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Getting Started With Personal Finance

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    Li-Kai Wu
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0. Prerequisites

  • None

1. Preface

This article gives a high-level overview on personal finance.

Personal finance is the process of managing one's money through earning, spending, saving, and investing.

We understand how confusing personal finance can be. When you hear terms like compound interest, capital gains, dividends, interest rate, and inflation, it's inevitable to feel intimidated.

But when we take a step back and look at personal finance from a high level, we can compartmentalize it into 3 different areas:

  1. Earning
  2. Spending
  3. Managing (Investing & Saving)

In this article, we will briefly introduce some concepts to help you optimize each area of personal finance.

We want you to be familiar with personal finance topics that you can further look into yourself, — and not everything about personal finance in one long article.

2. What is Personal Finance?

Personal finance is an umbrella term for all the topics related to managing one's money, or finances. This naturally includes how one...

  • earns through one or more income streams
  • spends with intentions and awareness
  • safely saves and deposits savings
  • invest to grow their money

Before we go over each area individually, you should ask yourself...

Before we go over each area individually, you should ask yourself...

2.1. What Are My Goals in Personal Finance?

By keeping tabs on your financial goals, you will be able to reach them in a much more efficient matter. For example...

  • Paying off debt
  • Buying a house
  • Saving for retirement
  • Starting a business
  • Feeling financially secure

What are your goals?


3. Income

Income refers to money received in exchange for working, providing a service or product, or through investment, usually on a regular basis.

Earning a salary or wage is the most common way to earn money, where you typically exchange your time and service for money. Although this is one of the most consistent streams of income, many wealthy people didn't become accumulate wealth simply through this method, but by incorporating other sources and types of income. These include:

  • Business - money earned by selling a service or product for more than what it costs you to produce
  • Interest - money earned by lending people or businesses money
  • Rental - money earned in exchange for the use or occupation of rental property
  • Dividend - money earned by owning a part of a business and receiving a part of its profits
  • Capital Gains - money earned by realizing the appreciation in value of assets
  • Royalty - money earned by building a product and licensing it to people or businesses to use at a price

3.1. Should I Diversify My Income Streams?

You can see that there are many possible streams of income that you can incorporate and earn from. Diversifying your sources of income becomes crucial if you want to hedge against the risk of losing all your income from a single source.



3.2. What Is Active Income?

Active income refers to income received for work that requires active participation or time. Usually, the time spent working is strongly connected to the amount of money earned. A good rule of thumb here is, that you are exchanging time or service for income.

Examples:

  • Wages
  • Salaries
  • Commissions
  • Tips


3.3. What Is Passive Income?

On the other hand, passive income refers to income received for work that requires a minimal amount of effort and time. Earning passive income typically involves building or acquiring assets that bring in passive income in the long run. They may require a significant amount of money, time, or effort upfront, but the key is that these assets continuously collect income even as time passes. A good rule of thumb here is, that your passive income is largely correlated to the assets you own.

Examples:

  • Interest / Dividends / Capital Gains / Rental Properties - Accumulating enough initial capital to own assets (bonds, stocks, and real estate) that yield passive income like these will require money from active income or other sources. However, once you own them, you can start earning passively.
  • Royalties - The time, expertise, and initial capital invested upfront (for example, to write songs, design digital graphics, or create courses) may be active but the residual income in the form of royalties becomes passive later on.
  • Owning a Business - can be very active in the beginning but this could also slowly become passive after a while


3.4. Active vs Passive Income

It's rare to find people that became financially wealthy by simply increasing their active income. Wealthy people become rich by building or acquiring assets and earning passive income from them. Even if you start with earning a lot of active income, it becomes imperative to start decoupling time from money since time as we all know is finite.

4. Spending

Managing your expenses is important for preventing any of your hard-earned money from disappearing unknowingly.

4.1. How Should I Track My Expenses?

You can track your expenses with pencil and paper, a digital spreadsheet, or even a budgeting software. This is just a personal preference — choose what fits you the best!



4.2. How Should I Categorize My Expenses?

Examples:

  • fixed | variable
  • one-time purchase | recurring
  • annually | quarterly | bi-monthly | monthly | weekly
  • needs | wants | savings | investing
  • foods | transportation | travel | services | health | entertainment

4.3. What is the 50/30/20 Rule?

Elizabeth Warren, a senior U.S. Senator, popularized the 50/30/20 rule, where you allocate 50% of your income for your needs, 30% for wants, and 20% for saving and investing.

The main feature of this guideline is its simplicity, and it is best for people who are just getting started or struggling with budgeting.



