Lately I've had a lot of requests for information for young people just starting out in life. Regardless of whether they are in their 20s or 30s (or even 40s--you know who you are!), these folks realize that a little upfront organization can put them ahead of the game. So let's talk strategy for starting out your financial life with your best foot forward. For you readers with younger children or grandchildren, feel free to pass this article on to them.
Start at the Very Beginning
There are two things you need to do right away.
1. Envision where you want to be in five years: How much will you have saved? Will you own a home or rent an apartment? Will you have kids that you expect will go to college someday? What kind of car do you see yourself driving? Will you need additional training to progress in your career? What else is important to you financially?
2. Think about pitfalls that you don't want to fall into: Owing too much on credit cards. Still paying off student loans. Having to borrow from your parents. (Again!) Wondering how you'll pay the rent each month. Make a list of all of the things that worry you or keep you up at night.
Setting Priorities and Timelines
Let's put some perspective in place to help you sort out how to approach these questions.
Use this timeline to sketch out what you hope to accomplish year by year:
Saving Goals by Time Horizon
Goals for 2008:
Goals for 2009:
Goals for 2010:
Goals for 2011:
Goals for 2012:
Let's look at an example to give you some ideas. Claire and Patrick are in their early 30s. She's a lawyer and he's an architect. They were married last year. She owes $50,000 in law school loans. They both have good jobs with 401(k) plans. She makes $80,000 a year and he makes $60,000. They live in an apartment but want to buy a house. They think they want to start a family in about four years. They've been using credit cards since their college days and now owe $6,000 on three cards. They both drive "old beater" cars and would like to replace them. Here's how they prioritized their goals over the next five years:
Claire and Patrick's Goals
Goals for 2008:
1. Pay off $25,000 of law school loans.
2. Pay off remaining credit card balances and resolve to pay bills in full each month.
3. Start contributing 5% of pay to both 401(k) plans.
Goals for 2009:
1. Pay off balance of law school loans.
2. Replace one car.
3. Increase 401(k) plan contributions to 8% of pay.
Goals for 2010:
1. Save $25,000 toward down payment of house.
2. Replace second car.
3. Think about how much we can comfortably spend on a house and start looking at neighborhoods where we can find houses in our price range.
4. Increase 401(k) plan contributions to 10% of pay.
Goals for 2011:
1. Save another $15,000 for the house.
2. Put an offer on a house in the desired neighborhood.
3. Take out a mortgage.
Goals for 2012:
1. First child is born. Set up a 529 college savings plan.
2. Take out term life insurance to cover the mortgage and the child's college education if something should happen to either parent.
3. Have a will drawn up by an attorney who specializes in estate planning.
4. Save 10% of take-home pay for future goals.
You can see from this example that if you have competing goals, it may call for a multiyear approach. Try to make some progress on each goal every year.
Making Choices about How to Spend Your Money
You can see from the example that in order to meet your financial objectives, you have to have some discretionary cash to put aside. The only way to do that is to take a close look at the money coming in and the money going out. That's typically called "budgeting," but I think it sounds much better as your "Personal Spending Plan." Either way, you need to think about the money you have to work with and how you're going to divvy it up. Click here for a worksheet that can help in that process. Everyone can benefit from going through this exercise--you don't have to be in your 20s or 30s.
As you'll see in the worksheet, I've divided the way you spend your money into several categories: Caring for Self, Caring for Others, Hearth and Home, Staying Connected, Getting Around, Staying Healthy, Edibles, Fun, and IOU. Over the years, I've found it helpful to think about these types of categories when planning how to spend money. The way you spend your money is a reflection of how you choose to spend your life.
You may find that you have more "wants" than you have money coming in. There are a couple of steps you can take to address that. First, go through a prioritization process again so that you know what's most important to you. Don't be afraid to think outside the box. Maybe owning a home isn't as important to you as taking a trip to Africa to help the people there. Maybe driving the old beater car an extra year is okay if you're finally free of that credit card debt. Second, you may need to get creative about cutting costs. You can find more ideas on how to save money by reading this article about how to cut expenses.
You should also make sure to budget money to invest. Ideally that will be about 10% of take-home pay. But you may need to work up to that goal over a couple of years.
Set Aside an Emergency Fund
Your first investment goal should be to set up an emergency fund--money you can tap in case you lose your job or are hit with an emergency bill, such as medical expenses. I can't emphasize enough how important it is to set aside some emergency cash: It gives you peace of mind, and it gives you a cushion so you don't fall into a vicious cycle with credit card debt. Typically you'll need enough in your emergency fund to cover three to six months' worth of living expenses. This money should be invested in a money market or savings account.
Start Building Your Core Portfolio
Once you've taken care of the emergency fund, it's time to choose the building blocks for your portfolio. This doesn't have to be difficult. Index funds--either conventional funds or exchange-traded funds--fit the bill nicely. An index fund buys enough stocks or bonds to mimic the benchmark it covers. For example, if you buy Vanguard Total Stock Market Index (NASDAQ:VTSMX - News), it holds representative stocks to cover all styles and market caps in the broader stock market. The same is true of Vanguard Total Bond Market Index (NASDAQ:VBMFX - News) for bonds. You can find index funds for just about any stock or bond market segment.
An exchange-traded fund is an index fund that trades like a stock. With regular mutual funds (that's what an index fund is), all movement in and out of the fund happens at the end of a day. With an ETF, the trade is executed when placed. So, if you put your trade in at 10:00 a.m., you buy (or sell) that ETF at that particular time--not at the end of the day. You'll also pay a brokerage fee to buy an ETF. You may or may not have to pay brokerage costs with an index fund.
In general, if you are going to invest a chunk of money all at once, use an ETF. If you are going to be adding to your investments monthly, use a conventional mutual fund.
If you are in your 20s or 30s and are investing money for the long term (you don't plan to touch it for at least five years), you can use an allocation something like this:
âEuro¢ 10% to 15% Vanguard Total Bond Market Index
âEuro¢ 25% Vanguard FTSE All-World ex-US Index (NASDAQ:VFWIX - News) (an index mutual fund that owns a broad cross-section of non-U.S. companies)
âEuro¢ 60% to 65% Vanguard Total US Stock Market Index
Regardless of which index fund or ETF you use, make sure the expense ratio is low. For example, try not to pay more than 0.25%.
You can use this same approach in your 401(k), too. Most plans will have investment choices that correspond to these basic categories. You can check the expense ratios for any mutual fund at www.morningstar.com.
To start your life with a firm financial foundation, you need to understand your assets and liabilities (net worth), set priorities for your goals, create a realistic spending plan, set up an emergency fund, and put the core pieces of your investment plan in place. By doing these things, you will have the confidence to make sound decisions early in life that will set you up for even more success in the future.
A version of this article appeared in a previous issue of Morningstar Practical Finance.
Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above.