Humans overcomplicate personal finance. We are naturally drawn to complex investment methods, jargon, sophisticated budgets, and get-rich-quick schemes.
This self-induced complexity generates more harm than good. The reality is that personal finance is simple (but hard). Adding complexity increases your odds of failure, because complex systems are fragile.
These complex systems tend to fail at the worst times. Life is already difficult and complex. During life’s difficulties, you want your money systems to run on autopilot. This way you can channel your time and energy to resolve life’s challenges.
And simple does not mean easy. Personal finance is simple but hard, just like healthy living.
Table of Contents
The Personal Finance Formula
The personal finance formula, when followed, will free you from the shackles of consumer debt. Anxiety about money will be minimal, and your net worth will grow exponentially. Here is the formula:
Save and invest. Do this consistently, for decades.
This formula represents a system, not a one-time goal. This system can be customized to your unique needs by varying the savings rate, and through your specific investments.
To succeed in this personal finance game, you need patience, persistence, and self-discipline. There is no easy way, no get-rich-quick formula, no home-run investment, and no special course that will make you millions.
Savings: Two Factors
Savings, the difference between after-tax income and expenses, can only be increased by changing two factors:
- Increase after-tax income; or
- Reduce expenses.
Goals vs. Systems: Focus on Systems
I used to love the idea of goals, but now I focus my energy on developing systems. Naturally, I also develop the habits that support these systems. This is abstract, so lets get specific.
Goals are Specific, Measurable, Attainable, Realistic, and Time-bound (SMART Goals). But goals have one problem – they have an end state. Once you meet your goal, what do you do?
This is where systems come into play. Systems persist, and by following a system, you will generate habits that stick around.
For example, the personal finance formula is a system, not a goal. It has no end date. Instead, it is something that requires repetition over time. Through repetition, habits will form and the system will become natural. The outcomes of the system will include reduced money anxiety, financial independence and wealth.
Some examples of my systems are:
- Read for 30 min/day;
- Write blog content for 1hr/day;
- Save xx% of my income and invest every 2 months; and
- Workout for at least 3 hrs/week.
Personal finance is made simple when you begin to focus on improving a few core systems that enable you to consistently spend less than you earn and invest. The book Atomic Habits dives into this concept of habits and systems.
Want to make good money decisions, but never learned how?
Access the resources that I used to learn about personal finance.
Core Personal Finance Concepts
A deep understanding of a few core concepts sets you up for success. You can view a concept as an idea that can be applied to a variety of unique personal finance situations. This is good – personal finance is personal.
These universal personal finance concepts include:
- Compound Growth
- Opportunity Cost
- Lifestyle Creep
- Understanding Asset Types
- Why Expense Management Is More Important Than Income
- The Basis for Wellbeing: The PERMA Model
- Self Discipline, Delayed Gratification – The Key to Building Wealth
Our minds are biologically wired to think in linear terms. But that is not how money grows. Rather, investments grow exponentially. The growth starts painfully slow, then BOOM, it takes off.
Let’s say you invest $100 today at a 10% annual return. You’ll have:
- $110 at the end of year 1;
- $271 in year 10;
- $733 in year 20; and
- $14,600 in year 40.
When you spend money you give up alternate uses of that money. The opportunity cost is equal to the best “alternate” use of that money. This is best shown through example.
Say you spend $100 today. That $100, if invested at a 7% return, would grow to $200 in 10 years, $400 in 20 years, and $800 in 30 years.
By spending $100 today, I am giving up the opportunity to have $200 in 10 years, $400 in 20 years, or $800 in 30 years. That’s the opportunity cost.
Opportunity cost, when combined with an understanding of compound growth, will help you consider the future in your present money decisions. This can help you curtail spending.
Understand Asset Types
An asset is anything that can be sold for money. It is helpful to view assets based on two characteristics:
- Appreciation or Depreciation.
There are three asset types:
- Use Assets: These are things you use. Like bikes, electronics, cars and your home (structure only). These assets depreciate and can result in maintenance costs (negative cash flow).
