Published: April 2nd, 2023 by Chris McGrath
Last Updated: August 31st, 2023
Note for readers outside the USA
This is the start of a series of articles about Personal Finance.
I'd estimate that at least 75% of the content, with the Personal Finance tag, will be generically applicable to everyone around the world.
It's worth pointing out that this content was written by an American. So it's likely that there are instances of opinionated advice that are more relevant within the contextual circumstances of the US. (I suspect this will be true for credit cards, college, and taxes.) There are also instances of US specific vocabulary terms used.
The parts that are US-specific may still be worth reading by non-US readers who are willing to determine if some insights could be applicable to similar scenarios within their own country. As many countries have conceptually similar terms, tax systems, retirement plans, and access to similar investments.
That said, non-US readers should try to determine and ignore non-applicable advice.
Vocabulary and Concepts
A percentage fee given in exchange for borrowing money.
- You Receiving Interest:
Banks tend to offer 1% interest to encourage people to leave money in their savings account. If you leave $1,000 in a savings account for a year. By the end of the year it'll grow to $1,010
(1000 • 1.01)
- You Paying Interest:
If you borrow $1,000 on a line of credit for a year without paying it back, and you're charged 10% interest, by the end of the year $1100 would be required to pay off the loan.
A method of paying for goods and services on credit.
(Credit: An agreement that you'll borrow now and repay later.)
Potential Features of Interest:
- The ability to carry a small balance interest free:
Instead of being charged interest daily, you get charged interest at the end of a monthly billing cycle.
- The ability to avoid overdrafting your checking account:
If you need to make a purchase when your checking account has a $0 balance. Using your credit card instead of your debit card, will allow you to avoid an overdraft fee of $10-35.
- Purchase Protection: (credit cards have it, debit cards don't)
- Example 1:
If your credit card becomes lost or stolen and someone makes a fraudulent purchase. As long as you report it in a timely manner, you can be refunded for the charge and won't have to pay for the fraudulent purchase.
- Example 2:
If you buy from a website that's selling some goods at a price that seems too good to be true. Then a month goes by without receiving your goods, so you google the site and find it's a fraudulent site. You can inform your credit card company and request a chargeback / refund.
- Example 1:
- 1-5% Cashback on purchases:
Credit card companies charge merchants credit card processing fees of 1.5 - 3.5% of the transaction. To encourage consumers to pay with credit card instead of cash/debit card, some credit card companies offer cash back. Example Scenario:
- You buy $100 worth of goods from a merchant on your cash back credit card.
- The credit card company charges the merchant a $2.74 processing fee.
- The merchant gets $97.26
- You get $2.00 cash back
- The Credit card company still makes $0.74 from the processing fee.
Traps to Avoid:
- Cash Advance option: Never do this with a credit card (outrageous fees).
- Carrying a Balance you can't pay off: High Interest Rates (~18-30%)
- 0% Interest for time period: Makes it easy to fall into trap #2
LOC (Line of Credit)
Basically a preapproved loan.
If you have a $5,000 line of credit. You can choose not to use it, not using it means you pay no interest. The advantage of having one is having access to money with 0 lag time. If your car breaks down, and you need it fixed the same day, but the mechanic only accepts cash, it's not a problem, just transfer $500 from the line of credit into your checking account. Then withdrawal the cash.
How it's different from a credit card:
- There's no penalty associated with a cash advance.
- You get
- Tend to have lower interest rates that credit cards (Example: 10% vs 20%)
HELOC (Home Equity Line of Credit)
A line of credit, with a
(HomeEquity = HomeValue - Mortgage)
Inflation refers to the total amount of money in circulation increasing over time. The increase is the result of the US government printing new money year over year. When more money comes into existence, the relative value of the money goes down. Basically, the purchasing power of money decreases over time. According to worlddata.info the average US inflation rate is 3.8% (1960-2021).
Example of Inflation:
If this year, a 50 gram bar of chocolate is $1.00.
Then next year, you can expect one of the following outcomes:
Outcome A: The same bar of chocolate to cost $1.04
Outcome B: You still pay $1.00 for a bar of chocolate, but instead of a 50 gram bar, you get a 48 gram bar.
Outcome C: You still pay $1.00 for a 50 gram bar of chocolate, but the factory tweaks the recipe, so the product can be made using cheaper ingredients, so the quality of the product gets worse over time.
Stocks represent fractional ownership of a company.
(Note: shareholder is a synonym for stock owner.)
Two main ways to earn money from stocks
- Buy. Hold until the company grows in value. Then sell at a higher price.