4.4. What is the 0-Balance Rule?

In 0-balance based budgeting, you allocate every dollar that comes into either your savings/investing or expenses.

It is called the 0-balance rule because when you subtract the money you distribute to your savings/investing or use for expenses from your income, you should end up with nothing left.

0=Income−Expenses−Savings−Investing\Large {{0}=\textcolor{#61A0AF}{Income}-\textcolor{#F5D491}{Expenses}-\textcolor{#F06C9B}{Savings}-\textcolor{#F9B9B7}{Investing}}

It's really just a fancy way of saying using every dollar with intention.



4.5. Questions to Ask Yourself

  • How much are my monthly expenses?
  • How much do I spend on my needs?
  • How much do I spend on my wants?
  • How much do I save after everything?
  • How much am I investing?
  • Can I do anything to reduce my bills?
  • Am I eating more than I thought I was?
  • How much is the bare minimum I need if I lose all my sources of income?
  • Some Typical Examples of Needs
    • Mortgage
      • Property Tax
    • Rent
    • Debt (Paying minimum only if necessary; ideally full balance)
      • Student
      • Auto
    • Utilities
      • Electricity
      • Water
      • Gas
      • Trash
      • Internet
    • Transporation
    • Food
    • Phone
    • Family
      • Child Care
      • Tuition
    • Insurance
      • Life
      • Health
      • Car
    • Household Items & Supplies
      • Toiletries
      • Laundry Detergent
      • Dishwasher Detergent or Dish soap
  • Some Typical Examples of Wants
    • Entertainment
      • Cable
      • Subscriptions
      • Gym Membership
      • Movies
      • Concerts
      • Events
    • Eating Out
    • Clothing
    • Travel
    • Hobbies
    • Self-Care & Grooming
      • Spa
      • Salon
      • Cosmetics

Try listing out and reviewing your expenses from the past few months.

If most or all of your expenses are covered by someone else, try calculating hypothetically. How much would you ideally earn, spend, and save or invest? What would my expenses be if they were not covered?

4.5. Everyone's Definition of Needs and Wants Are Different

One thing to keep in mind is that everyone's definition of needs and wants are different. To some people, their morning routine of getting Starbucks every day before work can be a need, especially if that helps them be effective at work! It might be considered a want for some other people, but who cares! The important thing here is to really reflect on what are needs and wants for you, and distribute your income appropriately.

5. Management (Saving & Investing)

Once you know how much you will be earning and spending, the next thing in line is to reflect on how you would manage your money.

There are many different directions you can head with money management, especially since everyone's situations are different and something that is best for you might not be for another person.

However, there are still core concepts that apply to most cases.

  1. Keep an emergency fund.
  2. Pay off debt
  3. Invest

5.1. Emergency Fund

It is commonly advised to save at least 3 to 6 months' worth of expenses in your emergency fund.

Some people, including myself, save 9 months' worth of expenses if they are in a unique situation that might demand more expenses. For example,

  • those with health conditions and are at high risk for potential large medical bills (although buying a disability insurance may be more fit in this case)
  • those with unstable income or in an industry where layoffs are common

If you are older, you may want to consider saving more in case your investments take a turn for the worse and decrease in value.



5.2. Why Should I Keep an Emergency Fund?

Emergencies happen all the time. You want to be prepared for those times.

Having an emergency fund will give you both the emotional and financial buffer to sustain an emergency, which could otherwise put you and your family in a devastating situation.

5.3. Where Should I Keep My Emergency Fund?

  1. High-Yield Savings Account


  1. Money Market Account - allows you to earn interest like a savings account while simultaneously allowing you to withdraw or debit money, giving you the same functionalities as a checking account. However, money market accounts usually require a higher minimum balance in order to use them.
  2. Certificate of Deposits - often have higher interest rates than savings or money market accounts but charge an early withdrawal penalty if you pull out the money before the end of the CD's term.


5.4. What Is Investing?

When you invest, you allocate resources — usually money — with the intention and goal of earning an income or profit.

Some examples of investments (sometimes also called investment vehicles or financial instruments) are:

  • Stocks
  • Bonds
  • Funds
  • Real Estate
  • Cryptocurrency
  • Art
  • Private Companies
  • Commodities

Each type of investment has its advantages and disadvantages. There isn't one best investment vehicle that you should be pouring all your money into — most people invest in more than one to diversify. Choosing which financial instrument to invest in depends on the situation you are in.

5.5. Where Do I Start With Investing?

Many beginners are suggested to start by investing in index funds.

In short, an index fund is a group of investments (such as stocks and bonds) that is designed to match the composition and performance of a financial market index.

