Understandingthe Basics ofPersonal Finance

Chapter 2

In This Chapter

➤ Understand that successful investing begins with saving

➤ Why you don’t need to feel bad about not sticking to a budget

➤ Learn why it’s so important to pay yourself first

➤ Discover the secret of compound returns

Now that you understand a bit about how your computer and the Internet works,you still need a few more lessons before you jump feet-first into the online world. It’stime for an overview of some of the most important things you need to know as youbegin a lifetime of investing.

You Gotta Learn to Swim Before You SurfWhenever it comes to money, it’s easy to feel intimidated. And with the millions ofpages of information related to finance and investing out there on the Web, it’s eveneasier to feel like you’re in over your head.

Never fear! Even though you may have been taught to swim by being thrown intothe deep end of the pool, most people start out in the shallow end doing the dogpaddle, and gradually pick up the pace from there. In time, and with practice, youwill be using the butterfly stroke or Australian crawl to swim lap after lap.

Before you start investing (and certainly before you start surfing the Web for answersto your financial questions), you need to know a few things about money.

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It All Starts with SavingHow would you like to know the true secret to building wealth? The honest-to-goodness, sure-fire way to create your own million-dollar portfolio? Read carefully tolearn how millionaires are made, in just two steps:

1. Spend less than you earn.

2. Invest the rest.

That’s it!

Learning to be a good saver is the first part of any solid plan to accumulate wealth,whether you’re looking forward to a comfortable retirement, a top-level education foryour kids, or your dream home. But, finding the extra bit of money to fund yourinvesting plan can be tough—at least until you finish this chapter!

The “B” Word: Budgeting (Yuck!)Conventional wisdom says that you can find the money to invest just by preparing ahousehold budget. Unfortunately, the mere mention of the word budgeting is enough tocause any reasonable person to turn and run in horror! So here’s an idea that will throwmost professional financial advisors into a frenzy: Forget about the “b” word entirely!

Most of the time, you probably have no trouble finding enough money to pay all yourbills without going through the process of micromanaging your spending habits. It’slikely you already have a pretty good idea of where your money goes each month—essentials such as rent, mortgage, utilities, auto expenses, and telephone bills; andnonessentials such as double mocha cappuccinos from your local coffee house or a newlyremastered double-CD of the hits of Ol’ Blue Eyes (okay, well maybe that is an essential,but you get the point). You can probably trim plenty of fat from your monthly expenses.

Throwing Out Your Budget Doesn’t Mean You Can SpendWhatever You Like!

You don’t need a degree in economics to understand this scientific concept: The amount ofmoney you can spend each month is determined by the supply of money that you haveaccess to, either money in the bank or money in your wallet. If you spend more than youhave, month after month, you will be headed for just one place: bankruptcy court!

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Pay Yourself First—You’re Worth It!Who’s the most important person to your financial plan? You are! So instead of tryingto budget all the fun out of your life and hoping to end up with enough at the end ofthe month to put into a savings plan, tackle the problem from the other direction: Payyourself first! Each month, before you pay the rest of your bills, write the first cheque toyourself and deposit it into a special account, at a bank, a brokerage firm, or a mutualfund company.

By putting your financial plan at the top of the priority list, you will never again giveyourself the short end of the stick when it comes time to pay bills. And somehow, youwill probably be able to find the money to meet the rest of your obligations each month.

So how much should you put away each month in a savings and investing plan? A goodgoal to shoot for is to save 10 percent of your paycheque, after all taxes and otherdeductions. If that sounds way too excessive for you, start with 5 percent. When you getyour annual raise, increase the percentage a bit more. When you get a little extra cashfrom a freelance job or bonus, add that to the pot. Keep working toward your goal ofsetting aside 10 percent of your paycheque on a regular basis, and pretty soon you willbe saving with the best of them!