- Some stocks pay dividends to their shareholders.
Taxes Associated with Stock Ownership:
- If your stocks are part of an Investment Account:
- If they offer dividends, then you'll have to pay taxes on the dividends every year.
- If you sell a stock for profit, then you'd pay capital gains taxes.
Note: Since you can choose when and how much of your stock to sell,
- If your stocks are part of a Retirement Account:
Then profits will either be tax free or taxed as income, depending on the type of retirement account.
Risks associated with buying individual stocks:
- Unpredictable Volatility:
- You're not guaranteed to make money: A company could experience a permanent decline or stagnation (growth below the rate of inflation).
- It's possible to lose 100% of your initial investment: If the company goes bankrupt, its stocks become worthless.
Capital Gains are profits from the sale of a property or investment.
Capital Gains Taxes Notes
Properties and investments that you sell at a profit are taxed at:
- The short-term capital gains tax rate, which is higher, if you own them for less than a year before selling.
- The before selling.
Dividends are company earnings that are shared with stockholders. (These have their own tax rate)
An index fund is an exchange traded diversified bundling of investments. They're Inherently diversified, because they're based on economic indexes, which are statistically significant sample representations of a larger group of funds.
- Vanguard Total Stock Market Index uses a sample size of 4100 stocks, as statistically significant representation of the stock market as a whole. Buying 1 share is equivalent to setting up an investment portfolio diversified between 4100 different stocks.
- The S&P 500 is a collection of ~500 stocks, it's a statistically
significant representation of a subset of the stock market called
large-cap stocks. Buying 1 share is equivalent to setting up an
investment portfolio diversified between 500 different stocks.
Index Funds mitigate the majority of risks associated with stocks:
- Predictable Volatility: While it's still impossible to accurately predict the short term up and downs of the stock market as a whole.
- You're guaranteed to make money in the long term: When a stock market crash occurs, the market tends to recover within 2 years.
- Diversification makes it statistically improbable to lose 100% of your initial investment. If a company listed in the index went bankrupt, it'd be replaced by a new company that better represents the index. Since index funds rebalance themselves over time,
ETFs (Exchange Traded Funds)
An ETF (Exchange Traded Fund)
is basically a hybrid between a stock and an Index Fund. ETFs and Index Funds
both have low fees.
The following covers how ETFs and Index Funds differ:
- How Index Funds vs ETFs are normally sold:
- Index Fund:
(An exception to this is that Vanguard sometimes has minimum entry requirements for an Index fund. In some cases, they'll require you to save up $3,000 before you can buy the fund, but once you hit that threshold then you could buy a penny's worth at a time as in going from $3,000 to $3,000.01)
In other words, you can't normally buy fractional pieces of a unit or a penny's worth of an ETF at a time. So if the ETF is trading for $467.92, you have to save up that much before you can buy one unit of it; Likewise, if you wanted to sell $100 worth of your ETF you can't, you have to sell it as a unit. (An exception to this is that Fidelity offers investors the ability to buy and sell fractional shares of ETFs.)
- Index Fund:
- Diversification of Index Funds vs ETFs:
- Index Funds tend to contain ~100-4100 stocks
- ETFs that mirror Index Funds exist.
- There's also ETFs that can target specific industry niches like GPUs, Artificial Intelligence, and Semiconductors. Since they're more targeted, they can contain ~25-50 stocks. ETFs that are more targeted / have a lower diversification of holdings can potentially have higher ROI and higher risk than Index Funds.
- What high ROI usually means:
The 10-year average ROI for an ETF could be higher than an index fund's 10-year average. (A targeted "hot" sector of the market can beat the market as a whole.)
- Higher risk can mean a few things:
- Risk will be explained in detail on the "Investing vs Gambling" page, but for now here's an introduction to what's meant by higher risk.
- The Highest risk worst case scenario is that you could lose all or part of your original investment after a 10-year investment horizon.
- High Risk can also represent the bad scenario of making less than you could have. After 10-years of investing in a high risk investment, you may end up earning less than if you simply invested in a lower risk surefire bet option, like a US Total Stock Market Index Fund.
- High Risk can also refer to high short term risk, but low long term risk. For example: If you were 100% invested in an index fund, you might see a -20% temporary loss during a bad year. If you were 100% invested in an ETF, you might see a -60% temporary loss during a bad year. (Let's say you started off the year with 100k then after -60% market crash, your 100k worth of ETF was temporarily worth 40k. If you were forced to sell at 40k. That'd be equivalent to losing at least 60k, plus the future accelerated growth that usually happens after a bad year.)
