Main ideas
Lazaroff opens with his first distinct memory of money. As a young kid at a local pizza shop, he asked his dad for change to pick a song on the jukebox. His dad asked, “Is it worth your money?” He said no, and his dad replied, “Then it’s not worth mine.” The next time they went, he asked again, and got the same question. This time, thinking he was clever, he said yes. “Great,” his dad said. “Then you can spend your own.”
It often takes a lesson like this to give us any sense of the importance of money growing up. Unfortunately, we aren’t taught about money in grade school, and our first real chance to learn doesn’t come until college or university, where we’re unlikely to take a deep dive into topics like retirement planning, buying a home, saving for a child’s education, or other money management situations: topics that impact all of us.
In school, you are given a lesson, then a test. In life, you are given a test and then you learn a lesson, and money lessons can be expensive.
The onus mostly falls on each of us to learn about money, unless we’re lucky enough to have positive money influences around us. It might feel overwhelming, but it doesn’t need to be. Starting early and keeping things simple can be an effective blueprint for success.
Making Money Simple aims to do just that. By simplifying the tools in our financial toolbox, it makes a complex topic simple. When we understand how our money works, we can focus on the things that actually matter, and make better decisions. Innovations will continue to shape the financial landscape, but good financial advice will never change.
Regardless of your specific situation, we all need to understand our money and what to do with it.
The power of time and compounding
The most powerful tool in our financial toolbox is time. Compound interest lets you earn a return not only on your contributions, but also on your past returns. It’s an exponential relationship, and that power is the most underappreciated part of a financial plan.
The issue with compound interest is that our brains simply aren’t good at visualizing exponential things. It’s nearly impossible to fold a piece of paper more than eight times. But if you could fold a piece of paper 50 times, doubling its thickness with each fold, how thick do you think it would become?
How many times you can double your money depends on your age and your rate of return. The rule of 72 says that if you divide 72 by your rate of return, the answer is the number of years it’ll take your money to double. For example, 72 ÷ 8 = 9 years. If you start with $10,000, after nine years it would double to $20,000. Another nine years, and you’d have $40,000. After nine more, $80,000. With each period, your money creates a new baseline, so you double that amount, not your original amount.
The more time you have, the more your wealth benefits from this compounding effect.
The most important rule of retirement planning is to save early and often. There’s no such thing as too soon, because starting early just gives you a longer time horizon. Warren Buffett says, “Life is like a snowball. The important thing is finding wet snow and a really long hill.” Compound interest works the same way: as the snowball rolls, it collects more snow with each turn, and the further it rolls, the more mass it gains. Even earning the same percentage return each year, our dollar growth increases every year: 8% of $10,000 is $800, and 8% of $10,800 is $864.
Time can also make a small amount of effort early on add up to more than a large amount of effort later.
But compounding works in both directions. Inflation is the rising cost of goods and services, which decreases our buying power over time. If inflation runs at 3% a year, the rule of 72 tells us our buying power gets cut in half every 24 years. Investment costs, fees and taxes can also add up over a long period to slice into our growth. And bad debt, like high-interest credit cards with low minimum payments, can grow to huge sums. A $2,500 purchase at 16% interest, paying only the minimum, would cost almost $4,000 in interest alone over the nearly 22 years it would take to pay off.
Compound interest is a very powerful tool at our disposal, but it can work for us or against us. By understanding how it works, and what matters most, we can make better decisions. The trick is to use time to turn small habits into incredible results.
Where do you want to go?
Achieving financial success can be challenging because it doesn’t happen immediately; it’s incremental. That’s especially true if you’re not sure where you’re trying to go. We have to start with the end in mind. Think about where you see yourself in 20 years, 30 years and beyond. What does your life look like? What milestones have you accomplished along the way? Allow yourself to dream; there are no wrong answers.
All too often, people make money decisions without considering the impact on their future. In fact, research shows that our brains think of saving for the future as a choice between spending money on ourselves and giving it to a complete stranger.
By feeling more connected to our future self, we can more easily make decisions that prioritize them. The trick is defining our destination, and creating a financial plan to get there, similar to how a pilot prepares a flight plan. Only by knowing where they are going can a pilot create a plan of action to get to their destination safely.
Writing down your goals and ranking them is an effective way to make them a priority. Because goals change over time, they should be something you revisit regularly to accommodate life’s inevitable changes. Although retirement might be decades away, it should always be a top priority, in order to take advantage of compound interest.
