We talk about personal finance a lot around here - it’s important to be responsible with personal finances, we should care about personal finance, etc. But what is personal finance? When I tried to give a quick definition of it I came up with “you know, everything you do with money - savings and investing and stuff.” And I’ll let you in on a secret - definitions that include the words “everything” and “stuff” are not very good definitions.
Armed with the realization that I myself had a rambling and imprecise understanding of personal finance, I set out to create a real definition of the concept this whole blog is based around.
Essentially, personal finance is exactly what it sounds like. It’s everything that you, an individual, does with their money (in contrast to government finance or corporate finance). In the academic world, finance deals with investments and the study of how money, assets, and markets grow and shrink over time. Personal finance is about how one individual’s money and stuff grows and shrinks over time. It’s not about having a piggy bank to stash your savings (that’s passive because your money just sits around doing nothing in that smiling ceramic pig), but about understanding the different elements of personal finance so that your money can be active and work for you.
Elements of Personal Finance
As soon as I had a definition of personal finance figured out I immediately felt overwhelmed. Where in the world do I start? How do I know what to do? What happens first? What if I make a mistake? I am easily intimidated by personal finance (ironic, eh?). So it was very helpful for me to realize that there are a total of five elements of personal finance. Only five. Each one is a distinct area with a relatively concrete set of rules, while still intimately connected to each other. And the end goal of personal finance is keeping these five elements in balance.
Earnings: all the money given to us in exchange for work that we complete (9-5 jobs, dog-sitting jobs, contract jobs, whatever). You could also include money received as gifts, or found in a pocket of that old coat you bought at the thrift store. Earnings are all the money coming into your life.
Savings: the money that accumulates from your earnings. Savings is the waystation between Earnings and Spending. When money comes into your life it doesn't get immediately spent. It first lands down in a savings account, checking account, wallet, or piggy bank. It may only be in that location for a small amount of time, but it's important to distinguish this waystation moment because it can lead to other greatness (investment accounts, earned interest, a new couch, or an emergency fund).
Spending: all the money you give to someone else in exchange for goods or services. Spending is the opposite of Earnings. Spending is fun not just because you get to buy stuff but because there is also a ton of room for optimization.
Taxes: In order for certain shared conveniences to be maintained (roads, libraries, fire trucks) and the government to keep functioning, some of the money we earn is sent to the government in the form of taxes. A lot of times taxes are taken out of our paychecks, but it’s important to keep track of what taxes you need to pay in order to adjust the amount of taxes being taken out of said paycheck.
Investing: Putting your savings to work to make more money. This can include investment funds, 401Ks, health savings accounts, retirement funds. IRAs, stocks, bonds, etc.
Each one of these elements is somewhat laughably straightforward. It was hard to write a definition of savings without feeling like Captain Obvious. But it’s the connections between these elements that is the essence of personal finance. Spending should be a smaller number than earning. Taxes should be thought about while earning (not just once a year and categorized under spending). Investments could be a type of spending, but the money made through investments goes back into the earnings pot. The different elements should balance each other out. If one element gets too big, you can make some adjustments in the other elements to even it out. For example, you may want to get your family some really intense Christmas presents this year, so you work on front-loading your savings bucket in October and November because you know the spending spigot will be on full throttle in December.
This balance is actually the end goal of personal finance. Once you understand and set up your personal financial system, it runs by itself, and you no longer have to be bombarded or bogged down by worries and thoughts about money. You should keep an eye on it of course, and sometimes it will need tweaking, but overall it just….goes. If you are like Alex, and you really enjoy playing with financial systems, you can do that too - but you don’t have to. A well-balanced personal finance system works by itself, frees you from anxiety, and gives you mental space.
Of course, understanding the ins and outs of the five elements of personal finance and getting them all to balance is challenging and takes a good deal of effort on our part. It can be extra tricky because a lot of the American financial world makes it difficult to see how the five elements connect. Credit cards obscure the 1 to 1 relationship between our earned dollars and our spent dollars and digital banking keeps money in the abstract. Investment plans and taxes often read like the white pages. A directly deposited paycheck every two weeks doesn’t make it clear what our time is actually worth by the hour. We’re excited to talk about all those things in much greater detail in later posts, but I just wanted to make it clear that while I love my tidy definition of personal finance, I know there’s still a lot of personal financial work to be done on my part.
A Fanciful Narrative of Personal Finance
Understanding personal finance does not come naturally or intuitively to me. I have to plod determinedly from one concept to the next, instead of gracefully gathering up knowledge in a single bound. There are two things that help me learn and internalize difficult topics. One is to explain the topic to someone else (hence the first half of this post), and the other is to create a fanciful narrative about that topic.
As it happens, I didn’t really get the point of a personal financial system until I started thinking about each of my dollars as my minion/employee. I read a great article that talked about how your money should always be going to work for you, not chilling out by the pool. This was a new idea to me - I thought money was a passive piece of paper (or digital paper) that sat in my accounts and gathered monetary dust (a few cents of interest each month in my bank’s savings account). But when I move some of those dollars to a 401K or an index fund it starts earning me money in turn and I imagine all my minions suddenly hurrying and scurrying back and forth carrying piles of folders, wearing spats, and squinting through their dusty monocles. My dollars are involved in all sorts of nefarious schemes, like building interest in a high-yield online savings account, getting matched with employer dollars from my 401K, generating dividends from stock, and appearing like magic in my Discover card cashback account. All their work pays off too - at the end of the month my 401K or investment fund has more money in it! Little dollar minions attract other little dollar minions. And the little dollar minions help me understand personal finance.
How do you all understand personal finance? Do you have a personal finance narrative that helps you makes sense of cents? Should there be more elements in the personal financial system? Which elements do you find to be the most challenging?