A Basic Financial Plan

Building a Small Business That Warren Buffett Would Love - Available Everywhere, Spring 2012

The following is from My Happy Assets, available at lulu.com. Much of the source material is from Dave Ramsey's Financial Peace.

In reading source upon source on the subject of investing, I have seen two main thoughts or religions surface:

1) The religion of cut up all of your credit cards, pay off all of your debts, invest in mutual funds, watch it grow and never go into to debt again, the No Debt Religion and …

2) Buy a lot of cash flowing real estate using debt leverage as a key aspect in your plan or the Leverage Religion.

Both plans have their merits and surprisingly they agree on basic tenants:

1) There is such a thing as bad debt and it is debt against items in your financial spectrum that merely create an expense in your income statement and do not put any net, cash in your pocket at the end of the month.

2) You need to get your personal finances in order before you move on to a higher level investment plan or attempt to control the finances of a business.

I think it is highly important to pay attention to the overlap of these two financial religions since they are the two leading thoughts on personal investing, they disagree on many points and thus, an area of overlap is highly important.

This overlap deserves magnified attention and should be deemed important to the core of your financial plan. What follows are the details of the overlap.

Step One: Sock away $1000 for an emergency fund and start creating a monthly budget.

The emergency fund money should be kept in an easy access, liquid account such as a money market account or an interest bearing checking account. This money should not be locked away in a CD or in long term investments. This money is for emergencies only. For example, if you lose your job and you need it to pay the heating bill, a legitimate use, not to upgrade to an HD TV. If you have to spend out of this account, you should return to this step and replenish the account back to $1000 before moving on with your current step.

Also, you need to be tracking your monthly income and expenses in a simple budget. If you have Microsoft Money or Quicken, great. If not, it doesn’t matter. Use Excel or just write it out on paper for that matter. The point is that you need to come to the table on a recurring basis to build this budget. Be detailed and accurate about it but don’t overcomplicate it so that it becomes a task you are unwilling to do.

Below are some sample entries you should probably have on your budget:

Income – your main source from your job or hopefully, passive income.

Other Income – perhaps you have an auction on eBay ending this month or a birthday coming up.

Gas – of course you could cut back here and start taking a bike to work.

Food – perhaps break this out by groceries and eating out which bottom line, is “entertainment” food.

Entertainment – those movie tickets are not free.

Miscellaneous – you should always factor in a 5 – 10% miscellaneous category.

Mortgage or rent – hopefully this is a mortgage and hopefully it won’t exist much longer.

Utilities – gotta have lights.

You’ll probably come up with more, pertinent expenses to your situation which is great. Get as detailed as possible. At the same time, don’t overcomplicate the budget until it drives you away from sitting down and developing it monthly. Once you have the first template in place and the first few months of trial and error out of the way, it will become easier and easier.

Step Two: Get rid of the credit cards, swear off taking out personal loans and maintaining frivolous lines of credit, stop leasing cars and pay off all of your debts, smallest to largest.

This has been named by Dave Ramsey as the debt snowball – you quickly knock out the lowest debt and then with that extra payment you attack the next largest and then so on and so forth until all of your payments are attacking the largest debt enabling you to eliminate all debt in a rapid manner. At the end of this step, you will have $1,000 in the bank and no debt except for your house.

Step Three: Ratchet up the emergency fund up to 3 to 6 months of your expenses.

A typical number would be $6,000 to $10,000 but again, this all depends on your personal expenses. To determine this, you need to make sure you are on the budget. You will be able to see a moving timeline of your expenses and you will be able to calculate an average from this. If your expenses are $2,000 a month, then $6,000 to $10,000 should be an ample emergency fund. Your budget will let you truly know what 3 to 6 months of expenses are for you.

Step Four: Max out all of your retirement savings, chiefly 401k and Roth IRA.

Make sure you contribute at least up to your company match – this is pure gravy and if you can, contribute at least 10%. Your 401k is pre-tax thus all of the savings you invest here get the benefit of a full dollar invested – there is no tax bite taking away from how much you can put down here. These savings grow tax free.

The yang to this yin is the Roth IRA. Here you can contribute post tax but your contributions are not taxed when you begin withdrawal. Having both the 401k and Roth IRA at retirement is a nice compliment because one grows tax free; the other is tax free withdrawals. This would be a sort of hedge if your tax bracket didn’t decrease in retirement as you probably expect it will.

Step Five: Begin mutual fund investing.

Although this is not the only asset class to invest in, and quite honestly, this is where the two financial religions begin to diverge, it is simply the easiest one to get involved in. Yes there are market risks and yes, unless you are heavy on income producing funds you are typically investing for capital gains and you will have to ride out the ups and downs of the market. But, this will break you in to the investment world and later you can diversify across asset classes, such as real estate and small business, both of which are detailed as part of the financial independence plan as detailed later in the book. You will be knocking out your house in the next part and you are already contributing a healthy percent to your retirement savings so, 10% is a decent figure to contribute to mutual funds at this stage. Later, you will be able to ramp it up.