Your other priority is your emergency fund. We often overlook it because we tend to believe that bad things only happen to others. An emergency fund helps cover life’s unexpected surprises, things that can happen to anyone. The size of your emergency fund depends on things like your expenses, job stability and income volatility, but a general goal is about six to 12 months of living expenses. It should be kept in an account that’s accessible when you need it, but with enough friction to keep you from using it for everyday expenses.
Personal preference can play a big role (for example, the desire to be debt free), but here’s how Lazaroff prioritizes investing and paying down debt from a math perspective:
- Contribute to your employer-sponsored plan to get the match.
- Pay down high-interest debt (8% or more) that isn’t tax deductible.
- Maximize contributions to tax-advantaged accounts, like employer-sponsored plans and registered accounts.
- Pay down your mortgage if it requires private mortgage insurance (PMI).
- Pay down high-interest debt (8% or more) that is tax deductible.
- Contribute to investment accounts with no tax benefits, where you expect to earn returns greater than the interest rate on your remaining debt.
- Pay down debt with interest rates below 8%.
The quality of the journey is just as important as the destination. That’s why it’s important to spend our money in a way that gives us the most value. Research suggests that experiences, not material things, are more likely to give us lasting happiness. Another way to create happiness with spending is to focus on purchases that free up time: spending more of our time in a way that’s ideal for us can be more than worth the cost.
Where are you today?
Before getting to where you want to be, you need to understand where you are today. Your net worth represents where you are, and moving forward, you’ll want to ask yourself two questions when facing personal finance decisions:
- How does this affect my net worth?
- How does this impact my ability to reach my goals?
Good financial decisions should increase your net worth, and move you closer to your goals. Running a decision through these two questions can help you make better decisions and minimize regret. There will be times when a decision goes against both, but in those cases, it should be for something you highly value.
Spending money is not a bad thing. The key is to make intentional choices with your saving and spending so that you get the most value out of your money.
An essential part of knowing where you are today is understanding your cash flow: what money comes in, and where it goes. Looking through statements or using a tracking app can be an easy way to assess your spending. The longer you track it, the more insightful the information becomes.
Once you have an idea of your cash flow, you can see how much is left over to work towards your goals. Dividing your leftover cash flow between your priorities can show whether you have enough to make them work, whether they’re realistic, or whether you need to restructure them. Start with your retirement savings and emergency fund, then work through the rest by what’s most important to you.
When evaluating your budget, don’t view it as a tragedy; view it as a way to have more money for what you really want. Cut down on impulse shopping by sticking to a list of what you really need. You can also look for ways to reduce spending on what you don’t need: increase insurance deductibles to lower premiums, get a cash-back credit card instead of points, downgrade your subscriptions, or make big purchases (like a car) less often. It may seem small, but just like compound interest, a little bit adds up to a lot over time.
Creating a system for financial success
Distractions are all around us: advertisements, social media marketing, Wall Street, gamified stock trading. They are all ways we can easily be tempted away from what matters most. Precommitment is a system of self-control we can set up to help us stay on course.
Reverse budgeting simply figures out how much you need to save, makes those savings automatic, and then allows you to spend the remaining money as you please.
Reverse budgeting is the idea of paying yourself first. Instead of waiting until your paycheque is gone to think about your future, make it the first thing. It requires almost no ongoing time commitment, so it’s much easier to stick to.
More than 40% of the actions people perform each day are driven by habit rather than actual decisions. Habits let us do what we need to do without much thought or energy, so it’s no surprise that putting our finances on autopilot can have a huge impact. Here’s how to start:
- Open the right accounts for your automated system.
- Pay yourself first.
- Set up payments for your bills and expenses.
- Automate contributions to your investment accounts.
- Increase your automated savings over time.
Setting your finances up for success not only helps lead to success, it makes it so much easier. We can’t spend money that goes straight to our priorities, so the system enforces what we want most, while eliminating what we don’t. By making intentional decisions, we can make sure we’re getting the most value out of each dollar we earn.
Your introduction to investing
Investing is a complex subject overall, but it doesn’t require a complex solution. A key ingredient of investing success goes against our intuition: simplicity. Many investors get in the way of their own returns, and it boils down to two critical factors: bad behavioural tendencies, and investment fees.
