This original article was written by Suzanne Woolley for Bloomberg.
Just 8 percent of college students taking a recent survey gave themselves an A for how well they manage their finances. In a larger, 2014 survey of U.S. adults, 18 percent gave themselves the top grade for their personal finance knowledge.
Many people get stressed even thinking about managing their money, seeing it as just too complicated. But Harold Pollack, a University of Chicago professor, famously fit the basics of good personal finance on an index card.
Here are seven simple ways to increase the odds of getting in and staying in good financial shape.
Once you’ve got these covered, you can explore investment opportunities like those offered in “Where to Invest $10,000 Right Now.”
1. Save early, and automatically
If you have a 401(k) at work, you may already be saving automatically. More companies are automatically enrolling workers in retirement savings plans when they’re hired, rather than waiting for employees to opt in to plans. Many companies start the percentage of tax-deferred earnings a worker contributes at 3 percent, though, which is low. Pollack’s original index card recommended saving 20 percent of income, overall; he lowered it to 10 percent to 20 percent in his book, realizing that many people simply cannot save a fifth of their income.
Saving in a taxable account is important as well. Ideally, with every direct-deposited paycheck, have your bank send a set amount directly from a checking account to a savings or investment account. You may not miss what you don’t see in your checking account. If you can, increase that amount over time.
The point is just to get in the habit of saving. Even if you start small, it’s a start. And seeing your money grow can be very motivating.
2. Expect financial emergencies
About 47 percent of respondents in the Federal Reserve’s 2014 household surveysaid they wouldn’t be able to cover an emergency $400 expense without selling something or borrowing money. So when you start saving, you may want to set aside money for an emergency fund before saving for retirement. That’s because, in a financial emergency, many people just tap into a retirement fund early and pay a penalty.
But saving for an emergency before saving for retirement is not the advice of Efficient Frontier Advisors’ William Bernstein, author of The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between. “You really need to get a roommate and eat ramen for two to three years so that you can do both,” he said. “It is so important.”
A more daunting prospect than needing $400 for a car repair or emergency dental work is saving in case of a layoff. Many financial advisers recommend building a stash that will see you through six months of expenses. The older you are and the higher your salary, the bigger your emergency fund should be, since it may take longer to find a job you want. Be sure to factor in higher health-care costs that come with losing an employer’s health benefits.
3. Set an asset allocation, and diversify
Asset allocation is an investor’s most important decision, said Bernstein. Research by numerous finance professors has shown that the vast majority of returns over time come from asset allocation rather than picking the right security or the right time to invest in the market.
One rough rule of thumb Bernstein uses for setting a stock-bond allocation is that your age should equal your bond allocation. A 50-50 or 60-40 split is a good starting point, he said, but then you need to figure out your risk tolerance and tweak your portfolio to reflect that.
That’s the tough part. “Filling out a risk questionnaire is worthless,” he said. “You don’t know your risk tolerance until you’ve been tested.” When his book came out in 2010, after the stock market low, lots of investors had been very tuned in to their true risk tolerance. “Now you have a lot of millennials who really don’t know what their risk tolerance is,” he said.
The riskiness of a stock depends on the given individual, said Bernstein. “For young savers, stocks aren’t really that risky because you’ve got a constant stream of savings,” he said. Young investors should want bad markets from time to time so they can buy stocks cheap. “On the other hand, for an older person with no savings stream left, no human capital, stocks are Fukushima toxic. You get a bad market early in retirement, and your goose is cooked.”
4. Keep fees low
With many people expecting future stock market returns to be muted, it’s more important than ever to keep fees low. Situations in which a retirement saver gets conflicted advice—meaning an adviser gets fees and commissions if the client buys a particular product—lead to returns roughly 1 percentage point lower per year, according to a report from the White House Council of Economic Advisers. The council estimated the aggregate annual cost of conflicted advice on IRA assets at about $17 billion a year.