Select four funds, each with a different investment strategy such as growth, income, value, an index fund, each with a great five and 10 year track record (preferably a 10-15% rate of return) and begin socking away some money in these vehicles. I won’t go into to great detail here on mutual fund analysis – you should go to Morningstar.com to get the skivvy on mutual fund selection – but I will say that you need to pay attention to the expense ratio and that the fund needs to be a no-load.

Here’s my brief mutual fund selection run-down:

1) Look for a good five and 10 year track record, preferably a 10 – 15% rate of return.

2) Diversify across mutual fund strategies. My top picks would be an income fund, international fund, growth and income, index and value.

3) Make sure the funds are no-load funds (loads are fees to shareholders and historically, when compared to no-load funds, you do not get higher returns) and check that expense ratios are 1.0 or less. There is no need to pay higher expenses because there is not a correlation between higher expenses and higher returns.

4) In the context of financial independence and passive income, we need funds that pay a dividend. Thus, screen for dividend yield as well.

5) Pay attention to Morningstar ratings. Morningstar is considered a qualified expert on grading mutual funds and they assign a star rating on a scale of one to five comparing a funds performance to a similar fund. Go to Morningstar.com for the full details.

You can probably get to all of the above information without having an account with a mutual fund broker but in the end, you are going to need an account to buy the mutual funds. My personal preference is Fidelity at fidelity.com but you have your run of choices: Schwabb, ING, TIAA-CREFF, etc.

Step Six: Pay off the house as rapidly as possible.

At this point, you should have no debt, your emergency fund is firmly in place and your retirement savings are accounted for. Scrape everything together, to the last cent and attack the house. With no debt you can rapidly knock this down, way ahead of the 30 year schedule most people are on. In as little as 5 years you can be entirely debt free, everything including the house.

Regarding the two financial religions, they both agree that your house is a monthly expense – it does not put money in your pocket. The No Debt Religion addresses this by having you pay it off. The Leverage Religion says instead of paying it off, use that money to buy cash flowing real estate but yet again, we see overlap. They both consider the house an expense, if it was paid off it would not be an expense item on your balance sheet and thus your monthly passive income bar would be lower.

Let’s say that your house payment is $800 a month, you have a remaining mortgage of $100,000 and you have total monthly expenses of $2,800 a month. If you paid off the house your passive income bar would be $2,000 a month. If instead you took that $100,000 and invested it at a 20% rate of return, you would have $1,667 of monthly income. Thus, you would only have to generate another $1,133 in monthly passive income to be financially free. So, the math favors the Leverage Religion but an argument is always made that the paid off house is a more conservative, safer approach. I will say this, it is impossible for a bank to foreclose on a paid off house and I favor the No Debt Religion on this one.

Step Seven: Saving For College

Now if you have a junior or a little missus junior, you should start contributing to their college savings. The best thing going right now for college savings is the ESA – an educational savings account. Essentially, this is the 401k of college savings, pre-tax investments are made here. To determine how much you should sock away, figure out what the little one’s tuition will cost in 18 years (or whatever little time you have left), factor in the college tuition inflation rate of 4 – 6% and the rate of return you should expect. The end result, you should know how much you need to sock away each month to send junior to Harvard or perhaps a quality, state college.

Do not go the route of pre-paid college tuition. These plans merely match the 4-6% rate of college inflation and thus you will be losing out on the mutual fund like returns of an ESA which can fall in the range of 10-11%.

With the completion of all of the preceding steps, you have the ability to get rich and then perhaps super-rich. More importantly, you have the solid foundation to move on to other investment strategies such as dividend single stocks, options, real estate and small business which lead us along the financial independence path. The preceding is the core of your plan. Once you have this in place you can confidently move forward to advanced passive income generating techniques. It is important to be smart and do your homework ahead of time before getting into riskier investments. This book will be a resource in that sense but continue to invest first in your education as you move forward.

A great book to read at this point is Robert Allen’s “Multiple Streams of Income.” You should continue to build in your mutual funds but at the same time you should expand to other asset class horizons. Warren Buffett says, put all of your eggs in one basket and then watch that basket very closely. I still believe in asset diversification but I do not believe that it merely means spreading your money across many different types of mutual funds. I believe you should spread your money across the major asset classes; stocks, real estate and business, which will be presented in the following chapters.

Another great book to read is Robert Kiyosaki’s “Rich Dad, Poor Dad” and if you want to get the skivvy on basic personal finance, check out Dave Ramsey’s book, “Total Money Makeover.”