A guide to finances
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I write this article to provide an easy way for people just entering the workforce (many of my friends) to manage their finances. I also think this article would also be a good reference for me, and may prove interesting (in hindsight) in a few years. If you want to spend as little time as possible, skip to the end. I would appreciate comments if you find this useful.
Note: this is not going to be rigorous, but it should make a fair bit of sense. Also, this article is pretty US-centric, so if you live outside the US, this may just be a “fun read” (if you find finance “fun”).
DISCLAIMER: Of course, this is only my opinion, I have not been paid by any of the sites/companies referred to in this article and I hope I don’t get sued for doling out advice that I think may be helpful (but may not be). I don’t have a degree in any of this and I haven’t taken even a single course in economics/finance/investing at a formal institution. All of this is information from my brain + the internet, neither of which can be counted upon. You have been warned!
General overview
Save up to 6-9 months worth of expenses as an “emergency fund”. Get your employer’s 401(k) match. Invest the rest. I’ll provide the details in a Q&A format.
Investing
Q: What do you mean “Invest the rest”?
A: If you’re in the US, depending on how young you are (your actual age, not how young you feel), you want to put a significant chunk into stocks (the stock market). Not (I repeat NOT) individual stocks, but a fund. If you’re outside the US, you may want to look at savings rates and compare the returns (for Indians abroad, see NRI).
Q: Why a fund? Why not individual stocks?
A: When you invest in a mutual fund, that money is used to buy a bunch of different individual stocks. Remember when in grade school you learned not to put all your eggs in one basket? By investing in a bunch of funds, your risk of losing all your money is lowered (by the same egg-basket principle). Take care not to invest in an actively managed mutual fund because the fees charged for maanging the funds will eat into your returns as John Oliver explains here.
Q: But, mutual funds are subject to market risks…!
A: Yes, they are, but the risk is much lower than investing in a single stock. Also, I’m assuming they have to say that so they don’t get sued. Later, I suggest some mutual/index funds you can invest in. Also, the S&P 500 has been down in a 10 year period only a couple of times, which seems promising (although past performance is no indicator of future success).
Q: But, I’m sure company ABC is going to be a huge hit and I’d get better returns there.
A: I’m sure people have had the same thought with IBM, Blackberry, Nokia, Twitter, etc. Yes, you might get lucky, but, it’s unlikely. If you need persuading, try this game.
Q: Which fund should I invest in?
A: You could invest in a retirement fund (these will have dates in their names, for e.g. Vanguard’s 2060 retirement fund, choose one that matches your intended year of retirement). Retirement funds will ensure that your cash is moved from stocks to bonds (high-risk/profit to low-risk/profit) as you grow older. If you’re young (below 35), you could put a significant chunk (Warren Buffett says 90%) in an S&P 500 (or stock market) mutal fund or index fund.
Q: What’s the difference between an index fund and a mutual fund?
A: I’m not entirely sure, but one difference is that you can only buy whole shares (you can’t buy fractional shares) of index funds whereas you can put any monetary amount into a mutual fund. So, if you want to invest a certain fixed amount every month, that would be possible with mutual funds. Vanguard has lower charges for their mutual funds once you invest $10,000. Also, an index fund essentially tries to “track” the market and follow it as closely as possible, but sometimes there may be a lag and that can cause concern.
Q: Why the S&P 500?
A: A total stock market fund may be better, as it doesn’t discriminate by only picking stocks of large companies. The S&P 500 invests in the 500 largest companies by market capitalization (which is just number of shares multiplied by share/stock price). In effect, you can think of it as investing in the 500 largest companies, which should be reflective of the market (I think I read somewhere that they reflect 86% of the market). Also, Warren Buffett is a fan.
Q: When should I start doing this?
A: ASAP. Over time, the market “tends” to grow. I use that word very loosely, because no one really knows what the market is going to do. We may be facing a crash, but, usually, the market grows, and by waiting you lose out on those gains.
Q: Wait… it may crash? Why should I invest then?
A: Let’s say the market does really poorly and mutual funds all go to zero (or near zero). You have now lost all your money, but so have tonnes of other people and if the dollar is worth nothing, then it really doesn’t matter if you have any or not. Note: As stated earlier, this may not be accurate since I am not an expert on this. I will add a correction if someone corrects me or I learn otherwise.
Emergency fund
Q: Why 6-9 months worth? Why not 4 or 10?
A: Honestly, I don’t know either. I’m guessing it is probably to give you a few months (enough) to get back on your feet if you find yourself without a job.
Q: What if you suddenly needed a lot more than 6-9 months of expenses?
