Earlier this month, I shared a new financial framework I’ve been developing, one that stresses earning, spending, and saving as the building blocks of personal finance.
Two weeks ago, I elaborated by sharing how I make money. Last week, I turned to the other half of the basic personal-finance equation: I shared how I spend money. (Or, more precisely, the ways in which I try not to spend money.)
Today, I’ll share the ways I save money. But because many folks found the term “save” confusing in this context, let’s call it the ways I invest money instead. Whichever word we use, I’m talking about how I put the surplus — the difference between what I earn and what I spend — to work so that it provides for my future.
My monthly surplus is used for two purposes: saving and investing. Some of the money is set aside for near-future use, such as buying a new car or taking vacations. Here, for example, are my targeted savings accounts at ING Direct:
But while these accounts were created by saving the surplus between what I earn and what I spend, I don’t really think of them as being part of the “saving” (or “investment”) building block. This is money that will be spent eventually. It’s sitting in an account that, at best, keeps pace with inflation. It’s not money I’m trying to grow.
The cash I have in my savings accounts represents money I’ve already harvested. The money I have in my Roth IRA, my 401(k), and my reguar investment accounts represents the funds I’m trying to grow.
Clumsy metaphors aside, your skill at investing comes from how you’re able to make your surplus grow. If you hide your money under a rock, your investing skill isn’t particularly good. Although you might think you’re protecting what you’ve saved, you’re actually losing money to inflation.
Skill at investing comes from learning everything you can about increasing your wealth. It comes from creating a plan and sticking to it, from making logical decisions (instead of emotional ones), from avoiding fads, and from understanding the fundamentals of investing, including diversification and asset allocation.
Of the three basic building blocks of personal finance, investing is the last one to be put into place. As a result, many people never master it. I’m just a novice investor; I have a grasp of earning and spending, but I’m new to investing, and still struggling to put theory into practice. (My ongoing series about rebalancing is an attempt to document part of this learning process.)
How do I invest?
- I contribute the maximum to my Roth IRA (or traditional IRA, if I don’t qualify for a Roth in a given year).
- I contribute the maximum to my self-employed 401(k).
- With any leftover money, I contribute to regular, taxable investment accounts.
When I say that I contribute “the maximum” to my tax-advantaged accounts every year, I mean the most I’m able to based on the law. Each account has different contribution limits. Sometimes these are confusing. For instance, the amount I can contribute to my 401(k) depends on how much my business earns in any given year. The more I earn, the more I can contribute. So, I contribute as much as I’m legally allowed. (How this works in reality: After doing my taxes, my accountant says, “Okay, J.D., you can put $XXX into your 401(k) for last year.” And I do it.)
Putting my surplus into investment accounts is only half the battle. I also have to decide what to invest in — and why. This is the part that’s especially tough for me right now. I feel like I have just enough knowledge to be dangerous. I have to force myself to make smart decisions. Even then, I come up short a lot of the time. My current series on rebalancing my portfolio describes which funds I invest in and why. If you read the first part, you know I have 18% of my investments in an energy mutual fund. This is silly.
So, while I seem to be doing well with the earning and spending building blocks, I haven’t yet mastered investing. My returns have been good, it’s true, but that’s mostly due to pure chance. I think it’ll take me several years to get more than a theoretical understanding of how investing works.