The Five Pillars of Personal Finance

Personal finance is an umbrella term that covers all the decisions you make related to your finances. The foundations of personal finance are built on 5 pillars. The Pillars are: Income, Spending, Saving, Investing, and Protection. When you master these pillars you can get out of debt, achieve financial security, and finally grow your wealth.

Unfortunately, school does a poor job of preparing you for handling your finances. Then you are faced with the decision to take on a large loan to attend college at 18 years old before you understand these financial principles.

So how do the 5 foundational pillars of personal finance help you to succeed?

The 5 Pillars of Personal Finance

All your personal finance decisions can be grouped into 5 different buckets. Each group builds on the others and are interconnected. When you understand all 5 pillars you will be able to achieve financial independence and grow your wealth.

1) Income – The Main Foundation

First is your income which is the most important pillar to understand. Your ability to earn more money is the single most impactful thing you can do for your finances. All the other financial decisions you make will be strongly tied to how much income you make. There is no limit to the amount of money you can make.

Income encompasses all your earnings in a given period: your salary, any side income, earnings from gig work, wages & tips, rents collected, dividends & interest on investment, etc. Basically any positive cashflow you are earning in is part of your income.

You need to take your earnings and decide how you use it to live, save, and invest. The more earnings you have coming in, the more you can allocate to all your needs.

1.1) Salary From Your Job

The income you earn from your primary job is one of the first areas to look to increase your income. Additionally, many careers give you the opportunity to get raises and even bonuses. You should look to optimize all aspect of your earnings from your primary job.

• Are you in a role that allows you to be promoted?
• Are you learning new skills on the job?
• Can you be a top quartile (25%) performer to get large raises & bonuses?

These are the questions you should be asking yourself. If the answer is no, you should be looking to switch careers, companies, or roles. Especially early on in your career where you have more mobility.

1.2) Side Income & Gig Income

To really optimize your earnings, you want to look at additional income streams outside your main job.

The Law of Diminishing Returns says that after a certain point, for each additional unit of input, there is a decreasing amount of output. This is relevant to your main job. The additional income you make working 50 hours instead of 40 hours a week is likely higher than working an additional 10 hours (60 hours a week). At some point, your additional effort will be better spent on a second income stream than your main job.

We live in a world full of gigs and secondary income. Supplementing your main income with additional earnings streams allows you to make major jumps in your financial pursuits.

1.3) Dividends & Interest and Real Estate

When you are starting out in your adult life, you likely don’t have a large investment portfolio. Therefore, this will make up a very small portion of your income.

However, as you save & invest more, you will reach a point where your cash flow from investments is approaching your main salary. When you reach the point where your investments are earning more than your cost of living, you are near financial independence. Cash flow from investments is another source of earnings.

2) Spending – The Stumbling Block

“Spend less than you earn.” The whole section on spending can be summed up in those few words. This is why income is first and spending is the second pillar. You need to know how much you earn before you can budget for how much to spend.

“Spend less than you earn”

Professor B.T. Effer

The 2 biggest challenges most people face when looking at their spending are:

1. Incurring Bad Debts, and
2. Lifestyle Creep

The easiest way see where you are overspending is through a budget. If you have significant amount of bad debt, it will be very visible as you try to reconcile your budget. And after making a budget plan, if you stick to it you will avoid lifestyle creep. Therefore, to ensure you are spending less than you earn, you should use a budget.

2.1) Budgeting

A budget is a plan for how much you will spend. By setting up a budget, you can more easily track your spending and ensure you are hitting your saving & investing targets.

A budget doesn’t have to be complicated, a simple spreadsheet is all that is needed. First, you add up all your income from all your sources. Then you take out all your expenses, your planned savings, and your investment contributions.

Illustrative Budget Example

Below is an illustrative budget sheet. Each month you would add a new column of your actual spending for that month.

A few items to note in the illustrative budget:

• Your budget assumes one time expenses each month so you are prepared for reasonable additional ‘unexpected costs’. Above we have $100 earmarked for any unexpected minor events.
• When you set your monthly budget, every dollar is accounted for leaving you with $0 net cashflow
• However, each month you will see some deviation from plan, in the above illustration the month of January saw
  • More side income than you budgeted for but you also spent a little more on miscellaneous discretionary costs
  • There was no one time expenses and you were able to contribute more money to your investments
  • You ended up with a positive net cashflow meaning you spent less than you made, saved, and invested. This allows you to make an excess contributions to your savings and investing this month.

Budgets can be as simple or complex as you make them, but tracking your money is a vital step in managing your finances.

2.2) Control Your Spending

Once you set a budget, the two simplest ways to improve your financials is to avoid taking on bad debt and avoid lifestyle creep.

