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The steps to financial success

(Yes, I could have called this post "4 steps to financial success", but I hate clickbaity titles.)

This is a 50,000 foot, birds-eye view article. If you're only interested in advanced tactics, you can skip it. That said, as every engineer who's had an interview can attest: everyone could use a brush-up on the fundamentals now and then.

So let's take a step back and ask ourselves the big question: "how do I achieve financial success?" Anyone who's got experience in working to reach Big Goals knows that there are three components to getting there: mindset, strategy, and tactics -- in that order.

Mindset

Yeah, it sounds "woo-woo", but mindset is always the first step towards achieving the goal. Sure, we like to be analytical and make decisions in a rational manner, but we also have to acknowledge the fact that we're human, or we're going to be continually surprised when things don't go according to plan.

So we have to make sure we have the right mindset -- in this case, that we know what "financial success" means, and we understand that it's (a) achievable, and (b) a good thing. (Otherwise, our subconscious will find all sorts of ways to sabotage us. Yeah, it's annoying, but that's humanity for you.)

And what does financial success mean? That's up to you to decide, but let me provide some examples to get you thinking.

  • Money goes where you want (or where you know it has to go), intentionally, rather than just sort of vanishing into you-don't-know-where.

  • Your money and your values match up: you "put your money where your mouth is", rather than you saying one thing about yourself and your spending saying something different.

  • The future is planned for, rather than financial "surprises" popping up every month. ("It's Christmas? I did not see that coming!")

  • Sudden, large expenses are annoyances, rather than financial train wrecks.

  • You have the resources to take unexpected opportunities for investment, giving, or spending, rather than having to turn them down because you don't have a stable financial foundation.

  • Your daily and monthly finances are on automatic, rather than you having to do a juggling act to make sure none of your checks bounce.

Note: none of these things require you to be "wealthy". I know multi-millionaires who struggle with this, and I know teachers who would fit this definition of financial success.

Strategy

Once your mindset is clear, you can look at high-level strategy. In broad strokes, how are you going to get where you want to go? Without an effective strategy, you could go down any number of rabbit holes in search of "shinies", and not get any closer to success. Where finances are concerned, I suggest the following:

Step 1: Establish cash flow management

Step 2: Mitigate risk

Step 3: Reduce debt

Step 4: Invest for the future

It's not fancy -- but good strategies aren't. You can get elaborate with tactics, if that's fun for you (and it is for me!), but where strategy is concerned you want a rock-solid foundation that you can always come back to.

Note that these are in order: generally, I recommend focusing on each step in turn, rather than trying to fight a battle on multiple fronts and risk getting overwhelmed. Of course, your mileage may vary significantly; this advice is intended for 90% of readers, 90% of the time.

Step 1: Establish Cash Flow Management

If you aren't managing your cash flow -- if your expenses exceed your income in an uncontrolled manner -- you're not going to be able to progress towards financial success. There's no point in maxing out your 401(k) if your bonuses are always going towards paying off your credit card balance.

Now, this doesn't necessarily mean that you have to have a budget (yes, I said the "b" word, please take a moment for a breather if that word causes you apoplexy). Some people just naturally spend less than they make, for various reasons. However, I do think regularly-updated, zero-based budgets are a fantastic tool for everyone. "Giving every dollar a job" is of course a great way to make sure you don't overspend, but remember: money exists to be spent (which includes being given away). If you're not intentional about your money, even if you just naturally accumulate wealth, then at some point you may as well just be lighting it on fire or throwing it out the window. Do you really want your children to be "trust-fund kids"? Do you really want to wait until retirement to start living the life you want?

Oh, and if you want a recommendation for budgeting software: YNAB is the best zero-based budget program around, period. No, I have no relationship with them, other than being a user myself -- they're just that good. Ask Nerdwallet, Wirecutter, and Investopedia.

Step 2: Mitigate Risk

Once you've got your cash flow under control, risk mitigation can enter the picture. Financial slings and arrows can assail you at any time; having a shield in place can prevent them from causing you severe setbacks on your journey.

Any good financial advisor will tell you that the best way to mitigate risk is to establish an emergency savings fund. The idea behind this fund is that it is a buffer set aside for large, sudden expenses that can't normally be taken care of in your normal cash flow, and will severely impact your quality of life. This generally includes:

  • Major out-of-pocket vehicle repair

  • Major out-of-pocket home repair

  • Major out-of-pocket medical expenses

  • Job loss

Now, keeping around enough money to cover all of those simultaneously may be a bit much, which is why you'll often hear the (sound) recommendation of just being ready for the biggest one -- job loss -- by keeping 3-6 months living expenses in liquid savings. You can get fancy by creating a CD ladder or signing up with MaxMyInterest, which automatically saves your money at the highest interest rate it can find...or you can keep it simple by going to a reputable online bank like Ally, Capital One 360 (formerly ING Direct), American Express, or Goldman Sachs' "Marcus".