For most people, keeping investments simple is the most cost-effective strategy. Warren Buffett is a longtime fan of investing in low-cost index funds, and in his 2013 Berkshire Hathaway shareholder letter, Buffett shared the advice he gave to his estate’s trustee:
“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions or individuals—who employ high-fee managers.”
The expense ratio on the Vanguard 500 Index Admiral (VFIAX), which has a minimum of $10,000, is 0.05 percent of the assets invested.
5. Use an adviser who is a fiduciary
Late-night television isn’t usually the place to find financial wisdom. But then there’s Last Week Tonight With John Oliver. A recent segment on the financial impact of conflicted advice is required—and very funny—viewing for savers.
For those who don’t have 21 minutes handy, here’s a little of what the segment said about financial advisers and fiduciaries:
- “Financial analyst is just a fancy term that doesn’t actually mean anything. Even many well-credentialed financial advisers are paid on commission, so if they recommend something for you it may be because they stand to make money. Sometimes they’re actively incentivized not to act in your best interests.”
- “If you have an adviser, ask if they are a fiduciary. If they say no, run.”
Watch the clip. It gets into how fees are like termites and how there can be legions of them in your retirement savings plan. And it shows Kristin Chenoweth being crushed by a giant domino.
6. Spend less than you earn
Spending more than they earn is a pattern for 23 percent of millennials and 19 percent of Gen Xers, according to a 2014 study by the Financial Industry Regulatory Authority’s Investor Education Foundation. So it’s not surprising that only about a third of each demographic has an emergency fund in place.
Part of what can make it tough to build an emergency fund is lifestyle creep. As we (hopefully) earn more, we often ratchet up our spending—we upgrade phones or cars, or take fancier vacations—rather than increasing our 401(k) contributions by 1 percent, or setting a higher amount of savings to automatically be taken out of a paycheck.
Financial planner Michael Kitces, 38 years old and a father of three, wages a daily battle against letting expenses creep up. Most of his clients who are just over 50 and struggling to get to retirement are in such a bind because they let spending rise with their income, he said. They had great careers but never really got ahead in their saving.
If you spend less than you earn, you can likely avoid getting trapped in any kind of downward financial spiral. That can happen if you need to take out a high-interest rate loan to pay for a financial emergency you haven’t saved for.
7. Maximize employee benefits
Only one in four employees whose companies offer to match employees’ 401(k) contributions saves enough in their plan to get the full match. That’s according to a May 2015 study by Financial Engines, which examined the records of 4.4 million participants at 533 companies.
Forgoing the full match meant not getting an average of $1,336 for each employee, or an extra 2.4 percent of annual income. Low salaries and budget constraints may be the issue keeping low-income and younger plan participants from getting the full match, but even 10 percent of employees with incomes over $100,000 didn’t put in enough money to get the full employer match, Financial Engines found.
Roth 401(k)s are an underutilized part of employee benefit programs, said Marina Edwards, a senior retirement consultant at Willis Towers Watson. A Roth 401(k) is funded with after-tax dollars, whereas the tax on money going into traditional 401(k)s is deferred until you take it out in retirement. About 50 percent of all employers now offer Roths, but only about 25 percent of plan participants choose them.
Roths are a good idea for young people with low incomes, particularly if they figure tax rates will go up in their lifetime. It may prove helpful to have a pot of money to draw from in retirement that won’t shrink because of taxes.
Another benefit worth paying attention to: disability insurance. Of all the financial wellness benefits, it’s probably the most important, said Jackie Reinberg, national practice leader for Absence, Disability Management and Life at Willis Towers Watson. “A lot of individuals think about life insurance, but you are much more likely to be disabled than to die,” she said.
Most large companies provide basic disability insurance as a benefit, and if you choose to pay the premium yourself, disability payments will be tax-free. The premiums tend to be pretty small at large employers, and the benefits of getting disability payments tax-free can be big.
Maximizing your employer’s benefits also includes signing on for options like a flexible spending account, a health savings account, or a commuter program that you can fund with pretax dollars. Not only does it make your money go further, but it lowers your wage amount for income tax purposes.