- Save at least 5% for retirement, being sure to take full advantage of any employer matching funds in a 401k or similar account.
- Send creditors unscheduled principal payments regularly. That will retire debt faster, making You, Inc. more profitable.
- When borrowing money, keep the term as short as possible. A $250,000 mortgage costs roughly $550 more per month on a 15-year amortization, but the net savings over the life of the loan will be greater than $150,000.
Summary
Personal financial management should be treated as a business. Thoughtful money management will improve personal profitability, liquidity and ultimately, equity.
Do not fall into the trap that starting when things are”better” makes sense. Good habits can’t wait until then. Reduce expenses to create profitability, eliminate consumer debt, put as much money aside as possible and increase net worth every single month.
You, Inc. is the most important business you’ll ever manage. Treat it accordingly.
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