Bad debt can be both high-interest debts like paying interest on a credit card balance (most credit cards charge 15-30%+ a year) and overspending on items (ie-buying a luxury car you can’t afford because you didn’t follow a guideline like the 20/4/10 rule). Bad debt will have a large monthly drain on your earnings and keep you from financial freedom.

Lifestyle creep is when your earnings go up but you increase your living expenses by the same amount. This means you don’t increase your savings & investing as you earn more and severely hampers your future wealth. A good rule of thumb is to increase your investing rate by at least 1/2 of any raise or earnings increase. If you get a 4% raise, you should increase your investing rate by at least 2% of that 4% raise. If you work at a job with a 401k, increasing your 401k contribution is the simplest way to ensure this happens.

3) Savings – Your Safety Net

An emergency fund is there to protect you in case any unforeseen expenses occur. When you budget, you should include an item for minor unexpected day-to-day expenses since there is always something that occurs in a month. Your emergency fund is there for more major surprise costs.

For example, your budget can account for needing to get an oil change one month ($50), but your emergency fund is there if you need a new transmission ($1,000s).

You should aim for 3-12 months of expenses in your emergency fund. If you have a high variable income (ie-commission-based sales job or rely on tips), you want a larger emergency fund. Or if you have dependents you likely need more of an emergency fund than if you are single.

The emergency fund is there to help prevent you from needing to use credit cards and other forms of debt to cover rough patches.

Your savings should be in a high-yield, FDIC-insured, savings account. This money is for a rainy day and you want to be able to immediately access it if needed. Additionally, you don’t want to risk it in investments where the value can decrease and you end up with less money than expected.

Lastly, if you have a known major purchase coming up, you should be increasing your savings account to prepare for it. For example, if you are looking to purchase a house and need a $50,000 down payment in 2 years, then you should be building up an additional $50,000 in your savings account. Although, you may want to do this in a separate account than your emergency fund for simplicity.

4) Investing – Growing Your Wealth

You increased your earnings, built a budget, spend less than you make, and have an emergency fund. Now it is time to focus heavily on investing and increase your wealth. Investing in assets is the way to wealth accumulation. The expected return on a savings account is too low to help you grow wealth. You need to be willing to accept some more risk and volatility in order to get the returns to grow your wealth.

The sooner you start investing the better. Compounding is when you get a return on previous returns and over time it leads to significant portfolio value growth. If you invest $1,000 today and it earns 8% a year for 30 years, it grows to over $10,000, ten times more money than you started with.

Saving just $5,000 a year for your working life and earning around the average equity returns of 10%, you would have nearly $2.5 million in 40 years.

You would have contributed $200,000 to your account, yet you wind up with over 12 times that amount due to compound growth on your investments.

However, the same $5,000 a year in a savings account at 2% doesn’t even result in $500,000.

This is why investing is necessary to grow wealth and security. You may see volatility in your investments, but over the long-run investing in assets is the way to large increases in wealth

There are many different assets and accounts you can invest in to grow your wealth.

4.1) Types of Investments To Choose

Investing can be intimidating and complex. Luckily, there have been immense progress made in creating simplified investment offerings. There are a lot of different assets to choose from, stocks, bonds, mutual funds, exchange traded funds (ETFs), options, futures, etc.

However, most people should purchase low-cost, passive, broad-market Exchange Traded Funds (ETFs) on a reoccurring buy basis. It is a ‘set it and forget it’ strategy. Let’s break down what that means:

• Low Cost: fees and expenses can have an enormous drag on your portfolio growth. When looking at funds to invest, you want to make sure you avoid high fees. Vanguard pioneered the low-cost ETF but many firms have come to market with alternatives. There are a plethora of ETFs with expense ratios under 0.10%.
• Passive: passive ETFs are designed to track the market. The manager is largely rebalancing the holdings to represent the relative weights of each stock in the index. For example, the S&P500 index is made up of around 500 of the largest domestic companies in the US. The index is market-weighted, meaning the bigger the company the higher the allocation in the index. A passive fund will rebalance so the holdings of the fund closely resemble the entire S&P500 index. This is the opposite of an active managed fund where the index will choose which stocks to invest and how much of each to own. A passive fund will track the overall market.
• Broad-Market: a broad-market index has a wide range of companies in it. This ensures you are getting diversification and aren’t over-exposed to any one stock or sector (like energy or tech). The S&P500 is an example of a broad-market index.
• Exchange Traded Funds: ETFs are an alternative to mutual funds. They are generally more tax-efficient and lower cost.

There are ETFs for nearly all types of assets. When you are just starting out, investing in a broad-market stock only fund (ie – S&P500), a total market fund (invests in both stocks & bonds), or a world market fund (invests in both US and non-US assets) are more than enough options.