Good investing isn’t necessarily about earning the highest returns. It’s about doing the same thing for decades on end.
Our natural intuition often goes against the correct investment decision. That’s because we tend to feel the pain of a loss about twice as much as the pleasure of a gain of the same size. If markets showed emotion instead of share prices, you’d see excitement peak at the highs, and fear and panic bottom out at the lows.
We’ve all heard the phrase “buy low, sell high”, but quite often we do the opposite. When markets drop, fear kicks in and makes us feel like we have to do something, so we sell. When markets are at their highest, we see never-ending wealth, and buy. That’s “buy high, sell low”, the opposite of what we know we should do. We see the biggest inflows of money at highs, and the biggest outflows at lows.
Chasing performance is another bad behavioural tendency. Past performance offers no indication of future results. We overconfidently put importance on short-term trends, pouring money into a stock we think will do well (recency bias), or that others believe will do well (herding). On a year-to-year basis, there’s no pattern in the best- or worst-performing asset classes. The best approach is to have a healthy mix of it all.
It’s important to know what you’re paying for. A lot of funds have fees that aren’t necessarily hidden, but aren’t transparent either. Just like anything else, you can overpay for something you could get much cheaper. Over your lifetime, small fees can make a big difference in your overall returns, and therefore your retirement income.
Harnessing the power of markets
Markets operate under a simple force: supply and demand. When demand is high, prices rise. When supply is high, prices drop. We respect supply and demand in many areas of our day-to-day lives, like produce at the grocery store, but that respect stops with financial markets. We try to outsmart the market by taking big bets, and overestimate the opportunity for above-average returns.
In 2017, the global stock market averaged 76.5 million trades per day, worth about $441 billion. There is so much information available, and so many people participating in markets, that the collective knowledge is incredible. By the time we see a headline, it’s likely already old news that markets have priced in.
Research shows that actively managed funds largely underperform their benchmarks. Beating the market is hard, and the odds are stacked against you. Higher operating fees and human error make it even tougher.
Investing is one of the rare activities in which greater effort and talent doesn’t automatically translate to superior results.
The data also shows that managers who have outperformed over a short period are more likely to underperform moving forward. There are always outliers, but it’s impossible to know who they’ll be ahead of time. Investing in the market as a whole automatically harnesses all of the knowledge it contains.
There’s a lot of evidence that simple is best. A rules-based approach takes forecasting out of the equation, and makes decisions based on a predetermined set of rules and methodology. The other simple fact is that fees come out of performance: the more you pay, the less you keep.
Building a portfolio to meet your goals
Investing is all about risk and reward. You earn a return in exchange for accepting volatility, uncertainty and the potential for permanent loss. Your portfolio should follow overall market trends, but your outcome depends on your specific mix of stocks and bonds.
More stocks means more risk, more reward and less stability. More bonds means less risk, less reward and more stability. Stocks represent a share of ownership in a company, and a share of its future profits. Bonds represent loans to be repaid, with a share of future interest payments and the return of principal.
To maximize performance over the long term, stocks are essential. The day-to-day experience of owning stocks can be more stressful, but it’s the price you pay as an investor, and over the long term, it’s more than worth it.
Even though their expected return is lower than stocks, bonds play a key role in our investments. Bonds greatly reduce the volatility we feel during market declines, making them more tolerable. The key is to invest smartly for as long as possible, so it’s critical that your portfolio behaves in a way that’s aligned with your appetite for risk.
Your ability to tolerate risk depends on your time horizon, liquidity needs, human capital (your future earning power) and how flexible your goals are. Your willingness to tolerate risk is more subjective, and usually depends on your investing experience. Aligning your ability and willingness is important to maximize growth and efficiency towards your goals, while protecting your investments when you need to rely on them.
A properly diversified portfolio not only holds many different companies, but holds companies from different industries and countries all over the world. You also want to be careful not to own different funds with a lot of overlap, which gives a false sense of diversification. We never know what will perform best from year to year, and different asset classes are driven by different factors. Owning a diversified mix gives us the best chance to consistently do well.
When it comes to investing, you’ll want to have several baskets. And you’ll want more than just eggs in them.