A: Of things that I can think of that cost that much, you probably should have insurance to cover (healthcare expenses, car/home damage expenses). For expensive buys like cars/houses, you probably would have a loan (after your down payment).
Q: Where should I put my emergency fund?
A: A bank account where you can withdraw money easily. You could use Ally (an online bank) as they provide 1%, higher than most banks.
Buying a house
Q: Should I buy a house or rent?
A: It depends. You could do either. It’s tough to say which one would be better long-term. It’s important to note that any savings you make on rent should be invested, if you are to come out equal (or on top). Here’s a spiffy calculator from the New York Times (The Upshot).
Q: I don’t want to plug in all those numbers. Just tell me what to do.
A: If you’re staying in a city for a long duration (>5 years), it would probably make sense to buy a house. Do the math before making a decision, though, it would not be prudent to do otherwise.
401(k)
If you put your money in a traditional 401(k), it will be invested before tax is levied. You will pay tax on it when you withdraw the funds (when you retire). This is like a provident fund in India, but money is invested in the market in a 401(k).
Q: Should I put money in a 401(k)?
A: Yes, almost certainly, yes. Especially if your employer will match a percentage of how much you put in as that is “free” money.
Q: How much money should I put in a 401(k)?
A: At least as much as your employer will match. You can put more after that as well, but missing out on the employer match is missing out on “free” money (once it is vested).
Q: Why are you writing “free” in quotation marks?
A: See next question.
Q: What happens if I withdraw the funds before I retire (at the age of at most 59.5)?
A: You pay a 10% penalty on the funds withdrawn. After you are 59.5 years old, there is no penalty.
Q: What’s this about a Roth 401(k)?
A: For the Roth 401(k), you pay taxes on it now before it is invested. This is different from just investing in the stock market, because your profits will not be taxed! However, you will still be subject to the penalty if you withdraw early.
Q: Where is the money invested?
A: It’s invested in the market. You can choose the funds you want to put the money in. Usually, only a limited number of funds are available. This further differentiates it from investing in the stock market.
Q: So, if I retire, and am unemployed, I can withdraw funds tax-free?
A: No. The amount you withdraw will be included in your income for the year. You will be taxed based on whatever tax rate that income is subject to.
Q: What if I have a life-threatening emergency and need the funds?
A: In some cases, you can withdraw the money without a penalty.
Q: My employer doesn’t have a 401(k) program. Can I put money in an IRA instead?
A: Yeah, sure. It’s pretty similar, but I won’t detail the differences here.
Q: Why the hell is the k in parentheses?
A: I think this is because it is covered under Section k of the Internal Revenue Code.
Credit cards
Most people who have a decent credit score should get the Citi Double Cash back card. It gives you 2% on everything.
Q: But, I travel a lot and care more about travel rewards.
A: Then, it may make sense to get one of the Chase cards or an airline/hotel card.
Q: Doesn’t Discover give 5%?
A: Yes, but only on select categories every quarter. The Citi Double Cash back gives 2% on everything. So, if you have only one card, you should get the Citi. If you are getting additional cards, you can get Discover, Chase Freedom, etc. as well.
NRI
As banks in India offer a high interest rate (earlier around 10%, currently they offer around 8%) on fixed deposits (FDs), investing in India may seem an incredibly tempting option compared to the low US savings rates (around 1%). However, the Rupee has been falling steadily compared to the dollar. Five years ago, in 2012, 1 USD would get you around 53 INR. In 2017, you’d get around 68 INR for a dollar. Doing the math, that means if you invested the equivalent of 1000$ in both places, assuming a conservative 5.5% annual return for the S&P 500 investment in the US, you would end up with 1307$ in the US and only 1255$ if you had invested in an FD in India. When you adjust for the lower FD rates and the exchange fees, it makes more sense (to me) to invest in the US.
Where do I learn more?
(Alternative title: How did you learn this?)
Having an interest: 20%.
Having friends who like talking about this: 30%.
Reading reddit’s personal finance and investing subreddits: 15%.
Realizing Warren Buffett has more personality and money than you’ll ever have: percentage-less.
I don’t want to read all this
Long story short, keep 6-9 months of expenses in an emergency fund, contribute enough to your 401(k) to get your employer’s match and (if you’re below 35) put the rest in a fund that tracks the S&P 500 or tracks the stock market.
Q: How do I invest in a fund?
A: Either go to Vanguard as they have low fees and invest in either VFIAX or VTSMX or both (both mutual funds), or download the RobinHood app and invest in VOO or SPY or both (both index funds).