Investing in stocks is just one part of your financial life picture and perhaps secondary, not primary.
Stock price fluctuations and the amazing success of the past 35 years make it seem like the stock market is the most important thing when it comes to your finances. However, in this motivational personal finance article, I’m going to discuss something more important and touch on the complete personal finance picture which in the end, if done smartly, will lead you to your financial goals. The stock market might not lead you to your goals as 30 years of negative cumulative returns aren’t uncommon.
I’ll use an actual example as I recently received a message from a young reader looking for financial life advice. Theirs is, I think, unfortunately an average situation for an American college graduate and for some Europeans. I’ll describe the situation and then apply some rational financial techniques, but also behavioral ones that will allow for the creation of good long-term investing/rational habits. The habit is the key over the long term.
This is the situation:
- $60k gross income with 2% to 3% increase per year – safe job.
- $110k total debt – ($80K student loans, $16K personal loan, $10K car, $4K credit cards).
- Credit score – 700.
His question was that after paying the bills, he struggles with whether his emphasis should be on bringing his debt down or trying to invest or save. How much should he put toward debt reduction and how much toward saving/investing?
After getting his message, I asked some questions that would give an even better picture:
- What is the interest on the debt?
- What is the expected return on your investments?
- How do you feel when in debt?
- Do you plan to own a house?
The answers were the following:
- Started college when he was 16 with debt (naïve).
- $35k gross for the past 5 years (promoted last September to $60k).
- The interest on the debt was the following:
5.75% on $80k broken up in different loans.
9.5% on the personal loan.
6% on $10k car loan.
Credit Cards: 14.4% on $4K, again this is a weighted average, and one card has 15 months of 0% apr. After this it will be 23% average.
- $2K in a 401K, $1K in the stock market (doesn’t expect much of a return on that because he has just been playing around to learn how it works).
- Debt is crushing.
- Plans to own a house, but seems crazy.
- Lives in Ambler, a Philadelphia suburb (splits costs with girlfriend).
- Rent is about $700 (out of $1,100 for 1br/1ba).
Bills/utilities/insurance is $400.
Groceries are at most $300.
Gas is $120 (travel a lot for work).
Student Loans $450
Personal Loan $350
Credit Cards $80
What To Do
The steps are: setting a goal, implementing a path, and making a decision and taking action.
I bet such a situation is overwhelming, but there is always a way out which requires discipline and will, but there is a way out, there is always a way. The first thing to do is to start looking for solutions and setting clear goals.
With a $48k down payment, the monthly mortgage would be $961 fixed for 30 years which is perhaps better than the 1 bed/1 bath rent for $1,100. Now, I know the $48k down payment sounds absurd when you are $80k in debt, but there has to be a goal.
The key of buying vs. renting at the same cost is that the mortgage there is fixed at $961 over 30 years and after that, the house is yours. If Ambler sees good residential demand over the next 30 years due to good demographics, you might want to play that card.
Now that we have a goal, let’s see how we can get there.
With loans that have interest rates of 23%, 9.5%, or even 6%, there is no point in investing much in the stock market now as the expected returns from stocks are going to be 4% at best with a high probability of being negative over the next 10 years. However, it’s also important to invest in stocks to make it a habit because that habit will lead you to a better retirement.
Stocks yield 4% given that the price to earnings ratio is 25 for the S&P 500 (1/25 =4%), and there are loans that are no risk investments if you pay them off. So there are three ways to get to your goals. One painful, one potentially explosive, and one not painful and easy.
Pay Yourself First
As soon as the salary comes in, decide to put a fixed amount toward saving/investing that is going to bring down that debt in, let’s say, 5 years which would be $1,333 per month, or $16k per year. This is painful but it will give you a debt free position in 5 years, a house that will become yours over time, and allow you to invest the same amount in stocks over the next part of your life.
A good idea is to start with 90% debt repayment and 10% stock market just to keep the habit of repaying debt. Later, when the mortgage is 4% but stocks might yield 7%, the ratio can be turned towards stocks. This would definitely be painful as $16k on net income of $48k is a lot. However, you don’t have to be frugal to do this.
Find Additional Income
With a college degree, one can find a side job and make $1,000 per month extra which would allow for those payments without feeling pain. Do you have any hobby that you can start monetizing even if just for $100 per month at first, but that in the next few years could lead to significant additional income? Perhaps an Etsy account, an evening school teaching gig, editing, translating, or who knows what, even fishing. As soon as you start thinking about it, you’ll find something that will lead you towards your goals. However, again, the third way is the easiest.
Save More Later
With an expected yearly salary increase of 2% to 3%, one looks at $1k to $2k per year. Academics Richard Thaler and Shlomo Benartzi devised a plan for us to save more that doesn’t hurt us immediately as it doesn’t require you to cut spending. By simply saving more tomorrow, we can increase what we save and create a better future. The key is in putting your wage increase into savings or in this case, debt repayments:
- The first year you increase repayments/investments by $1.5k.
- The second year it is already at $3.03.
- The third year it is at $4.6.
- The fourth year it is at $6.2.
- The fifth year it is at $ 7.8…
In ten years, your debt is repaid at no cost to lifestyle and you have no debt, or at least no bad debt as perhaps you will switch your rent for a mortgage if you feel like living there for the rest of your life, or it’s a good rental area if you decide to move.
With personal finances, it’s always a fight between immediate and delayed gratification, but investing and wealth accumulation is a life cycle process and when you can make small steps to change that and get in the right direction, the life results could be amazing.
With a little bit of will, anything can be achieved. I hope I have motivated some of you and if I have helped you in making good financial decisions, please let me know 5 or 10 years down the road that this has helped.