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The Five Pillars of Personal Finance
Most of the personal finance advice you find out there, such as investing strategies and frugality tactics, rests on the back of a number of assumptions about the person that might use those tips.
Those assumptions are what I consider to be the foundations of personal finance. Almost everything you read about finances in books, in magazines, or on the Internet either describes one of those key pillars of personal finance or rests upon them.
Furthermore, it’s almost impossible to achieve lasting personal finance success without having those pillars in place. Virtually every financial success I’ve had in my life has either been due to the work put into establishing those pillars or has rested on those pillars.
Ready? Let’s take a look at them.
Pillar One: You Need to Have an Internal Reason for Getting in Control of Your Money
“So now, as an infallible way of making little ease great ease, I began to contract a quantity of debt.” – Charles Dickens, Great Expectations
Why? Why are you putting in any effort at all to care about your finances?
If you have this pillar in place, you’ll immediately have a strong answer or two. The reasons for getting in control of your money are obvious and, more importantly, they come from within you.
What do I mean by “within you”? It’s simple. If your response to that kind of question comes from other people – a spouse, a parent, a child, a boss, a friend – then the motivation and reason for changing your financial ways is an external one, and when that external reason changes or goes away, there’s nothing keeping you from snapping right back to poor personal finance decisions.
The reasons for change need to be internal. They need to be driven by things that you want out of your life and things that you want to achieve. It doesn’t have anything to do with other people, at least not in any direct fashion.
During my own personal finance journey, this was the first pillar that I put into place. Without it, it was really hard to rely on the other pillars in any way, and every attempt I made to establish those other pillars and rely on them fell apart.
I was initially inspired to change by my infant son, but what he actually did is inspire changes within me. His arrival in my life made me really look at the long term for the first time, as I was going to be responsible for him for the next 20 years or so. What is my life going to look like in 20 years? Am I happy with where I’ll be in 20 years if I keep doing what I’m doing?
It turned out that I wasn’t very happy with that direction at all. I wanted something better for me. I wanted to be a good father and a good husband during those years, without stress holding me back. I wanted career flexibility and the opportunity to try a career as a writer. I realized that I wasn’t going to have those things if I continued down my old financial path. So, I made changes.
Without that kind of central motivation for good financial choices, it is really easy to instead focus on pleasures and assume that everything will just kind of work itself out. For some people, that’s a financial philosophy to hold dear, but during the years in which I lived that way, I never found that it took me to any place that I actually wanted to go. It was not until I established strong internal reasons for getting in control of my money that things became better.
What are your internal reasons? Don’t feel bad if you don’t have them yet. If you’re reading this and do not have them, it’s likely that you’re already on the cusp of figuring them out. To get started, ask yourself why you are reading this article and then apply my favorite approach to really digging deep, the five “whys.” Keep asking yourself “why” in response to your answer to the previous question and eventually you’ll start getting very close to your internal reasons for change.
Pillar Two: You Need to Know Where Your Money Is Going
“We spent as much money as we could, and got as little for it as people could make up their minds to give us. We were always more or less miserable, and most of our acquaintance were in the same condition. There was a gay fiction among us that we were constantly enjoying ourselves, and a skeleton truth that we never did. To the best of my belief, our case was in the last aspect a rather common one.” – Charles Dickens, Great Expectations
Many people get into personal finance trouble simply because they lose track of all of their spending. They spend money online, at convenience stores, at restaurants, at the grocery store, at the hobby shop, and so on, and then they find that they’re suddenly low on funds. They try to think back and figure out where their money went… and they don’t remember a lot of the expenses. So it just seems like a mystery.
If you want personal finance success, that mystery needs to end. You need to know where every dime of your spending is going, whether or not that expense is actually a necessity or not, and whether or not that expense actually makes any sense or not. That decision about the worthiness of an expense should be happening away from the moment of impulse where you’ve decided to spend, too.
That seems tough, but it really isn’t. All you need is a good system for going through all of your expenses, categorizing them, and thinking about them.
Personally, I use You Need a Budget for exactly that. This is a great expense tracking program that lets you categorize your expenditures however you’d like. You can enter them on the go on your smartphone or put them in when you’re at your desktop computer and there’s no remote server that will have access to your account data. (Many people use Mint, which makes this process even easier, but it does require you to share a lot of account information.)