Establishing the right asset allocation is the first step, diversifying properly is next, and the ongoing maintenance of rebalancing comes last. Over time, asset classes perform differently, which can shift your allocation away from its design (a 50/50 split drifting to 60/40, for example). Rebalancing takes you back to where you should be. It’s not guaranteed to help performance, but it keeps your risk exposure in line with your risk tolerance.
How and where to invest your savings
Dollar-cost averaging is making set, regular contributions towards your goals. It takes the thought and timing out of investing, so you invest regularly no matter what’s happening in the markets. If you accumulate cash, or come into money you want to invest, don’t overthink it; just get it invested. Time in the market is more important than timing the market.
A Peter Lynch study looked at investing $1,000 a year from 1965 to 1995 in three scenarios: the best timing, the worst timing, and no timing at all (just investing on the first day of the year). Here are the average annual returns for each:
Perfect timing beat no timing by just 0.7% a year. Source: Peter Lynch’s study of three hypothetical investors.
Perfect timing only did 1.1% better than the worst timing, and only 0.7% better than no timing at all. All three returns are incredibly good, and the fact that they’re so close shows the power of time, and how little power timing has over the long term. (I wrote more about this study in Swensen’s Key to Investing Performance.)
It’s time and the power of compounding that act as the biggest drivers of building wealth in markets.
A secret of investing that’s entirely within your control is your savings rate, which is more important than your rate of return. How much you invest dictates your end result. By saving more, you could also be in a position to take less risk, because although returns are important, your plan doesn’t hang in the balance of performance. Increasing your savings rate increases your success.
There are a lot of different accounts you could use for a broad goal like retirement, or for specific goals like education. Accounts generally have different tax rules that make one more advantageous than another. Since we all have different time horizons and goals, it’s important to assess your unique situation, rather than do the same thing someone else does. Your financial plan should be unique to you.
Facing the realities of market downturns
It’s important to understand the realities of investing, and to have a good understanding of the process. You don’t need to be an expert by any means, but you should at least understand what you’re looking at.
One of the first things to accept as an investor is that you’ll occasionally lose money, sometimes a lot of money, on the way to earning a decent return.
On any given day, whether the market goes up or down is close to a coin flip. But as our timeline gets longer, the odds shift heavily towards a positive outcome. Research shows that the less frequently investors check their investments, the more likely they are to see that they’re up, and not change a thing.
Looking back historically, we know the stock market is down quite often. Double-digit declines happen in 65% of calendar years, even when the market ends up positive overall. Nearly 25% of the time, a calendar year includes a decline of 20% or more. Despite these frequent declines, the S&P 500 averaged an annual return of 10.16% over this period.
When we look at a short time horizon, our results are less predictable and more volatile. As we extend our view, softer and smoother lines form, and the volatility shrinks. Instead of trying to time the market and predict downturns, we should expect them to happen with regular frequency, and focus on what we can control: continuing to invest. If we set realistic expectations, we won’t be tempted to change our approach at the slightest negative movement.
We should also understand that, in spite of market losses, markets are up far more than they are down. Even the worst crashes of all time don’t look that noteworthy compared to the gains that surround them. Losses are short in duration, and nowhere near the magnitude of the gains.
It’s always important to keep in mind why you’re investing, what goals you’re working towards, and whether they’re still on track. Financial success isn’t magic; it’s engineered. A plan should take the good years and the bad years into account, and be based on a realistic expected return. Even through the downs, a good financial plan will still be on track.
Family finances
Whether or not you combine finances and accounts with your spouse, it’s important to have an honest conversation and make sure both of your views are taken into account. You could combine all of your accounts, keep things separate, or use a hybrid approach that pools income for shared expenses. Money is often one of the biggest strains on a marriage, so honesty, communication and a mutually agreed solution go a long way to reducing stress.
Saving for a child’s education can really help give them every opportunity, but don’t feel 100% responsible. If you want to help them out, it’s important to know which accounts you have access to, since the government can help, and to start early so the growth of your investments can do the heavy lifting.
Buying a home is an emotional process, but we shouldn’t let our emotions control the decision. When it comes to buying a house, ask yourself the following questions to make an informed decision:
- Do you plan to live in the same place for at least five years?
- Is owning less expensive than renting?
- What are your current and future career prospects?
- Can you afford the down payment and the upfront costs of buying a home?
The biggest mistake people make when purchasing a home is not living there long enough for the finances to work out in their favour.
