The Personal Finance Journey
Flow charts are awesome. They break down complicated processes (like personal finance) into manageable steps.
I love flow charts; must be my inner engineer. I figured, why not try my hand at some personal finance flowcharts?
Personal finance is all about the process, where small, consistent actions compound to produce remarkable changes.
In this post, I break down the personal finance journey into bite-sized, manageable steps using four flowcharts. I hope that the manageable steps help you take action.
The Personal Finance Journey
Financially successful people progress to grow wealth based on the steps below.
You may note that nothing happens without the gap between your income and expenses. This gap is the fuel to pay down debt and invest.
But generating an income-expense gap is becoming more difficult due to the cost of living crisis, outlined as the top risk until 2025 by the World Economic Forum.
The flow charts in this post further refine the personal finance journey.
First, we will look at the process needed to eliminate debt and produce freedom from financial stress.
Flow Chart To Eliminate Financial Stress
The below flow chart guides you through pay down debt and building an emergency fund. The overall approach is time-tested by Dave Ramsey’s Baby Steps.
Debt Paydown
It is known that millionaires avoid debt like you avoid pain. They tend to avoid consumer debt and pay down their mortgage early, according to studies in The Next Millionaire Next Door.
For debt paydown, I like the debt snowball method. Under this method, you list debts from the smallest to the largest amounts. Then, you pay down the debts in sequence.
The debt snowball is behaviorally effective because it provides small wins that keep you motivated through the debt paydown process.
As you pay down debt, you free up cash flow that otherwise would have gone toward interest payments.
This cash flow can be used to pay down even more debt, further accelerating your progression along the personal finance journey. The power of compounding begins to take hold.
Employer Match
Why make use of an employer match before paying down debt? An employer match yields an immediate 100% risk-free return, where as debt-paydown yields a return equal to the interest rate on the debt.
Consider a case where your employer matches up to 4% of your salary on RRSP contributions, and you make $90,000/year.
You contribute $3,600 to retirement (4%*$90k), and your employer also contributes $3,600. By contributing $3,600, you turned it into $7,300 – an immediate 100% return.
The Emergency Fund
An emergency fund, held in cash (or cash-like assets), provides utility in the following ways:
- Stress reduction by providing a cash buffer for the unexpected.
- Prevents you from taking on debt to fund expenses.
- Eliminates the need to dip into investments to fund emergency expenses.
Debt avoidance and the act of leaving investments alone are strong financial behaviours.
Plus, you don’t want to invert your debt-paydown momentum by taking on debt to fund an emergency expense.
Short-Term Goals
Short-term savings goals are those coming due in less than five years. A five-year time frame is too short for stock/bond investments.
This restricts you to cash-like investments, or maybe a short-term bond fund on the long end (3+ years).
Consider an upcoming family vacation costing $10,000. How are you funding it?
The vacation is not an emergency. You can’t fund it with the emergency fund. To prevent going into debt, you must save ahead of time … this is a sinking fund.
Instead of writing out the process for short-term savings, I’ve made a flowchart.
Not all short-term savings goals are essential. Weddings, vacations and new cars are examples of non-essentials.
Non-essential short-term savings goals are not a problem … as long as minimum retirement goals are funded. Otherwise, sacrifice of the non-essentials is required to delay gratification into the future; self-discipline required.
Investing Flow Chart
Congrats! You are debt free with an emergency fund. Time to consider investing above and beyond your employer match.
Investing starts with financial goal setting. This is the fun part; it is more of a life-design exercise, and less of a financial exercise.
First, it’s essential to understand the basics of stocks and bonds and their sources of returns. The book A Random Walk Down Wall Street covers the fundamentals well.
Confidence in the underlying sources of stock and bond returns can help you remain invested during market turmoil. Instead of fearing a market crash, you may instead view it as an opportunity to buy a group of businesses on sale.
Next up is finding your risk tolerance and setting your asset allocation. This may be the most challenging part.
Once you know your risk tolerance, you can find an asset allocation stock/bond index fund aligned with your unique risk tolerance. These “asset allocation ETFs” are stock and bond index “portfolios in a box.”
These low-cost total-market index funds provide better expected outcomes than (high-fee) mutual funds.
Your advisor may argue otherwise; most advisors are paid through sales commissions on high-fee products. Because commission based advisors are incentivized to act against your best interest, it’s essential to be equipped with the evidence for index funds.
But what accounts do you place these investments in to minimize your tax bill? This merits another flow chart.
Mortgage Paydown vs Invest
Paying down your mortgage provides a risk-free return equal to the interest rate on the mortgage. Mortgage rates are closely tied to bond returns, but bonds are not risk-free.
Therefore, if your risk tolerance requires a bond exposure, it may be sensible to pay down the mortgage in an amount equal to your bond exposure.
That leaves people with a high risk-tolerance who must select between a 100% stock portfolio or mortgage paydown.
Investing with a mortgage is a form of leverage – taking on debt to invest. Therefore, it’s fine to invest in a 100% stock index fund while holding a mortgage, as long as it’s aligned with your risk tolerance.
Flow Chart to Prioritize Canadian Tax-Sheltered Accounts (Asset Location)
Once you have selected your asset allocation ETF using the flowchart above, it is time to consider where to locate your ETF.
For example, Fred has a risk tolerance for a 60% stock and 40% bond portfolio. He decides to buy VBAL, an “index portfolio in a box” with a 60% stock allocation and a 40% bond allocation.
Fred needs to know what accounts he should use to buy (locate) his ETF: in a RRSP, TFSA, RESP or taxable account?
I use the process below to locate my assets between Canadian tax-sheltered accounts.
Each account may be tagged with a specific goal with a unique time horizon. Each unique time horizon may necessitate a specific asset mix of stocks, bonds and/or cash.
For example, an FHSA used to buy a house in 2 years should not have stocks and bonds. But a TFSA used for retirement in 20 years may hold a 100% stock index portfolio.
Finally, you may notice my RRSP loop. As you contribute to the RRSP, you may reduce your tax rate today.
Hence the loop back to assessing today’s tax rate against future rates. It’s also worth noting that future tax rates can be uncertain based on changes in government policy.
Conclusion
Personal finance is complicated (but not complex). The good news is that complicated systems consist of many simple steps. Simplicity enables execution.
By producing bite-sized steps, I hope my personal finance flow charts help you take meaningful action.
Your circumstances are unique, and this is just a high-level guide. Like all models, there are simplifications. For a custom-tailored look at your financial situation, book a coaching call.
Jake out.
