Editor’s note: This article was first published in November 2015, and its examples reflect that year: the Gamesa share price and the author’s hindsight on its recovery by late 2015, and a 1% mortgage rate typical of Spain in 2015. Gamesa has since merged into Siemens Gamesa and been delisted.
One of the most widespread messages in financial education is “pay yourself first”. Sometimes this message is misunderstood or distorted, but basically it means the following.
Don’t save whatever money you haven’t spent by the end of the month. Instead, as soon as you get paid, set aside the money you’re going to put towards saving and investing, and whatever is left (once you’ve covered your obligations) is what you can spend on treats and nights out.
Some people think paying yourself first means that as soon as you get paid you can take 300 euros and say: “This money is for clothes, movies and drinks.”
No. Those 300 euros are for saving and investing, and the money left after paying for electricity, water, the mortgage, food, insurance and so on is what you have available to spend on restaurants, parties and drinks. If the money doesn’t stretch that far, it’s probably because you can’t afford that lifestyle. But don’t worry (for now).
Pay yourself first, but how much?
As we’ve said on several occasions, ideally you should be able to save 20% or 30% of your income. We’ve seen how a Google employee saved 90% of his salary, but that’s not really the plan either.
Clearly, if you can’t save at least 20% of your income, your finances aren’t healthy: too much spending, too little income, or a major imbalance between the two.
That means that if you earn 1,000 euros, you should be able to put at least 200 euros towards saving and investing. Otherwise, something is wrong with your finances.
As a rule, there are only two things to do
- 1. Spend less. But since we assume it’s sometimes too late to get rid of many unavoidable expenses that come with our previous standard of living, we automatically move on to the second.
- 2. Earn more money. If we earn more, we can obviously put more money towards paying off debt, saving and investing.
Treat every euro as an investment
Instead of “pay yourself first”, let’s use this other expression and see whether loss aversion can work in our favor here.
The money you have right now, and even the money you were paid at the start of the month, is already yours. You don’t have to work for it or earn it again. It already belongs to you. It’s your asset at this moment.
If we asked someone with a high level of financial knowledge what the basic principle is for handling the money we have available, they would say: “grow that money.” That’s true, but it isn’t the first principle. The first step towards wealth isn’t increasing wealth but preserving it.
See also: Living off the stock market? This is the only way to do it
So we’re going to treat every note and every coin we have as if it were an investment. Not spending that money is already an investment in itself. Every euro in our pocket or our bank account is an opportunity.
A somewhat extreme example
I knew a guy who always complained, saying the same thing: “I wish I had money to invest, but I don’t.” I gave him just one example, with coffee (and I know these kinds of examples aren’t very fair). Like me, he drinks two coffees a day. Let’s round the price of a coffee to 1 euro, which was roughly the price Gamesa shares were trading at back then.
I told him jokingly that he thought he was spending only 60 euros a month on coffee, but in reality he was spending close to 900 euros (allowing for the possibility that, over the years, Gamesa shares might reach 15 euros again).
I didn’t know that for certain, although today, with hindsight, we can see it has more or less come true. He looked at me as if I were crazy. So I gave him the usual explanation: “If you avoid an expense today and invest the money in shares, what you’re really spending in the future is even more, because you’re missing out on the growth of that money.”
As you can imagine, when someone is hiding behind an excuse, this explanation usually triggers a counter-attack along with another excuse:
Excuse: But what if the shares go down instead of up?
Attack: Why don’t you follow your own advice? You drink two coffees a day too.
Either way, both answers reveal one fact: “This person has money to invest.” As the saying goes: “Those who want to get there look for ways; those who don’t look for excuses.”
Answering the attack was easier: “I drink coffee because I have money to invest, and I’m not complaining.”
He was right about one thing, though: shares can go up or down. But that’s no excuse, because the money you spend now is an investment with a 100% loss. Investing it means taking on a small, moderate or high risk, and the return will depend on the risk we’ve decided to take.
See also: 11 rules of personal finance
But careful! I’m not in favor of anyone giving up small pleasures like having a coffee.
The truth is that when I analyze people’s finances, the 80/20 rule usually applies here too: 20% of purchases or expenses account for 80% of the erosion of the money we could be investing. In other words, the problem isn’t having a coffee or a beer, but clothes you don’t need, the latest smartphone, or replacing a car that worked perfectly well.
Personal finances are often wrecked by avoidable spending and by trying to keep up a lifestyle you can’t really afford. Because, I insist: being able to pay for something doesn’t mean you can afford it.
We should use the money we save to meet financial goals that gradually build peace of mind and financial stability, always remembering that the ultimate goal is financial freedom, not necessarily getting rich.
So the money we earn should go, basically in this order, to:
1. Paying off high-interest debt
If we have a mortgage at 1% interest, it may not be a good idea to use our money to pay it off early, since we can easily beat that 1% annual return by investing in the markets.
What we’re talking about is literally destroying credit card debt, the kind on which we pay high interest that we’ll rarely manage to beat in the markets. With this type of debt, the best investment is to eliminate it. You can see this illustrated example: How an out-of-control credit card hits your personal finances.
Remember when we discussed the magic of compound interest for building wealth in depth. Credit card debt works exactly like compound interest, but in reverse: it works to destroy our finances. That’s why the most profitable and wisest investment is paying off that debt.
Building up cash: an emergency fund
Before investing for the long term, we need an emergency fund to deal with possible emergencies, as the name suggests, without having to touch our investments. But how much money should the emergency fund hold?
We’ve always said it should, at a minimum, cover at least 6 months of expenses in case we stopped receiving income. That said, there are a few more things to add.
For an ordinary person with a stable income and few responsibilities, those 6 months will be enough. In other cases, the recommendation is:
Between 12 and 18 months if you have an unstable job, work in an unstable industry, or run a business that doesn’t grow consistently every year.
Between 3 and 5 years if, because of your age, retirement is around the corner and you’ll have to live on a small pension.
In these cases, each situation would need to be analyzed individually to see what best suits that person’s financial peace of mind after retirement.
And finally…
Once we’re free of toxic debt and the emergency fund is ready, all that’s left is to save and invest as much as we can, building a portfolio of assets and taking on risk and diversification according to our own experience.
Of course, there will always be someone around you who says things like: “All this saving for the future, and what if you die first?”
I always answer that question the same way: “And what if you’re unlucky enough not to die first?”
An 85-year-old man once told me: “Carlos, you have no idea how long old age feels when you reach it without money.”
Other people will tell you: “I’d rather enjoy today and not focus so much on money. I’m not so materialistic that I’d spend my life hoarding it. It’s not as if you can take it with you when you die.”
Here, I think, there’s one piece of nonsense and one contradiction.
Contradiction: “I’d rather enjoy today and not focus so much on money because I’m not materialistic,” says the person who takes it for granted that they won’t be able to enjoy themselves while saving and not spending money. As I always say, if you can’t enjoy yourself without spending money, when you have money you’ll be miserable with money.
Nonsense: “It’s not as if you can take the money with you when you die,” says the person who seems to think they’ll take the TV, Sálvame Deluxe (a Spanish celebrity gossip show) or the Champions (League football) with them. It’s not about what you take with you, but what you leave behind. If you plant a seed and die, someone will harvest the fruit when you’re gone.
Featured image: TheCulinaryGeek, CC BY 2.0, via Flickr.