It’s important not to overextend yourself with your house budget. Just because you could get approved for a specific amount doesn’t mean you have to spend that amount. You still want to be able to afford and enjoy the other parts of your life.
Historically speaking, a home is not a great long-term investment. The annualized returns are poor compared to the stock market, and even more so once we consider all of the ongoing costs of homeownership (property taxes, repairs, maintenance and so on). Don’t look at your home as an investment, but as what it is: your home. Buy because it makes sense, not because you have the urge to.
Big financial decisions at critical junctions in life
Having an estate plan in place can give you significant control over where your assets go. You’re never too young to have a plan, but getting married should be a trigger point. It should be reviewed every few years, or whenever there are big life changes.
Life insurance becomes a priority as soon as someone depends on you financially, or if your spouse would face a large expense without you (like a stay-at-home parent). The amount of life insurance you need depends on a lot of different factors, so sitting down with a professional is a good idea, and remember to take any coverage through your employer into account. There are two main types of life insurance: term and permanent.
Term insurance can be thought of as renting; an example would be insurance in place to cover your mortgage balance. Permanent insurance is designed to last a lifetime. It’s more expensive, because as long as premiums are paid, it’s almost guaranteed to pay out. Insurance is not an investment, and it shouldn’t be viewed as one, even if it has an investment component. As an investment, insurance is inefficient at best.
Your biggest asset over your life is your ability to earn an income. We tend to believe bad things only happen to other people, but disability is more common than we think. Unlike life insurance, which pays someone else, disability insurance pays you, at a time when you still have bills to pay.
The amount of coverage you need can be complex to figure out; talking to a professional, or analyzing your cash flow, can help. During your career, you’re more likely to become disabled than to die. Accidents and illness can strike anyone, so disability coverage shouldn’t be overlooked in your financial plan.
How to create your own team of professionals
We’ve covered a lot of information, and even if it all makes sense, it can still be overwhelming. Hiring a financial professional can make the process easier and more effective. Although you pay for a financial planner, a Vanguard study suggests that working with one can add a lot of value to your results.
Just like any other profession, not all financial planners are created equal. Taking the time to select the right person is an important investment. Their standard of care, credentials and compensation should all be considered. Here is a list of questions you can ask a prospective advisor (or even your current one):
- How do you get paid?
- Does your firm earn revenue from anyone other than me?
- What services do you provide? Would you consider charging a retainer or an hourly fee instead of a percentage of my assets?
- How are you personally (not the firm) paid?
- Do you always act as a fiduciary, and will you state that in writing?
- Do you have experience working with clients like me?
- What experience, education and credentials do you have?
- What is your investment philosophy?
- What is the all-in cost of working with you?
Then ask yourself: what is my overall impression of this advisor? Try not to overthink it, but take everything into consideration. The advisor-client relationship should be one that lasts decades, one you could refer your friends, family and children to one day. It might feel like a lot of work, but it’s a very important decision.
You could also round out your team of professionals with an estate lawyer, an accountant, an insurance broker and a banker. You may not need them often, but having someone to turn to when you do can make a high-stakes situation a little easier.
Building a system for financial success
Financial success is not magic. The key is to minimize mistakes, and leverage the power of compounding over your financial life. Define your goals, optimize your savings, and automate as much of your financial plan as possible. The earlier you start, the easier it’ll be to reach your goals.
For worksheets to help you get your financial house in order, visit Peter Lazaroff’s resources page.
Final thoughts
I often find that finance books are either too simple or too complex. Too simple leaves the reader wanting more, and wondering where to go from here. Too complex requires the reader to already have a foundation of understanding to apply the lessons. Making Money Simple is neither. It lays out the foundation of understanding while giving you actionable steps the entire way.
On top of that, there’s the perfect amount of historical data and visuals to support its perspective, without making it feel like you’re reading a textbook. That’s what really puts this book on another level. Peter has a gift for turning complex topics into easy-to-understand lessons that don’t leave you guessing.
It’s a complete, practical guide for someone looking to better understand how their finances work. It also provides data that will give someone already familiar with finance a whole new appreciation. There’s a lot to learn for every reader, regardless of their financial literacy. If you’re looking to learn about finances, and take action to improve yours, look no further.
All ideas, quotes and illustrations are borrowed from or based on Making Money Simple by Peter Lazaroff. To learn more, visit peterlazaroff.com.