I usually keep receipts in my pocket and write down expenses that don’t involve a receipt either directly in my phone or in my pocket notebook. Then, when I empty out my pockets, I enter those receipts into You Need a Budget for later evaluation. I also use bank and credit card statements to make sure that I’ve recorded everything.
The point of this system is to provide a constant reminder of how much I’m spending and where. When I actually step back and see where every dollar is going, it becomes easy to see excessive spending patterns over time. For example, if I spent $100 in a month buying beverages at a convenience store, that’s ridiculously excessive, but if a person just stops there and spends $5 every night after work, it doesn’t seem that excessive. I likely wouldn’t see the big consequences of that pattern if I didn’t track my spending.
Knowing where your money is going also reveals the areas where it might make sense to cut back on spending. For example, I might not recognize that I’m overspending on a hobby, but if I see that I’m spending $200 over the course of a month, it can be a sign that I really need to cut back there.
Pillar Three: You Need to Be Able to Live Within Your Means and Spend Less Than You Earn
“Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” – Charles Dickens, David Copperfield
Spend less than you earn.
I consider that simple statement to be nothing less than the fundamental rule of personal finance, and although all of the pillars are connected to that idea, it is this pillar that is closest to that central rule.
Whatever your income is, whether it’s $20,000 a year, $200,000 a year, or $2 million a year, that is the absolute upper limit on what you should be spending. If at all possible, your spending should be well below that level.
Without that gap between your income and your spending, where you have leftover money at the end of the month, you will never be able to pay down your debts. You will never be able to save for big goals. You will never be able to find any degree of lasting security.
For the vast majority of Americans, the real challenge here comes from the “spend less” part of the equation. Modern society makes it so incredibly easy to take our “wants” and inflate them directly into “needs.”
We spend our money on things like cell phones, Internet access, cable and satellite television, expensive foods, large houses, shiny cars, and so on, and act as if those things are “needs” when they’re truly just “wants.”
Even worse, we subject ourselves to a nonstop flood of impulse buys and small “treats,” all of which are the most vague of “wants.” A serious look at the results of the second pillar will help get that under control, of course.
The challenge is that your “cap” on spending is entirely dependent on what you earn. Not what you might earn someday or what you dream about, but what your actual income is.
This is the pillar upon which things like career improvement and entrepreneurship are truly built. Those kinds of tactics – starting a side business, working to make passive income streams, improving your resume, taking classes to improve skills or earn certifications or degrees – all work toward improving your income, giving you more breathing room for your spending. (Of course, it’s a good idea to hold spending steady when your income increases so that you can start using that money to rapidly pay off debts and save for things like retirement.)
Pillar Four: You Need to Value the Long Term at Least as Much as the Short Term
“The father of this pleasant grandfather, of the neighbourhood of Mount Pleasant, was a horny-skinned, two-legged, money-getting species of spider who spun webs to catch unwary flies and retired into holes until they were entrapped. The name of this old pagan’s god was Compound Interest.” – Charles Dickens, Bleak House
We humans are born to value the short term. Throughout almost all of human history, it was a waste of time for almost anyone to think beyond the next week or two. Even at the dawn of agriculture, the crops that were planted were fairly short-term crops that grew year round, meaning that even then, there wasn’t much time between the initial labor and the payoff of food in the belly.
It is only in the past few millennia that many humans at all had enough security to worry about things beyond the next few weeks, and only in the last century or two has that number expanded with any significance. It’s no wonder that we’re all wired to think about the short term.
However, it’s that short-term thinking that causes a lot of our problems. We don’t sign up for retirement savings plans because that’s far off in the future. We don’t save for upcoming expenses because, well, they’re quite a bit down the road. We take on student loans because they’ll be paid off someday later on by our future selves, who might as well be someone else.
The thing is, those long-term things are actually extremely important. The results of those decisions are going to have impact on your lives for many, many, many years. The choice to not sign up at retirement at age 25 is going to send you into an utter panic starting at about age 40 and make your retirement far worse at age 65 and beyond – it’s literally damaging half of your lifespan on this earth. The choice to skip out on upcoming expenses means that you’re going to wind up saddled with debt that will take years to pay off.