The other major risk mitigation tool is insurance. Self-insurance via emergency savings is great, but note those "out-of-pocket" lines above -- your savings likely won't cover the full cost of replacing your home if it burns down, which is where insurance comes in. By insuring for property, liability, health, and life, you can self-insure the deductible (and it can be a fairly hefty deductible, if your emergency savings does indeed cover 3-6 months of living expenses!) and other necessary out-of-pocket expenses, and let insurance take care of the rest.

Step 3: Reduce debt

Note, I said "reduce", not (necessarily) "eliminate". While paying off a 14% interest rate credit card is clearly a better investment than buying stocks, the choice becomes less clear when you're looking at accelerating your 4% mortgage payoff or paying down your 6% student loans. While that analysis deserves a post of its own, there is a guideline I'd like for you to be aware of: the 50/20/10 rule. I'll break this down into its components:

The 50/20/10 rule is simply this: I recommend you target, as a long-term goal, spending less than 50% of your budget on non-discretionary expenses, at least 20% of your budget on saving (including paying down debt), and at least 10% of your budget on giving. (The rest, of course, is for whatever you want.) While this, too, deserves its own post, I'd like to at least talk a bit about the "50" part of that rule.

Remember the definition of financial success we talked about, way back at the beginning of this post? Well, if you read between the lines, you'll see the "flexibility" is a big theme. It makes threats less threatening, and opportunities easier to take on. By paying down debt and eliminating other nondiscretionary expenses, you greatly increase your flexibility. If you're deciding whether to eliminate debt (or take some on), take a look at where you stand with respect to the 50% rule, and use that to help you make your decision.

Now, as far as how to go about paying down that debt, there are several methods, each of which is a very personal decision.

Avalanche: In this method, you use as much of your discretionary income as possible to pay down the highest-interest rate debt first. From an analytical perspective, this will get you out of debt faster than the "snowball" method below, so I find that analytical minds often gravitate to this.

Snowball: In this method, espoused by Dave Ramsey, you pay off the lowest balance debt first, then use the money you were using to pay that debt to pay off the next lowest balance debt, etc. You can see where the name comes from, as your debt payments gradually form a debt-crushing "snowball" as you pay off your various accounts. The advantage here is in momentum: the snowball is, honestly, more exciting to many people, which gives them the motivation to keep going. This pays homage to the old-and-true saw that "the best method is the one that you'll actually use".

Snowflake: This can be used in combination with either of the other two. In this method, you take any small savings or income, such as from using coupons, spare change from paying in cash, or selling small personal possessions, and put that towards your debt. The idea is that these small gains can add up -- and they do.

Step 4: Invest for the future

Once you've got your cash flow in check, you've established your risk mitigation system, and you've reduced your debt to the target you've designated, then it's time for what many people consider to be "the fun stuff": investing.

Note that I've put this last for precisely this reason, as the stock market has all of the enticing appeal of a Vegas casino, and should be appropriately handled with great caution, and only when you are fully prepared. When people -- even fellow engineers -- find out that I'm a financial advisor, almost inevitably the next question is "what do you think about Apple/Tesla/Bitcoin?" It's fun to imagine getting incredibly wealthy off of picking the right investment...fun, and dangerous.

Obviously, there's an order of magnitude more to say about investing than can fit into a couple paragraphs. However, a great place to start is an Investment Policy Statement, in which you lay out the basic framework for your investments, which can help you avoid shooting yourself in the foot in a moment of greed or fear.

Tactics

We've talked about mindset, and we've talked about strategy, so now we can talk about tactics. Just as the specific investments you choose should flow from your IPS, your tactics should flow from your strategy. I've already given many specific tactics above, so I'm just going to leave you with some general thoughts:

When choosing a tactic, do at least a cursory opportunity cost/benefit analysis. Just because something saves or earns you money, doesn't mean it's worth the time you spent on it. All that time you spent working on your portfolio could have been spent increasing your earning potential -- and the single most powerful way to boost your investments is to contribute more to them, earlier!

Consider the Pareto Principle. "20% of the invested input is responsible for 80% of the results obtained" is a maxim that works in many areas of life, and financial tactics are no exception. For example, don't let your desire for a fully optimized portfolio keep you from starting; rather, consider investing in a simple, low-cost target retirement fund at first, and then optimizing later.

Consider finding an expert to help. I'd be remiss not to point out that in the sea of salespeople and sharks, there are solid, fee-only financial planners that put you first, and can steer you towards the tactics that work and away from the ones that aren't worth your time and energy.

Finally: the most effective financial tactics are often the most boring. Figure out a good budgeting process. Get good insurance. Pay down your high-interest credit card debt. Invest in a low-cost, diversified mutual fund. These aren't exciting -- but they're highly effective.

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