Personal finance is the ugly step-child of finance. Most of Wall Street’s resources are geared toward helping institutional investors get richer. The rest of us get watered-down versions of their advice and insights.
This is not what we need. A trust fund or endowment has a fairly simple objective: build up as much wealth as possible. The average household, by contrast, saves in order to spend. Regular people need to finance key life expenses like a house, education, healthcare, and retirement. Making sure incomes and investments stretch to cover these costs, in addition to life’s many surprises—from a spell of unemployment to a roof repair—is a complex financial puzzle. It is harder, in fact, than what the average institutional investor deals with. That’s because there are more sources of risk and regular people have less money to go around, giving them less margin for error in their financial decisions.
The rich can afford the best financial advice, even though they don’t need it as much as people with more modest means. It’s no wonder that the personal finance world is a bit of a mess, featuring cult figures, scams, and plenty of contradictory counsel. The following manifesto is a five-point plan to thinking about your personal finances, telling good advice from bad, and judging what is worth paying for.
1. Set goals and get risk right
It sounds obvious, but we never do it. In finance, like in life, if you set a goal you are more likely to achieve it. If your goal is saving enough money to buy a house in five years, you will save and invest with that in mind. If your goal is to ensure an income in retirement that’s 70% of your current salary, that will determine your investment strategy. Set aside portions of your savings to target these different goals, since each one probably requires a different strategy.
Right now, the financial industry pays lip service to goal-based investing, but it rarely offers investment advice that actively targets a specific goal. Instead, people are told to invest based on some vague notion of their risk tolerance and investment time horizon. A more useful way to devise an investment strategy is to set goals and then take two steps…
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First, define your low-risk portfolio. Often this means short-term bonds or cash, but what counts as low risk really depends on your goal. If you have a long-term savings goal, short-term bonds aren’t low risk because they don’t keep up with inflation.
Second, divide the money you are saving for a goal into portfolios of risky assets (stocks, commodities, certain kinds of bonds) and no- or low-risk assets. The right split depends on how much money you have and your risk tolerance. You should take on just enough risk to reach your goal. If low-risk assets will deliver the house you want in five years, invest in just low-risk assets. If you aren’t comfortable with the risk necessary to meet your goal, scale back your plans.
2. Diversify, then hedge
People confuse diversification—that is, buying lots of different stocks or a variety of assets— with risk management. Diversification is an important part of any investment strategy; in fact, it should be among the first things you do. A well-diversified group of assets is ideal for your risky portfolio. But diversification merely reduces idiosyncratic or unnecessary risk, or the risk one asset will gain or lose value because of factors unique to that asset. It does not remove the risk that the whole market will crash, taking everything down with it.
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A complete investment strategy addresses all sources of risk. First diversify, and then you can manage risk by hedging, investing more in low-risk assets, or by buying insurance or an annuity.
3. You get what you pay for
Index funds are one of the best inventions in the history of finance. They allow ordinary investors to get diversification for cheap. There is no need to pay a premium for diversification or for empty claims of a manager’s ability to beat the market. Still, the low-fee gospel can go to far.
Often, you need to pay for risk management. With insurance, someone takes on your downside risk, like the risk your house will burn down or you’ll outlive your savings. This will never be free because risks are not totally eliminated but transferred to someone else. The party that takes on the risk will want money in return, and sometimes that is worth paying for.
The best hedging strategy depends on your goals: There is no universal hedge. Sometimes, you can hedge by investing in risk-free assets. Other times, you hedge by buying an asset that goes up when your other holdings go down (for example, if you are a taxi driver you could buy shares in car-sharing companies). Identifying the right hedging strategy is hard and sometimes takes expertise, which you need to pay to access. Good financial advisors can help you manage risk, but they should never promise that they’ll beat the market.
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Financial products and advice aren’t often transparent on fees. There is no reason for this to be complicated: Make you you know what you are paying for and what it buys for you. If no one can explain it to you in terms you understand, the product or service is not right for you.
4. Don’t discriminate against asset classes
People often view their savings and their homes as their primary assets. But you are most like your most valuable asset, especially when you are young. If you have a college degree, you can expect to earn nearly $1 million more in your lifetime than if you don’t. That $1 million is an asset like any other, albeit one you can’t access until you’ve earned the money. In the meantime, you can invest in yourself with more education, increasing the value of that asset. It is not guaranteed to pay off, but it often will. So if you can’t buy a house because you have student loans, give yourself a break. You just made a different investment choice, and probably a good one.
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Your investment strategy should account for all your assets. Your future income tends to pay off like a bond: regular, somewhat predictable payments. So if you are thinking about how much risk you want in your portfolio—say, by deciding on a mix between stocks and bonds—your future earnings count towards bonds. If you are young, that means you should invest more in stocks. Or, if your income varies with the market— like if you work on commission—it may be wise to take less risk with your savings and invest more in bonds.
5. Expect the unexpected
No matter how well you plan your finances, things will always come up you can’t foresee. It could be a car accident, illness, or job loss. The best way to manage these risks is liquidity, or savings that you can readily access and will always be there for you. If possible, try to keep an emergency fund to cover three months’ worth of expenses in the bank.
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Liquid savings should always be your first priority. If you can’t work and pay your bills, this will undermine even the best investment strategy.