Monday, May 16, 2011

Getting your financial house in order

Hey folks!

Today I'd like to talk not about investing per se, but about something related to investing.  You could look at this as the roots from which the grass of successful investing habits grow.  Not every investment you will make will be a straight line upward and so there is something you need to consider before you make any investment.

Since you are looking to acquire companies that properly financially manage themselves, you too must seek to emulate this sort of successful behavior before you attempt to invest in the stock market.

This is why, before you invest a dime in equities, you need to get your financial house in order.

The first thing you should really get at least a basic competence in is personal accounting.  I'm not saying that you need to go attend a four year degree in accounting.  If you are someone who is not invested, chances are your accounts are relatively simple.  And talking about maintaining a set of personal books for yourself may sound like a daunting task to some, especially for the younger amongst you who may only be entertaining their first job.

But if you don't know where your money is going, you won't know where you're losing it.  If at the end of every month you check your bank balance and you frown, thinking you should have more, then money is sneaking away from you.  You need to know why.

And today is a great day to start!  Trust me, readers, if you intend to get your fingers involved in all sorts of investments, your personal accounts are going to become a bit of a headache.  It's better to start now, today, this minute, because (if things go well) your accounts are just going to get more complicated for you as time progresses!

But accounting software is expensive, you say, and I say "Bah" and direct you here.  Download it.  I use it and my finances are pretty complicated (investments and cash in many different currencies).  This software keeps track of it all.

Okay, now that that software is downloading in the background, let me explain what a debit and a credit are.

The root of the words "debit" and "credit" in accounting are founded in the concept of debt.  Debits are debts owed to you, and credits are debts you owe to others.  But trying to identify these words with concepts grows confusing as we get further into accounting, so don't care.  There's no reason to anyways.  All you need to remember is that debit means "left" and credit means "right."  Accounting functions based on the principle of balance, and your debits must always equal your credits no matter what.  Assets are debits, and liabilities are credits.  You want your assets to have lots of numbers on the left, and you want your liabilities to be as small as possible on the right.

So open up GnuCash and try some stuff out!  You can modify the starting balances of your various items, but the key concept is once you do that, everything must balance in some way.  For example, let's presume that you have $100 on hand and you spend $50 on gas for you car.  This would cause a $50 credit to your cash on hand account, and create a $50 debit in your fuel expenses.  The beauty of this system is that it leaves a paper trail for every transaction you perform.  At the end of each month you can identify your expenses and incomes, and see whether your assets grow or shrink.

Why am I trying to convince you to engage in the relatively boring and relatively mundane exercise of tracking your finances?  Because as someone who has invested for a number of years in the market and who manages money, I cannot in good conscience advise you to invest any money that you cannot spare-- that you do not truly consider "excess cash."  What's more, I can't advise you to invest money if you do not have further cash coming in down the road to invest.  Investment is an active process.  Each investment you consider worth pursuing needs to have money poured into it on a regular basis.  If your financial house is not in order, you cannot make the commitment to pour money into an investment regularly, and thus you really should not invest  in anything, especially equities.

Jumping in and out of stock positions will inevitably prove hazardous to your health.  If you rely on flipping stock positions to supplement your spending deficit, it is as if the entire foundation of your financial house is built on quicksand.  Everything will go well, until it doesn't.  Again, another benefit of learning to treat yourself like an accountant-- you will understand the difference in terms of income from capital gains and income from interest and dividends.  The latter add to your financial house, the former is not so predictable.

So when can you start really getting going with stock investments?  When your monthly expenses are at least 70% or lower than your monthly income.  You will be able to identify when you have entered this position because of your new found love of your accounting software!  And as you develop further income through your investments, you will continue to see this percentage decrease-- your monthly cash flow will grow and grow.  In the beginning, it may be sensible to sacrifice a few items that cost you.  For example, the typical iPhone user spends $100 - $200 per month on their cell phone bill.  If a 25 year old invests $200 per month at a compounded annual return of 5.5%, by the time he is 65 he will have an extra $348,207 in investments.  Is an iPhone today costing you a happy retirement tomorrow?

When Warren Buffett was 25, he would often view things in terms of what it was costing him tomorrow.  Convinced that through successful value investing he could at least earn a 15% annual return (he exceeded this expectation), Buffett would ask himself whether he really wanted to spend $5,420 of his future dollars on a $5 haircut today.   Despite earning billions, Buffett remains in the modest house he purchased years ago.

Benjamin Franklin once said:  "He whose income exceeds his expenses has found the philosopher's stone."  If you're looking to get richer, start at the root--focus on your personal finances before attempting to invest in the finances of others.  No amount of successful stock market gambling will make you richer when your personal finances are in shambles!  And who knows, you might even enjoy the new found power that a well organized setting of accounting books can bring.

Feel free to ask your accounting related questions in the comment section and I will do my best to answer them.  I consider myself an accountant first and a financier second: my understanding of company financial statements is directly impacted by my understanding of accounting, and I can't stress how useful that is!

Keep happy, healthy, and rich!  And see you next week!


  1. Using GNUCash seems pretty intimidating at first. What do you think about Mint? It's automatic information because it connects to your bank(s).

  2. I do not know what its going to take to get the financial house over in the euro zone in order.