Personal financal is the act of managing one’s own monetary resources. This includes, but is not limited to, savings, investments, insurances, loans, bills, and taxes. Financial literacy is a mostly overlooked part of general education, however various countries are starting to understand the importance of financial knowledge (see for example the Financial Literacy Month).
In my opinion, to get a hold on personal finances, one needs to understand some accounting basics.
In accounting, we want to measure and track information about entities. In the most general sense, that entity would be money, but it could be anything else as well. To do so, we group those entities into three categories: Assets, Liabilities and Equity. Those form the basis of the so called “Accounting equation”:
Equity = Assets − Liabilities
When applied to personal finance (for a single person at least), equity can be equated to net worth. Assets are things we own (primarily money, but also objects such as a car or a house) and liabilties is our debt (such as student loans or credit cards).
On top of that, we’ll use Expenses and Revenue to describe changes to the aformentioned categories.
To analyse the flow of our money over time, we need to do Bookkeeping. There are various methods of bookkeeping, but one system which has prooven itself over time is the so-called Double-Entry bookkeeping system.
In it, each change to an account needs to be accompanied by an inverse change of a second account.
A simple example is a money transfer from our chequing account to our savings account: If we register a debit on the chequing account, we also have to register a credit to the savings account.
Things get more involved if the second account is outside of our control. For example, if we get paid by our employer, we will still record a change to two accounts: One being our chequing account, the other being a “virtual” account of the employer.
What makes the double-entry bookkeeping system so powerful is that it’s trivial to detect errors: The total sum of all accounts is always zero.
Each change (expense or revenue) is recorded in a journal. That journal is often called Ledger. One could have a physical ledger, but various digital ones exist which might be easier to manage. Personally, I like plaintextaccounting.org
The primary reason why bookkeeping is important is to maximize savings. But why is having savings so important?
Emergencies. We don’t want to find ourselves in a situation where we are forced to pay but can’t do so. A rule of thumb is to have two months of income liquid.
Large purchases. There will always be some purchases for which we need to save first. Prime examples are cars and real estate. If we save more, we can realise those large purchases more quickly. Note that not all purchases will reduce your net worth. For example, a house will usually hold its value (if not increase). Therefor we can think of of purchasing a house as a different form of savings.
Passive income. If invested right, savings can produce a fair amount of passive income.
Retirement. This is the largest reason. There will be a time where we cannot generate income anymore and need to live from pensions. Usually a pension consists of three parts: Some social benefits paid by the state, employment-based pensions (i.e. money we pay into a pension plan while being employed) and personal savings. The latter we can influence the most.
As previously noted, the biggest reason for savings is our retirement. There are two numbers to keep in mind: Our life expectancy and the date of our retirement. There are various resources online to get an idea of your life expactancy and how to improve it. But for the sake of the argument, let’s assume one dies at 85 and retires at 65. This leaves 20 years during which we need to support ourselves.
Retirement plans can get very complex, but the basic idea is to calculate your annual expenses and cover those with your savings. A naive example would be annual expenses of 20,000$, which would mean that we need to have 400,000$ in savings at the age of 65 (adjusted for inflation: 586,403.51$).
Passive income and financial independence
The previous calculations, besides being somewhat naive, have one other flaw: We cannot accurately predict our life expectancy. If we spend our savings as if we’ll die with 85, we’d be broke the day we turn 86. Therefore, lots of people just save as much as they can (or are comfortable with) and try to limit their spending in their retirement.
However, there is a better way: Passive income. Because with enough passive income, we achieve financial independence - i.e. our passive income surpases all of our expenses.
There are many ways to generate passive income, but the most common one is through dividends of investments. For example, if we have stock which pays 4% in dividends, we would need to invest 25 times our expenses.
Again, if we reduce our expenses, we also reduce to amount of money we need to invest. But thinking back to our naive retirement example from earlier: We said that we’d need 20 years of expenses if we plan to retire 20 years. It turns out that pushing that a little further to 25 “years” of expenses paid, we could be financially independent.
This option is the most attractive when we plan to retire more than 25 years. Therefore most people who try to be financially independent also plan to retire early, thus coining the term “FIRE”.