In short, personal finance success requires you to think of the long term with real seriousness. You need to consider the impact of the decision you make today on yourself in five years, 10 years, 20 years, 40 years. Quite often, it’s a real impact, if not because of the individual choices you make, but because of the patterns it represents.
Do you really need to go out to eat three times a week? The $50 or $100 you spend on that could be paying off debts, giving you breathing room in the next few years, or on retirement, giving you breathing room during the later stages of your life. How important is another meal at Applebee’s in comparison to that?
Those kinds of questions need to become central in your thinking. Even more, you need to value that long-term result even more than you might normally, because you’re naturally wired to favor the short term. Make most of your choices in favor of the long term and you’ll be a much happier person over the course of the rest of your life.
Pillar Five: You Need to Learn How to Control Your Emotions Around Money
“For gold conjures up a mist about a man, more destructive of all his old senses and lulling to his feelings than the fumes of charcoal.” – Charles Dickens, Nicholas Nickleby
Whenever you handle money while being driven by emotion, you’re probably making a mistake of some kind.
Have you ever thought about changing your investments because you’re worried about the ups and downs of the stock market? That’s an emotional response, and you’re probably going to lose money.
Have you ever bought a giant pizza or a new video game or some alcohol or something else like that during a moment when you’re feeling sad or upset or frustrated? That’s an emotional response, and you’ve just lost money.
Have you ever engaged in “retail therapy” as a response to stress? Again, that’s an emotional response, and you’ve just lost money.
Those kinds of purchases are fine if you approach them with rational thought, making sure that the decision you’re making is a good one that’s in line with the things that you value. You should make all of your decisions regarding money when you’re in a calm state without emotional interference.
What about spontaneity, though? Sure, there’s nothing wrong with spontaneous spending sometimes. The trick is to put some borders and limits on it so that you’re not spending in a way that damages your financial plans. I do this by budgeting a certain amount each month for “free spending” – money I can spend with no questions asked. Within that limit, I can do whatever I want without any guilt and without any negative impact on my financial plans or my future.
Dial back – or, ideally, eliminate – your spending when you’re dealing with an emotion, whether it’s stress or worry or joy or something else. Instead, spend when you’re feeling cool and rational and analytical. You’ll make much better choices.
What’s Atop the Pillars?
Let’s assume you have these pillars in place in your life. What’s next? Here are some things that stand atop the pillars, some of which I still find myself working on.
Building an emergency fund. An emergency fund is perhaps the first thing that you should achieve once you’ve begun to master spending less than you earn. It’s simply cash in your savings account that you can tap in an emergency, a reservoir that identity theft or cancelled credit cards or a job loss can’t touch. It’s there for you, no matter what comes your way.
Paying off debt. Debt, particularly debt that’s got a high interest rate attached to it, is like a giant weight around your neck. The interest and the ceaseless monthly payments are a constant drain on your finances. If you’re spending less than you earn and have a good grip on your spending, you can make extra payments on your debts, eliminating them quickly and minimizing how much money you lose to interest.
Saving for retirement. There are many, many options for retirement savings, but they all require you to actually save, and that saving requires you to have money that isn’t being diverted elsewhere. Having a forward thinking mindset and a good grip on where your money is going opens the door to channeling some of that money into retirement.
Improving your spending choices. This is a constant process in which you evaluate how you spend your money, figure out whether you got value for the money you spent, and try to improve from there. It’s smart frugality, in other words. It’s all about cutting the most wasteful spending, buying products that last and meet your needs well, and knowing how to avoid purchases that aren’t going to wind up being useful for you.
Improving your investment choices. There are countless options out there for investing. Even within your retirement plan, there are usually a bunch of options to choose from. As you invest some time and some cool analysis, you can slowly move towards better choices; as you keep your impulsiveness in check during a turbulent market, you can keep yourself from locking in losses.
Improving your career arc or launching a better one. Earning more makes so many other things possible, so investing time and energy towards improving your career situation, starting a business, or launching a new career will help improve your income (or at least your happiness with your work), putting you in a position where all of these things become easier.
All of your financial and professional choices rest, at least in part, upon those five pillars. It’s well worth your time to make sure that those pillars are strong so that they can support you well throughout your life.
In the end, your financial success is up to you. Building a good foundation for that success is key, and if you have those pillars in place, it becomes easier to build to whatever kind of dreams you want.