- Investment Assets: These go up and value and pay you cash flow over time. Stocks, bonds and cash-flowing real estate are the primary investment assets. These assets are best when you don’t need the money for 10+ years.
- Monetary Assets: Cash-like assets, like cash held in a chequing or savings account, or money in a money market fund. Cash is easily accessible (liquid) and is the best place to store money that you need within the next 5 years.
Look at assets through the lens of cash flow and appreciation. You will see where it makes sense to place our money over the long term.
Lifestyle creep is a natural phenomenon where our expenses naturally creep up to match our income. This is an obstacle to the “saving” part of the personal-finance formula.
Lifestyle creep is the reason many high earners remain broke and shackled to a paycheck to paycheck life.
Why Expense Management Is More Important Than Income
Because of lifestyle creep, your income only matters once you can first manage your expenses.
This concept is backed by this study that shows that large cash transfers to those in financial distress does not solve their money problems.
You don’t have to look far to find examples. There is a large supply of broke lottery winners and bankrupt pro athletes. These peeps did not have an income problem, they had problems with spending behaviors and habits.
An increase in income is a financial band-aid until you can fix spending habits and behaviors. This is hard and requires discipline.
The Basis for Wellbeing: The PERMA Model
An understanding of well-being helps you spend money (and time) in the best possible way. This can help you achieve balance, so you can enjoy life and meet your financial goals. For deeper reading on this subject, check out the Ultimate Guide on Money, Wellbeing, and Happiness.
There is an academic model of wellbeing that I like. It’s called the PERMA model. This model identifies 5 factors for wellbeing. Let’s go through it.
- Positive Emotion: Gratitude, physical pleasure, mindfulness, hope, and optimism about the future.
- Engagement: When your skills are matched to a challenging activity. You enter a state of “Flow”.
- Relationships: Forming and sustaining connections with other humans. Acts of kindness, and improving the lives of others.
- Meaning: Serving a purpose that is greater than your individual self. This involves some form of self-sacrifice. An example is serving in the armed forces.
- Accomplishment: When you overcome obstacles, it feels good. Examples include getting home after a hard workout or finishing a blog post.
My main takeaways from the PERMA model are as follows:
- Your work is a major source of wellbeing;
- Well-being requires responsibility and an ability to endure difficulty; and
- Money can buy you time, and time can bring you well-being. But only if time is used in the right way.
Self Discipline: The Key to Building Wealth
Personal finance is simple but hard. Here are some examples of items that are hard:
- Altering habits is hard
- It is hard to control spending today, to delay gratification into the future; and
- Suppressing ego to remain a rational investor is hard.
All of this requires self-discipline. You must sacrifice today’s pleasure to generate a future gain. This can be viewed differently – you can choose to endure present pain to avoid future pain.
Self-discipline is even more important in today’s world because businesses are playing on your natural disposition towards immediate gratification.
Work Smart, Not Hard: How to Limit Demands on Self-Discipline
Learn more about the importance of self-discipline in this post. Although self-discipline is key, we can also work smart to limit demands on our self-discipline. To do this, you can engineer your environment and build habits.
I, for example, will eat cookies if they are out on the counter. I do not have enough self-control. Therefore, I don’t buy the cookies in the first place. I engineer my environment, rather than relying on self-discipline.
How to Manage Expenses With Simplicity
This portion of the guide will look at ways to simplify expense management.
The theme is to identify and focus on the biggest expense categories. This way we can extract the most use of our financial decisions. In addition, we can take advantage of lifestyle creep to manage our smaller expenses with simplicity.
Focus on the Three Large Expense Categories
Here are the three large expense categories, which consume over 56% of after-tax income for Canadians:
- Transport; and
Three Huge Financial Decisions
The first two major expenses – shelter and transport – are based on three large financial decisions. These three decisions influence your expenses for years to come. Putting effort into these decisions is working smart, not hard.
