Personal Finance 101

I have been wanting to talk about finances on the blog for awhile now, but wasn’t sure how to approach the subject. I’ve heard a lot of interesting questions come up over the years from friends about how to manage money and what should be made of the the future of the economy. With the recent economic downturn, and the approach of the tax season, now is as good a time as ever to start learning. I have been lucky enough to have a financial advisor/economist dad who has taught me everything I know - and I wish others could know these things too.

Better than explain things myself, I am trying a new medium here by presenting a question and answer session with my dad, Robert Friedland, Associate Professor of Economics at Georgetown University, using questions and conversation bits that have come up among my peers. Enjoy!

Q: How do I get a credit card if I don't have any credit to begin with? Where do I start?

The first time is the hardest. Options:

  1. Get a parent to cosign for the card.

  2. Start with a department store, Discover, or a card from your local bank where you have a checking account.

  3. Start with a pre-paid debt card.

You only need one credit card to begin – but it is critical that you always make the minimum payment prior to when the payment is due and that you never let the balance of the credit card extend for more than two months.  That is, pay it off in full at least once every two months or so. After a few years you can try ordering a second credit card.  Once approved, keep the first credit card as a back-up.  Don’t close it, but of course do not use it either.  Managing two cards will improve your credit score dramatically, even if you never use one of the cards. However, the easiest way to see your credit score decline is just one late payment.

Q: In light of the financial downturn of the market, and of recent fires across California (and other natural disasters, impacting property investments) - what should I invest in?

Nothing is safe.  It is imperative that you keep emergency funds in a savings account that is insured either by FDIC or the NCUA.  If you are the sole employee, try and save 8-10 months of living expenses.  If your partner is working, aim for 6-8 months of living expenses.  In addition, if you are saving for a large purchase, like the down payment on a home, then those funds should be saved in a savings account.

While the principal of these funds will be safe, over the longer term they will be worth because of inflation.  Savings accounts will not keep up with the cost of living.

Funds that you do not anticipate needing for 10 or more years, however, should be invested in the stock market.  The easiest way to do this is through mutual funds.  Either increase your monthly investments to your pension plan at work ($18,500 is the limit*), invest to an Individual Retirement Account ($5,500 is the limit*), or invest in a taxable investment account (there is no limit). This is the order in which you should invest your long-term savings. Everyone will need to have some of their retirement savings in non-retirement accounts.

(*Note: these limits are higher for those age 50 or older.)

Q: If I don't make a lot of money, and the cost of living in my city is astronomical - how can I invest for my retirement?

Just do it.  Start by maximizing your contributions at work.  If your employer does not have a 401(k); 403(b) or some other form of retirement plan, than you will need to contribute to a Roth IRA and contribute to a taxable investment account.  As you make more money you will want to contribute to your plan at work, to your IRA, and to your taxable investment account. For most people, maximizing your contributions at work will not be sufficient.

If you are living on your own, try to invest 25 percent of take-home pay.  If you are a couple with two paychecks, try living on the higher paycheck and investing the lower one.  If you do not have 6-8 months of emergency funds set aside or if you are trying to save for a large purchase in the next 5-8 years, put half of your savings in the bank and invest the rest in the market.

Make this process automatic, in accordance with your weekly, bi-monthly or monthly pay-checks by having the institutions automatically transfer the funds and automatically investing. Bi-monthly investments in small increments will often do better than larger quarterly investments. 

Q: If I want to invest, where do I begin? How do I know what are good stocks/portfolios? Can I do this on my own or do I have to hire someone to help me?  

What matters the most is that your investments are diversified (firm sizes, industries, and across the world).  The easiest way to do this is through mutual funds or exchange traded funds (ETFs) that do not have a transaction cost. Conceptually, mutual funds are easier to understand but ETFs are usually less expensive and more tax efficient (which is only relevant if the investments are in a taxable account).

You will first need to decide on a brokerage firm.  It will be wiser in the longer term to start with a discount broker so that you are forced to learn how to handle this yourself.  There are many brokerage firms. A few of the better-known names are Schwab, E-Trade, Fidelity Investments, and Vanguard Investments.  While the websites differ in their structure, they all have very similar tools, offer the same basic services, and will help you get up and running by phone or in person. There are no upfront costs for setting up your investment account. Most brokerages allow you to set up regular monthly or bi-monthly investments. (Editor's note: if you want to do more research on getting started with stock trading and investing, check out this site which has weighed some of the cheapest options around!).

At some point, perhaps 10 years down the road, if you are uncertain about your efforts you might want to hire a fee-only financial planner to review your investments to be sure they are allocated appropriately and to give you some advice about how to modify your allocation as you move into your 40s or 50s.

Q: Is it true that with the cost of living these days, I'll never be able to afford to own, only rent?

It may seem futile, but if you are disciplined, savings will accumulate.  You should try and save about 8-10 percent of the cost of the home – you may only need 3-5 percent as a down-payment, but it is better to have a financial cushion for those unexpected costs that seem to arise with home ownership.   This means that for a $600,000 home, you should try and set aside $48,000 - $60,000.  This would require saving $178 -$222 per week for 5 years.

If you put 5% down ($30,000) and finance the balance ($570,000), then a 30-year mortgage at 4% would require a monthly mortgage of $2,713 (plus property taxes and utilities).  While property taxes and utilities will change, the $2,713 mortgage remains the same until you sell or refinance.

Q: What are ways I can reduce my cost of living to be able to be more financially stable?

Avoid splurging on your rent. Splurge on a used car, not a new car.  Save restaurants and bars for truly special events.  Hold more pot-luck dinner parties.  Seek free concerts, public parks, and special prices on entertainment.  Convert non-food shopping from a form of entertainment to a challenge to find the best “deals” by only shopping when necessary, combining shopping trips, and paying attention to seasonal sales. Pack your lunch for work and take advantage of the office coffee machine.

Q: What are the most important things I can do as a 20/30-something to secure my financial future?

Get into the habit of automatically saving and investing.  Increase your automatic savings with each raise at work.  If you get reimbursement for business travel, add the reimbursement to your savings account. If you are paid bi-monthly, budget for 24 pay-checks and add the two extra pay-checks to your savings and investments.

Q: What's the most common financial faux pas you have seen in your time advising others?

  • Borrowing from credit cards to meet ongoing living expenses.  Invariably, the first time creates a slippery slope to do it again, and this leads to out-of-control debt.

  • Trying to time the market. I have seen many people who are so proud that they got out of the market before it hit the bottom, and then later they don't know when to get back in.  In the short run, the market is always scary; and therefore, it is easy to avoid investing.  But investing is for the long-run.

Q: If you had to pick one thing you wish others knew about finances that has helped you, what would it be?

There are about 240 trading days a year. Virtually all of the investment gains for the year will stem from about 15 different trading days.  Even full-time stock speculators have a difficult time picking those specific days and therefore you do not need to be Warren Buffet to end up rich from investing.  It does take discipline, and it does take time.  You need the discipline to invest a little every week and the discipline to ignore the “market noise”  the other 225 days, year after year.

The year after year point is important because you will likely spend 35 years working and perhaps another 35 years in retirement.  Your savings over the next 35 years will determine just how financially independent you will be over the subsequent 35 years.