What would you have to give up to be able to pay yourself 10 percent each month? TheArmchair Millionaire features a fun calculator that will clue you in on just how easy it isto pay yourself first (http://www.armchairmillionaire.com/fivesteps/ step_2app.html).Just enter your monthly take-home pay, and the program will list a few ways you cankeep that cash in your pocket. If your monthly paycheques totalled $1,000 after taxes,for instance, here’s what you’d have to give up to save $100 a month:

$ 7.00 2 video rentals

$30.00 2 music CDs

$12.00 1 large pizza with the works, delivered

$ 3.00 1 fast-food burger with fries

$ 3.00 1 pint of ice cream, the good stuff

$25.00 1 latest best-selling novel (hardcover)

$ 6.00 2 beers (at a bar)

$ 3.00 1 bag of Oreos

$ 4.00 2 muffins

$ 4.00 1 chips and dip

$ .50 1 candy bar

$ 2.00 1 cappuccino

$99.50 Total

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When you really start to look at where your money goes each month, and when yourealize how far your money could go if it was invested for twenty-five or thirty years,you can be inspired to change your behaviour.

Still, when it comes to writing that cheque each month, many people fall flat on theirfaces. Don’t worry, there’s another, even easier way to fund your savings plan. Nearlyevery financial institution offers a plan where they will electronically transfer moneyfrom an account at another firm at a specific date each month.

The Armchair Millionairecan show you how easy itcan be to pay yourself firstwith their simplecalculator.

Automatic Investing Plans Have Another Advantage

If you set up an automatic investing plan with a brokerage firm or mutual fund company,you can often get around the minimum investment they might otherwise require all at onceto open an account. By committing a certain amount of money to be invested each month,at least until you’ve reached the minimum account size, you will be paying yourself, withoutthe need to come up with a minor fortune just to open an account.

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These automatic plans may be called automated transfer programs, moneylinks, orautomatic investment plans, but the concept is the same. You will have to fill out someforms (usually the company that’s receiving the money will provide these) and specifythe amount you would like to have transferred. Then all you have to do is remember toadd the transaction to your chequebook register each month! Now your pay-yourself-first plan will be taken care of each month!

Do You Appreciate Compound Interest?After you’ve found the money to start your investing plan, you can proceed to step #2of the secret of building wealth: putting the money to work! The key to successwhenever you’re saving and investing to meet any goal is to allow enough time for yourmoney to really work for you. Time is the fundamental ingredient in the plan: withouttime, your money just can’t work at its maximum potential for your benefit.

Why is time so essential? Because of the power of compound interest, referred to bysome as the “eighth wonder of the world.” The power of compound interest can causeyour money to multiply to amounts that you might have thought impossible. Here’show it works.

Let’s say you deposit $100 in a bank, and are able to earn 5 percent in interest a year. Atthe end of the year, you have $105 in the bank (5 percent of $100 is $5). Now, if youleave that $105 in the bank, how much will you have at the end of the second year,assuming you still earn 5 percent a year in interest? You will have $110.25. Five percentof your original $100 is still $5, but the $5 you earned last year and left in the bank alsoearned you interest of $0.25, for a total of $110.25. This is compound interest, whenyou earn interest on your interest! Maybe this short example doesn’t sound like much,but let’s consider another story in which we let time work its magic.

Twins Nelson and Nellie are 18 years old. Nellie decides to start her savings andinvesting plan at this young age, so she invests $2,000 a year for the next four years. Bythe age of 21, she has invested $8,000.

Nelson is a bit slower when it comes to financial matters, so he doesn’t invest anythinguntil he’s 30 years old. Then he puts away $2,000 a year, and keeps going until he’s onthe brink of retirement at age 64. Nelson is proud to have put $70,000 into hisbrokerage account.

Over the years, both Nelson and Nellie are able to earn an annual return of about 10 percent in their portfolios, the long-term average of the stock market (as you will learn later).

At age 65, Nelson smugly turns to Nellie and chastises her for neglecting herinvestments all those years. Nelson’s account balance is $596,254, and he’s feelingpretty good about it.

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But Nellie produces her account statement, and Nelson’s jaw drops. Her account isworth more than Nelson’s: her original $8,000 has grown to a total of $615,000.