1. The Size and Location of Your Home
The location and size of your home determine many expenses that repeat in the future:
- Property tax;
- Home maintenance;
- Utility bills;
- Home insurance costs;
- Furnishing costs; and
- Commute distance costs.
We tend to buy things to fill available space in our homes. This is similar to lifestyle creep, where our expenses naturally creep up to match our income.
The Value of Your Time
Humans tend to over-value money and undervalue time. Home size and location dictate your time demands. The time spent cutting grass, commuting, maintaining your house all depend on your home purchase decision. Plus, the size of your home drives the time spent to buy, maintain and dispose of all the stuff in your home.
A smart decision regarding shelter can free up time that you can use to improve wellbeing.
2. The Buy or Rent Decision for Your Home
Contrary to popular opinion, owning a home does not always maximize wealth. It can make more sense to rent if the annual rent is less than 5% of the home value.
Renting only works if renters invest their excess money into assets that provide higher returns than real-estate appreciation. Global stock returns, for example, are expected to exceed real-estate appreciation by 4% per year.
3. Transport: Vehicle Selection
Similar to home size and location, your choice of vehicle influences a series of future expenses:
- Maintenance costs;
- Insurance payments;
- How much you pay in vehicle depreciation; and
- Fuel payments based on fuel efficiency
The most cost-effective way to own a vehicle is to buy 2 or 3 year-old economy vehicle with cash – ideally a Honda or Toyota. A vehicle of this age (and brand) is reliable, and you get it at a discount because you skip the 25% to 30% first-year depreciation. You can read more in this post on vehicle depreciation.
For example, I drive a 2010 Honda Civic. I purchased it for $6,000, and I’ve driven about 100,000 km over the past 6 years. The single decision to buy this car has saved me thousands of dollars that have been growing as investments rather than depreciating in the driveway.
Food Spending - Your Habits
The amount you spend on food is habitual, with exception of how many children you feed – that was a decision (perhaps?).
Do you buy lunch every day, or do you prepare your own meals? Is socializing at restaurants and grabbing drinks part of your routine, or do you socialize in clubs oriented around your hobbies?
When altering habits, we tend to go too hard. Focus on one habit at a time, wait until the habit is formed before moving on to another. Over time, your habit changes will compound just like your investments.
The Easy Budget
The Traditional, Complicated Budget: Forced Savings
The traditional way to control spending is through the Zero-Based Budget, where every dollar is allocated a specific job. With this budget, you define expense categories and set targets for each category.
At the end of each month, you evaluate your actual spending against your targets for each category. Let’s go through an example of the zero based budget.
Zero Based Budget Example
Zero-Based Budget Is Complex
You may notice that the zero-based budget is micromanagement of your spending. It is complicated and places large demands on your time and willpower.
So, no wonder most people fail to keep on track with the zero-based budget. It’s a complex system, prone to failure. This system can be useful when you want maximum control over your money, if you have super-human discipline.
So, let’s dig into a more simple form of budgeting – Forced Savings.
The Easy Budget: Forced Savings
Forced savings is a simple, easy-to-implement system to control expenses. It occurs when you skim a set amount of money off every paycheck for savings or investments. You spend everything that is left.
With forced savings, you are literally paying yourself first. After paying yourself first, you let your spending habits naturally adapt towards your lower-income ceiling.
Because forced savings is simple, it is sustainable over the long term. It limits reliance on your discipline, especially when automated. Most importantly, it saves you time, so you can focus on the things that matter in life.
Forced Savings Example
Laura gets paid $2,000 on the 15th and 30th of every month. She transfers $500 from her chequing account to her investing (brokerage) account on the day following each pay-day – the 16th and 1st of each month. Laura is smart, so she automates these transfers with her bank.
Laura lives on $3,000 per month, even though her after-tax income is $4,000 per month. She understands the concept of lifestyle creep and sees that her expenses will adapt to this artificial limit of $3,000 per month.
The Problem With Forced Savings
Forced savings is not perfect. It’s more like a 90% solution. You still don’t know exactly where your money is going. I’m sure there are ways to allocate your money in ways that bring more value to your life.
