The only five money principles you need to know
THE STANDARD INSIDER
By Pauline Muindi
| July 19th 2020
Personal finance is a complex subject. There’s a wealth of information on personal finance on the internet, in books, podcasts and so on. It is easy to get overwhelmed with all the information. To complicate it even further, some of the personal finance advice might seem contradictory.
But the truth is that money matters don’t have to be so complicated. You don’t have to read all the books, listen to finance gurus, or read every article to become financially savvy. There are a few personal finance principles that determine your success. If you desire to build a strong financial future, know these principles by heart and apply them as closely as possible:
Principle #1 Spend less than you earn
One of the most important personal finance principles is to spend less that you earn. No matter how much you earn, if you spend all of it as soon as it lands in your account, you will be stuck in the perpetual payday-to-payday cycle. Making sure that your monthly expenses are less than your income is the only way to ensure that you have something saved for the future.
Although you should save as much as possible, most personal finance experts recommend aiming to save at least 20 per cent of your income. The best way to ensure that you spend less than you earn is by creating a budget and sticking to it. You can use a budgeting app if you don’t know where to start.
Principle #2 Earn more to save more
You can start saving with your current income, no matter how little. However, to boost your saving rate, you actually need to earn more money. The amount of money you can save through budgeting and saving is limited, but there’s no ceiling to the amount of money you can earn.
Instead of focusing too much on penny pinching, it makes sense to put a lot more effort into maximising your income. The more money you make, the more money you will have to save and invest. You can maximise your income by asking for a pay raise, looking for a higher-paying job, having a side hustle, or creating investments for passive income.
Principle #3 Always plan for emergencies
Emergencies are part of life. When emergencies happen, they can wreak havoc in your finances. For instance, you or your spouse might lose your job, your car might break down, or you might fall ill. These kinds of events can’t be planned for. However, having an emergency fund can help you handle emergencies more effectively. Ideally, you should have three to six months’ worth of living expenses saved in your emergency fund. If you don’t have an emergency fund set already, approach your bank and open a savings account and start depositing whatever you can manage every month.
Other than an emergency fund, make sure that you have all your necessary insurance coverages paid. Although insurance might seem like an unnecessary expense, having the right insurance can save you from big bills in case of an emergency. At a minimum, you should have health insurance and auto insurance.
Principle #4 Make your money work for you
If you save Sh10,000 every year for the next 40 years with no interest, you will only have Sh400,000 to show at the end. But if you invested Sh100,000 per year and earned 10 per cent return each year, you would have Sh5,267,155. This is because of something known as compound interest.
This simple example perfectly demonstrates the importance of investing. You can’t build wealth by working for every shilling and saving up. To build real wealth, you have to make your money work for you. You can put your money into stocks where you basically buy a small part of a corporation, buy bonds where you loan out your money and earn interest, invest in real estate, or start a business.
Stocks are a great place to start - you don’t need a huge amount of money to invest in stocks. Stocks have always outperformed bonds. With inflation accounted for, stocks provide an average return of 7 per cent annually and double their value every seven years. In contrast, bonds produce an average real return of 4.5 per cent annually and double their value every 16 years.
But because of the volatile nature of the stock market, don’t invest money that you need in the next few years. Stocks should be a long-term commitment. You will lose and gain money over the years. A good strategy is to have a diversified portfolio of stocks to distribute your risk.
Principle #5 Save for retirement
Most young people associate “retirement” with old age. Because of the tendency to delay making retirement plans, many millennials are not adequately prepared for retirement. Studies show that most millennials won’t retire till the age of 70 and upwards.
Finance experts recommend that you should start saving for retirement right from when you get your first job. The standard recommendation is to save 10-15 per cent of your income towards your retirement nest egg. But if you’re aiming for early retirement, you should put aside a much bigger percentage of your income for retirement.
To figure out how much money you need to have in your retirement fund, calculate how much you realistically expect to spend in a year in your retirement years. Account for about 30 years post-retirement. Make sure to account for inflation as it can significantly erode the purchasing power of your money over the years. If retirement planning sounds complex, it is a good idea to hire a professional to help you.
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