There are many core principles that each of us regularly follow throughout our lives. These principles help us navigate through the many decisions we make daily.
I have 10 favorite axioms that I follow — and share with my college classes and clients — to make personal financial life more satisfying and effective. Sometimes, many years after the class or meeting, former students and business acquaintances reflect upon the axiom and remark how it positively influenced their lives.
Here are the first five:
Spend Less Than You Make
This is the key to a successful personal financial life and probably the most important axiom. In personal financial planning, we learn to acquire, use and control our resources more efficiently. Wealth is determined more by how we spend than by how much we make.
Everyone has needs and everyone has wants; they are not the same and this fact must be recognized. We all have future needs such as attaining financial security. Financial security is accumulating sufficient assets so that we don’t have to work if we no longer want to work. Attaining this goal is a very gratifying position.
Good financial planning allows you to spend your money so that you get the most satisfaction from each dollar. It takes effort to measure the utility of our spending decisions. An executive that makes $1 million per year and spends $1.1 million is a failure. A laborer that makes $24,000 per year and saves $2,000 is a success. To be successful, part of what you earn needs to be yours to keep.
Planning Precedes Every Activity
Too many people mistakenly believe that financial planning is only for the wealthy. This is absolutely untrue. Everyone needs to develop a financial plan because it gives you the edge over someone that merely just reacts as events unfold.
The plan definitely needs to be written down. It includes what you want to accomplish financially, when you plan to complete your goal, and how you will achieve your objectives. Planning can be an intense process requiring introspection, discussion, evaluation, reassessment and reinforcement. This planning process is vitally important.
A relatively new field of finance, behavioral finance, tells us that the human brain is hard-wired to do things poorly in a time of crisis. Therefore, you need to plan before the crisis to avoid bad decisions.
The need for an investment plan and sticking to the plan became apparent to many during our latest stock market crisis. Without a plan, individuals bounce through life’s financial decisions like a pinball in an arcade game.
Systematically Monitor Your Progress
Periodic reports are the tools for developing and monitoring financial plans. The reports link future goals and plans with actual results. Simple-to-use software can assist you in preparing these tools. The reports describe how much you are worth, as well as what you earn and where it goes.. The comparison of actual to budgeted data helps you control future expenses and purchases so that you will have the needed funds to carry out your plans.
Save Early and as Much as Possible
— There are many examples of how saving early pays off with big results later. Here are two examples that may motivate you to start your saving plan now. First, if you invest your IRA in a balanced combination of 50 percent bonds and 50 percent stocks, you should expect to generate an annual return of approximately 7.5 percent. At that rate the investment doubles its value every 10 years. A deposit of $10,000 will equal $20,000 in a decade, $40,000 in two decades and $80,000 in 30 years. If you want to accumulate $1 million at 7.5 percent, it will take annual deposits of $4,241 over 40 years, $9,322 over 30 years, or $22,258 over 20 years. Save early to harness the enormous power of compounding.
Diversify, Diversify, Diversify
Diversification is the practice of allocating a portfolio among different investments to reduce risk. Risk is the chance that an investment will perform differently than what is expected. Individual securities are exposed to a variety of risks. Combining a large number of securities into a portfolio eliminates much of the risk exposure.
The simplest solution is not to purchase individual stocks, but to invest in mutual funds or exchange-traded funds. Mutual funds and ETFs provide adequate diversification and avoid the record keeping chores of managing the number of securities needed for a properly diversified portfolio. When it comes to investing, don’t take unnecessary risks.
Part 2: Things to consider when investing in mutual funds and the types of investments for a sound portfolio.