4.2) Common Investment Account Types

The second investment choice to make is what type of account to use. You can purchase ETFs in many different types of investment accounts. A few of the key investment accounts commonly used are:

• 401k: employer-provided retirement account. You can typically contribute through payroll deductions and your employer may match some of your contribution. If they do, you want to contribute at least enough to get the full employer match. These accounts have tax-advantages but the money is generally locked up until you reach retirement age. There are annual contribution limits.
• Individual Retirement Account (IRA): IRAs are accounts that you own. They are similarly tax-advantaged like 401ks with similar restraints on access to your money. There are also contribution limits.
• Roth Retirement Accounts: A Roth account receives after-tax contributions and grows tax free. There are Roth IRAs and some employers offer a Roth 401k. The main difference is that traditional 401k and IRAs allow you to contribute money pre-tax and tax you when you withdraw. However, Roth accounts allow you to pay taxes today and never pay taxes on the money again. There are income and contribution limits, although you can partially work around the limits with a backdoor Roth.
• Health Savings Accounts (HSA): if your employer offers a high-deductible health plan (HDHP), it typically comes with the option for an HSA. HSAs are never taxed as long as the contributions are used for a qualified medical expense. This makes them the only “triple tax-advantaged accounts”. Most HSAs allow for you to purchase assets for investments.
• Regular Taxable Brokerage: This is your standard investment account. You don’t get any tax advantages, however, there are no restrictions on you accessing your money and no contribution limits.
• College Savings Accounts (ie-529s): There are a host of college & education savings accounts available to you, with 529 plans being the most well-known. These accounts tend to offer tax-advantages if the money is used for qualified education purposes

The above list isn’t exhaustive, but for most people these will be their main investment accounts. Just like diversifying your investments is important, you should look to diversify your account types. These accounts have a mix of pre-tax, after-tax, and liquidity which each pose their own pros and cons.

5) Protection – Preparing For The Worst

The last pillar of personal finance is protection. This pillar largely consists of insurance and estate planning. These products are there to help you when catastrophe strikes and are vital for your overall financial success.

Insurance are products designed to protect you against losses and liabilities in low frequency but high severity events. Insurance products are NOT substitutes for savings & investing.

[Professor B.T. Effer Note – Insurance agents are notorious for trying to sell insurance products as an investment. Agents typically get paid a commission which means they benefit from convincing you to buy more & bigger products. You should almost always buy insurance for protection and leave the investments for your investment accounts.]

5.1) 4 Basic Types of Insurance

There are 4 basic types of insurance you need:

• Life Insurance: There are dozens of insurance products of various complexity and use cases. However, most people only need a basic term insurance product with a long enough time to maturity for your needs. Term insurance expires after a given period, but that allows it to be the lowest cost insurance option.

[Professor B.T. Effer Note – If you are worried about losing all your insurance after your term policies mature, but don’t want to pay the higher premium of a permanent policy today, you can get a conversion rider on your policy. A term conversion rider gives you the option to convert your term policy into a permanent policy that will be with you till you die.

These conversion riders tend to be relatively cheap so we recommend everyone consider purchasing one on all your term policies. You don’t know what life holds, and having additional flexibility is very valuable.]

• Health Insurance: health insurance covers hospital and doctors bills. The cost of healthcare is high and going up. Most people get their health insurance through an employer.
• Auto Insurance: If you own or drive a vehicle, you need auto insurance. This is to cover you in case of an accident. Review and shop your auto insurance around to ensure it is up to date and you aren’t overpaying.
• Home & Renter Insurance: Homeowner’s insurance is to cover any damage done to your home or items in it. Renter’s insurance covers your property within the home. Most mortgages require a homeowner’s policy and most landlords want you to have renter’s insurance.

Non-insurance items that fall into your protection bucket include your estate plan, wills & trusts, power of attorney, and identity-theft protection. You can also look for an umbrella policy that helps cover any liabilities or costs that fall through the cracks in your other insurance.

Frequently Asked Questions:

The Final Word – Five Pillars of Personal Finance

Personal finance covers a wide range of products, assets, accounts and strategies. However, they can be simplified into 5 pillars and a handful of generalized steps. The 5 pillars can be boiled down to:

• Increase your income and optimize your earnings per hour worked
• Spend less than you make and use a budget to stay on track
• Keep an emergency fund of at least 3 months for any unexpected events
• Invest at least 20% of your income to grow wealth
• Purchase adequate protection for any catastrophic events

If you master the 5 pillars of personal finance and follow the 5 steps above you will be well on your way to getting out of debt, getting financially secure, and growing your wealth.