There’s only one way to explain the difference in Nelson and Nellie’s investing plans,and that’s the power of compound returns. Nellie’s account grew and grew, notnecessarily because of her investing acumen. And it wasn’t because she continued to putmoney in her account, either, but because she didn’t take any money out! She left allthe interest and profits she earned in her account, and that interest and those profitsearned even more interest and profits, to the point where the biggest part of herportfolio by far comes from the compounding of returns.

Imagine where Nellie would be at age 65 if she had continued to invest $2,000 a yearafter age 21!

Time is your ally. Don’t be a prisoner of time. Let it work for you and help you reachyour financial goals. That means just one thing: Start saving and investing today!

Setting Goals and Meeting ThemYou’ve probably got a lot of dreams. We all do. You want things from life, whether it’syour dream house or a worry-free retirement or a luxurious sailboat. So how are you

going to make those dreams become reality? You’re goingto stretch to fulfill your desires with a savings andinvesting plan.

Articulating your goals is only part of what you will needto do in order to meet your objectives.

You also need to separate your long-term goals from yourshort-term goals. The reason for this is simple: If youexpect to be paying for college in three or four years forthat future doctor you’ve been raising, you don’t want toinvest all of your money in something that carries a lot ofrisk. If your investment didn’t work out, you would bestuck without enough money to pay the bills!

On the other hand, if your goal is to save for your retire-ment and you have twenty-five years until you expect toretire, you might be able to maximize the returns on yourinvestment if you don’t need to worry so much aboutshort-term changes (as long as you know that in the endyou have a good chance of ending up with a solidportfolio).

Overall, the Stock MarketGoes in One Direction

—Up!

Since 1928, the U.S. stock market(as represented by the Standard &Poor’s 500 Index, a collection ofthe best-known companies from allindustries) increased in fifty-two calendar years and declined intwenty years. However, the upswere much, much bigger than thedowns. In forty-one of those years,the market grew by more than 10 percent, but the market fell by10 percent or more in only eight of the down years.

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These two investors have vastly different goals, so they’re likely to end up with two verydifferent savings and investing plans to meet their objectives mainly due to theirdifferent time frames.

But how do you define “short term” and “long term”? Well, experts generally agree thatfive years is the dividing line. If you have a need for money in less than five years, youhave a short-term goal. If you don’t need the money for more than five years, you’vegot a long-term goal.

There are big differences between short-term and long-term goals and how you meetthem. Remember the story about Nellie and her not-so-bright twin brother Nelson? Ifyou have a long-term goal, the power of compounding plays a major role in helping youmeet your objectives. If you have a short-term goal, however, the only way you will beable to build up your bank or brokerage account is by putting money into the accounton a regular basis. Your contributions will be the most important part of your plan.

If you have long-term goals, you should probably be investing in the stock market. Overthe long term, the stock market has returned about 11 percent a year to investors. Butover the short term, the stock market fluctuates—and fluctuates a lot. In a single year,it’s not unusual for stocks to decline 25 percent! This kind of unpredictable declinecould wreak havoc on your financial plan, leaving you short by quite a few dollars justwhen you need the money the most.

Building Your PlanLater in this book, you will learn how to put together a plan on the Internet that fitsyour personal situation. You will learn how to balance risk and return, and discoverwhich investments are likely to be best for your own goals. And whether you’replanning for retirement, or college, or some other aim, you can find the tools on theInternet to help you reach all your goals.

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The Least You Need to Know

➤ No matter how rich or poor you are, the key to building your nest egg is learning to saveregularly. Pay yourself first each month, and your savings will quickly begin to grow.

➤ It doesn’t take much to begin your savings and investing plan, but every day you delaystarting is one day less that your money could be working for you. The principle ofcompound returns is the key to building wealth, so let time work on your side and notagainst you.

➤ You need to separate your long-term and your short-term goals, and create a plan tohelp you achieve both. Different types of investments are appropriate for each goal, somake sure you’re investing in the right place.