When constructing a house, the first step is to lay a firm and solid foundation. Likewise, a solid financial plan starts with the basics. Here, we want the short-term goals in place before moving on to medium-term and long-term goals. The essential short-term goal is to establish an emergency account. This account should be tucked away safely in a money market account. Generally, an emergency account will have 6 to 12 months worth of expenses. So, if a household’s average monthly expenses are $2000 a month, a suitable emergency account would have between $12,000 to $24,000. Once established, this ready reserve would be available to tap in the event of a layoff or an unexpected large purchase, such as replacing a broken hot water heater. I have been tracking my expenses all my adult life. Tracking one’s expenses does the following things. First, you are creating a document of what you are spending. Like a detective trying to solve a mystery, you are converting what you don’t know into something that you can know. In this case, the mystery you are trying to solve is “Where does the money go?” I find this information very useful. Now that I see where my money goes, I can then make decisions. I may see how much is spent on various discretionary items and decide whether to maintain those spending levels or cut back. A byproduct of tracking one’s expenses is that every spending action becomes more conscious. Each purchase becomes a deliberate act, not an automatic response. (For additional tips on saving, I recommend reading “The Armchair Millionaire.”) I believe also in reducing debts. Not only is it financially sound, but you gain the peace of mind that comes from not having to be beholden to a creditor. This is why I strongly recommend paying off credit cards and paying down other loans such as car loans.
The next step in planning one’s finances is to allocate savings to a purchase you plan to make within five years. These medium-term purchases could be for an exotic vacation, a new car or a down payment on a house. Money earmarked for purchases within five years can be kept in a money market account. Or if you want slightly better yield, albeit with some fluctuation to principal, you can use an ultra-short term bond fund.
For long-term goals, retirement for example, the most effective investment is in stocks. Why stocks? Because over long periods, inflation erodes purchasing power. T-bills offer no real return over inflation. And bonds barely keep ahead of inflation. I have studied and practiced many approaches to investing in stocks. The discussion that follows outlines my current approach to investing.
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