80/20 Rules of Financial Planning
If you lose 20 pounds, what attributes caused you to lose that weight?
You might say, I cleaned up my diet and started eating more whole foods, started exercising 3-5 times per week, substituted soda for water, and prioritized getting 8 hours of sleep each night.
These factors were primarily responsible for the returns you received from losing 20 pounds.
Yes, eating organic, using red-light to optimize your circadian rhythm, taking cold showers, and using magnesium threonate before bed all help in the progression towards your health goals - but the truth is, all effort is not rewarded the same.
Focus on the 20% on factors driving 80% of the results - ignore the rest.
Would you rather achieve the same results working 80 hours per week or 40?
There’s a reason some people get ahead, and others fall behind. Not all effort is created equal. Hard work does not guarantee success if you’re not focused on the right work.
Targeted work > Hard work.
Vilfredo Pareto originally discovered this fascinating idea that most things, in all areas of life, have an uneven distribution.
This mental model, called The Pareto Principle applies not only to your health but your wealth too.
Pro football Hall of fame coach, Vince Lombardi said it best:
“Football is two things. It’s blocking and tackling. I don’t care about formations or new offenses or tricks on defense. You block and tackle better than the team you’re playing, you win”
You become great by focusing on the factors most responsible for growth.
Applied to each discipline of financial planning, you can receive massive returns by blocking and tackling.
Cash Flow Planning
Cash flow is king. In financial planning, this is the lifeblood of the financial plan. To live the life you want, you need consistent streams of cash to fuel your consumption.
When focusing on cash flow, you must live in a cash flow surplus.
If you find yourself stretched, it’s usually because you’re overindulging in variable expenses.
Identify the leak and seal the hole.
Retirement Planning
Retirement boils down to how much and where to save. Many individuals with businesses need to translate their business growth into assets on their personal balance sheet.
On how much to save, I start with a minimum savings rate of 15% via the below prioritized list of accounts. Increase this rate until uncomfortable.
Your savings policy order of operations:
Emergency fund (3-6 months’ worth of expenses in cash)
Retirement plan (contribute minimum up to company match to max of $20,500 (2022 max employee contribution))
Health Savings Account (if you have a high deductible health plan this account is triple tax benefited: $3,650 2022 max contribution)
Traditional/Roth IRA (Up to $6,000 in 2022. Low/high income today relative to future = Roth/traditional, respectively)
Brokerage account (with remainder or after-tax contributions in 401k - if plan document allows)
Wealth creation takes time and discipline.
Freedom of choice later in life is worth more than present day upgrades in quality of living.
Investment Planning
In investing, the majority of your results will come over time through disciplined and consistent savings. A historically successful investment strategy entails low-cost efficient investment vehicles, broad diversification, and systematic rebalancing.
Choose market capitalization weighted index funds. Skip the active management.
S&P Indices versus Active U.S. Scorecard (SPIVA) puts out research each year on the historical lackluster returns generated from active managers. Results hover around 80% of active managers failing to beat their benchmark net of fees.
Market capitalization refers to the size of a company, as calculated by the number of shares outstanding by the present share price.
Effectively, you’re matching the weight of a security in your portfolio allocation. Microsoft has a market cap of $1,095,675,098 and makes up about 3.25% of the global equity market ($33,713,079,938). Therefore, my Microsoft portfolio weighting matches this.
Broad diversification is key. Spoiler - because you own the S&P 500 does not mean you’re diversified. While a good start, global stock diversification further encompasses U.S. mid-cap, small-cap and 22 Interntional developed markets and 26 emerging markets.
In 1992 David Booth and Eugene Fama published, “Diversification Returns and Asset Contributions” in which they found the rationale for incremental greater compounded rates of return was due to diversification.
Global stock returns are random. Investors who hold stocks from markets around the world experience less volatility as higher returns in one market help offset lower returns elsewhere, increasing risk-adjusted returns.
Tax Planning
Whether we like it or not, taxes are an absolute (& the biggest bill everyone pays each year). Unwanted events that can’t be avoided should be minimized. Throughout your lifetime, the primary way you can do this is by choosing when you pay tax on your savings.
In your employer sponsored plan you can choose pre-tax (traditional) contributions or post-tax (Roth) contributions. Many individuals don’t pay mind to this and grow their total retirement savings entirely pre-tax.
Come retirement, what this means is every dollar pulled out of your account is taxed as ordinary income. The upside is this makes things easy for you. The downside is you lose flexibility, and this means you paid way more tax over your lifetime than you should have.
In a perfect world, you have a mix of taxable (brokerage), tax-deferred (traditional IRA/401k, etc.), and tax-free (Roth) vehicles. This way, in retirement, you have more flexibility to choose when and how much tax to pay in any one given year versus your tax bracket being chosen for you with each distribution made from your retirement accounts deemed as ordinary income.
Added bonus here is maximizing employee benefits allowing for additional taxes saved. A health savings account (HSA) in 2022 allows for $3,650 to receive a tax deduction, grow tax-deferred, and be withdrawn tax-free for qualified health related expenses. A flexible savings account (FSA) in 2022 allows for a reduction in taxable income up to $2,850. Though, be careful with FSA’s, typically, you have until the end of the year to use those funds, or you forfeit them into the next year.
Lastly, utilize tax-loss harvesting in your taxable brokerage accounts to minimize your tax bill. This could allow for up to a $3,000 capital loss that can offset income and further losses can be carried forward into future years.
Risk Management
A necessary evil in life is insurance. A bill no one is happy to pay but glad they have it. In financial planning, the greatest risks to yourself or your family are death, disability, or declining health/long-term care need.
If you have a family who depends on you, term insurance is a good way to cover this risk. Consider 10x your income as a starting point until retirement age, post retirement, life insurance isn’t necessary.
Disability is worse than death. You’re here to deal with your own handicap, which can be costly. Consider 30-50% of your income paid out in the event of your disability. Disability could be lumbar cervical issues, mental health issues, nervous system disorders, cancer, heart disease, etc. Stick to long-term disability insurance, meaning the coverage only kicks in after a 90-day (minimum) waiting period or longer (you have an emergency fund for short-term emergencies). White collar professionals consider own-occupation disability. This means if you cannot perform the tasks of your own occupation, you will receive a payout. This helps to avoid the chance the insurance company won’t payout because you can technically flip burgers with an any occupation policy.
Declining health is a given, stay active for as long as possible. The goal is to closely match your healthspan with your lifespan.
Health is wealth.
Estate Planning
One day we’re going to die, and you should plan to make everyone who you love life’s easier when dealing with your passing. Nothing is worse than going through probate court and fighting relatives and friends who try to make a claim on your assets because there wasn’t any estate planning completed.
Founder of Zappos Tony Hsieh passed away without basic estate planning documents. A $500 million dollar estate is now being settled in probate court where his assets are being fought over from friends and family. It’s a shame.
Simple estate planning documents go a long way here. Consider estate planning basics such as a Will, medical directive, and power of attorney (someone to make medical/financial decisions in the event of your incapacity). Ensure your retirement assets have beneficiaries and your accounts and real assets are titled appropriately.
Trusts are a great way to distribute assets if you have more complex distribution needs and would like to specify when the assets are paid out over time versus all at once. Generally, stick to revocable trusts unless your net worth is over $12.06 million (2022 estate tax emption per person).
Death is tough, don’t make it any harder than it has to be.
In life there are things we cannot control and things we can control. How you choose to use your time is one thing we all seek to have more control over.
When you’re trying to optimize for the most return on your effort, focus on the activities most responsible for generating the highest return.
Direct your attention accordingly.