For this reason, I recommend you audit two months’ worth of expenses on your debit and credit statements, and that you do this at least twice a year. I cover the purposes of an expense audit in this post.
The Expense Management System
- Focus on the big decisions for shelter and transport.
- Use Forced Savings for the remainder of expenses.
- Build habits around other expenses such as food.
- Audit expenses twice per year.
- Revert back to the zero-based budget if you find yourself overspending your Forced Savings system.
Investing Made Simple
Investing is the exciting part of personal finance. It is where you reap the power of compounded returns to grow wealth.
Eventually, your investment nest egg will generate enough cash flow to cover your lifestyle costs. Now you have the freedom to use your time in a way that maximizes wellbeing. This point is called financial independence.
I love investing, but it is given way too much attention in the personal finance world. It’s often overcomplicated, with excessive focus on analysis, and not enough focus on human behavior. Lastly, many people are not ready to invest.
So let’s focus on the important parts of investing. Let’s cut the fat and make it simple.
Am I Ready to Invest?
To find out if you are ready to invest, ask yourself these questions:
- Do I have an emergency fund?
- Have I paid off all high-interest debt?
- Have I determined my asset allocation based on my unique willingness and ability to take on risk? See the investor questionnaire or this post for more.
- Do I understand where stock and bond returns come from, and why low-cost index funds are the ideal way to capture these returns?
- Do I understand the difference between decisions and outcomes?
You are ready to invest if you have answered yes to all of these questions. But before you storm ahead, I suggest you meet with an advisor for an unbiased perspective. It can be difficult to self-assess your risk tolerance.
The Simple Investment Portfolio: Index Funds
A simple portfolio of low-cost stock or bond index funds will maximize returns for your given asset allocation. I discuss the data backed reasons why in the post titled Understand Index Funds: A Simple Way to Invest.
Asset allocation ETFs offer a hands-off approach to index investing. These products offer a globally diversified portfolio of index funds in a box. You can read more about asset allocation ETFs here.
Simplicty and Human Biases
Your biggest investing task is not to find the right stock or to become more proficient at technical or fundamental analysis.
Instead, the biggest task you face is overcoming the human in your mirror. Most people fail to gain the market return over the long run (decades) due to overconfidence, herd behavior, and loss aversion. These very normal biases result in panic selling, return chasing, and overtrading. It took me about 6 years to recognize this.
A simple portfolio limits your involvement. You check your portfolio less, keeping you emotionally detached. This preserve returns and frees up your time for the important things in life. Read more about human behavior and investing in this post.
The Simple Investing System
Here is the simple investing system:
- Pay off all high-interest debt and build an emergency fund.
- Find your asset allocation based on your ability and willingness to take risk.
- Learn about the evidence and theory behind index funds. A Random Walk Down Wall Street is a great book.
- Invest the same amount into an asset allocation index fund. You repeat the system indefinitely, or until your asset allocation changes.
I’ll share my system as an example. I get paid every two weeks. I save a fraction of my income, and I let the savings accumulate over two months (four paychecks). Every two months I invest, regardless of what the market is doing.
The other piece is what I invest in. I have pre-determined target allocations for Canadian stocks, U.S stocks, International stocks, and Emerging Markets stocks. Specific ETFs give me coverage to nearly all stocks in these categories. I re-balance twice per year – once in January and again in July.
- An understanding of compound growth, lifestyle creep and models of wellbeing will naturally assist you with your finances.
- Building wealth is simple, but hard. Self-discipline is imperative to delay gratification into the future.
- Habits and systems are more sustainable than goals.
- Decisions surrounding shelter and transport are important. These are your largest expenses.
- Forced Savings helps you manage the rest of your expenses with simplicity.
- Index investing is hands-off, and it optimizes the risk/return trade-off. The simplicity helps you remain emotionally detached from your portfolio.
- A system of consistent investing into a pre-determined portfolio improves success and reduces the role of human biases.