A financial market index, is a hypothetical group, or a portfolio, of investments that represents a section of the financial market.

Here are some reasons why index investing is encouraged for beginners:

  • Diversification
  • Consistent Return Over Long-Term
  • Low Management Fee (Expense Ratio)
  • Tax-Efficient


5.5.1. Wait, But I Have Debts! Should I First Pay Them Off Or Invest?

It depends.

"But wait! If my student loan has an interest rate of 4% a year while my investments on average give me a 7% return a year, wouldn't I still be netting the 3% difference?

Yes and no.

You're probably thinking, “Um, why is it difficult? Isn't it just mAtH?”

There are two arguments explaining why saving may be a better fit for you.

5.5.2. The Risk Counter-Argument - Why You Might Actually Be Netting Less Than 3%

In a perfect world where you consistently get a 7% return annually on your investments, then the math generally checks out. Yes, you will be netting 3% of your money.

But unfortunately, the 7% annual return on your investment is just on average.

Without going into detail too much, the stock market's performance fluctuates over the years, but on average (or annualized) the return is 7% per year. That means the stock market might do horribly right after you start investing, and it may take a few years until the stock market rises back up and returns on average 7%.

However, your student loans will always and without a doubt charge you an interest of 4% every year. And since every dollar of your debt paid off is a few more dollars of interest saved (and thus earned), you can think that paying off your loans is a surefire way of saving (or earning) 4% every year.

Therefore, if you consider the risk in your investments in your calculations, the risk-adjusted annualized return rate may actually be somewhere near 4-6%, down from 7% and making your investments not as reliable as before.

So, when you consider the risk involved in your investments, it becomes more difficult to judge to prioritize saving or investing. Since your loan rates are different and the investment vehicles you put your money into can also be different, you will ultimately have to judge for yourself.

5.5.3. The Relief Counter-Argument - Why You Might Want To Save

Another reason is the emotional relief you get from paying off your debts. Many people feel pressured and shackled to their debts, making it difficult for them to venture out or start a business for example. Dealing with the cloud of stress that constantly lingers over your head is just not worth it for some people, and prefer to pay it off before investing in anything.

To reiterate, the answer is: it depends. How you want to prioritize is ultimately up to you.

5.9. Should I Save or Invest?

Again, it depends.

Do you have an emergency fund already set up? If not, you should save the money towards your emergency fund and consider investing after completing that.

Do you know when you'll need the money? You could invest if you won't touch it for a long time, and save if you will need it soon (about 5 years or shorter).

Do you feel comfortable with your money compounding but at the risk of market volatility? If you do, then investing is suggested.

There are many other factors to consider when deciding to save or invest, but hopefully, these questions help you get the mind thinking about them.

5.10. Should I Automate Parts of My Personal Finances

Automating your savings and investing can be exactly what beginning investors need.

New investors who aren't familiar with the emotional rollercoaster associated with investing may benefit from a systematic approach.



6. Other Important Topics

6.1. Taxes

You can't change the fact that you will be taxed on your income, but some investing strategies and retirement accounts grant lower taxation.





6.2. Credit Rating or Score (Your Financial Report Card)

Your creditworthiness, or credit rating/score, is determined by the lender before lending you credit. Based on your financial history, the creditor determines how much credit should be loaned to you and for what interest rate.

In short, having a good history of borrowing money and paying the full balance back helps you score (pun intended) better deals in the future.

You may:

  • qualify for lower interest rates on your car loans, mortgage, credit cards, etc.
  • look better to your future potential employees
  • get approved for higher credit limits


6.3. Compound Interest

Getting wealthy by investing can seem like a marathon and almost far-fetched, especially if you can't invest regularly.

And although it is, you will be letting your money do the heavy lifting if you let your money grow by compounding on itself.

Compounding is an imperative concept of growing your money by earning interest on both your principal and the interest that was already previously earned.

More on compound interest here!

🥳   Final Thoughts

Personal finance ultimately depends on multiple factors. For example...

  • How old are you?
  • Do you have dependents? Have you agreed on how to manage finance with members of your household?
  • Where do you live? Which country? Which city? Which neighborhood?
  • What is your residence status? Are staying in the country on a visa?
  • Do you have debt? Student loans? A mortgage?
  • Do you have any big expenses coming up soon? Wedding? Car? Traveling?
  • How much is your income and how stable or consistent is it?
  • How long can you live off of your savings if you lose your job one day?

These are important factors to consider when you are reflecting on your personal finances. But don't worry, we understand how difficult it could be, and we are here to help.