Bonds, CDs, and Laddering
Bonds are loans issued by governments and corporations that pay interest once every 6 months. (Federal government bonds are called Treasury Bonds. State and local government bonds are called Municipal Bonds. Corporations offer Corporate Bonds.)
- It's possible for the entity that issued the bond to default on the loan (fall behind on payments) or even go bankrupt.
- Bonds are categorized according to the issuer's credit worthiness.
- Government bonds have very low risk as they can raise taxes as needed.
- Corporations have credit scores.
- Corporations with good credit are said to offer Investment Grade Bonds.
- Corporations with bad credit are said to offer Junk Bonds, as there's
a risk of bankruptcy.
CDs (Certificate of Deposit):
CDs are offered by financial institutions like banks, credit unions, and brokerage firms.
- They're less risky than bonds because they're insured by the FDIC up to $250,000 per depositor, per insured bank, and for each account ownership category.
- Interest can be paid daily, monthly, quarterly, or yearly depending on
Laddering is where split your purchase of Bonds and CDs into parts, and try to spread the purchase date of those parts over time.
- Many Bonds pay out twice a year. If you buy them all at once, you'd get 2 large payments a year, which can cause cashflow issues.
- Splitting a purchase into multiple purchases has a few important benefits:
- You can spread out the payments to stabilize your cashflow. Rather than
getting 2 lump sums a year. You can get interest paid twice a month or
as often as you like.
- Buying pre-existing Bonds/CDs with different maturity dates, or
- Spreading out new purchases into 12 parts, then buying each 12th on the 1st and 15th of the month for 6 months.
- The interest rates and maturity dates of Bonds and CDs change over time. Buying over time helps smooth out interest rate fluctuations.
- Purchasing over time makes it easier to implement Manual Diversification of Bonds and CDs.
- You can spread out the payments to stabilize your cashflow. Rather than getting 2 lump sums a year. You can get interest paid twice a month or as often as you like.
FI (Financial Independence)
Financial Independence is half character traits and half life achievements, it can be described in terms of varying degrees. A person at the far right of the spectrum of Financial Independence would be confident that They wouldn't need to depend on a job for income. Nor would they need to depend on roommates, family members, their significant other, or any government programs to help them manage their finances, supplement their income, or help lower their expenses.
How does a financially independent person pay for their living expenses?
- They use their financial knowledge to leverage their wealth to
- They use their financial knowledge and money management skills to
- They aim to maintain a long term surplus of net income
(NetIncome = Income - Expenses). The surplus is used to build wealth and regardless of future cost of living increases, small mistakes, and unplanned events.
FF (Financial Freedom)
Financial Freedom also exists on a spectrum:
[Debt --- Debt Free --- Investing --- Financial Independence --- Financial Freedom]
After you've mastered Financial Independence, you start to enter the territory of Financial Freedom.while being able to maintain your Financial Independence. It also means you have the freedom to safely leave relationships with minimal impact on your life. You can choose to continue working for or living with someone because you want to, and not because you feel you have to in order to survive. You'd have the freedom to work for free or work at a job that you enjoy, but that wouldn't normally pay enough to live off of.
Digital currencies secured by cryptography.
Traps to Avoid:
- The United States IRS considers cryptocurrencies to be taxable:
- If you buy crypto and leave it on an exchange or move it to a private wallet, then you don't need to pay taxes.
- The trap that blindsides crypto noobs is that IRS Notice 2014-21,
In layman's terms:
- Converting your crypto back to cash is a taxable event.
- Using an exchange to trade / convert from 1 crypto to another is also a taxable event.
- It's gets worse: That "taxable event", is a "capital gains" taxable event. Also, if you haven't owned the crypto for at least a year before selling or exchanging it, then you'll pay the short term capital gains rate, which is higher than the long term capital gains rate.
- You'll also probably need to buy crypto tax preparation software like cointracking.info to generate a crypto tax report that can be fed into your normal tax prep software (Spoiler: They're all hard to use).
- You'll need to start using the more expensive premium version of H&R Block or whatever you use to do your taxes, since capital gains taxes are involved.
- (This message is brought to you by someone who understands cryptography, owns a small amount of cryptocurrency, and believes that cryptocurrency has intrinsic value and unrealized potential.)
- Why it's worth explicitly calling this out:
- Diversifying stock holdings, is a strategy for mitigating risks associated with investing in stocks.
- It's very easy to mistakenly think of cryptocurrencies like stocks and think that you can apply the concept of diversification to cryptocurrencies to mitigate risk. The thing is, diversification works for stocks, because they're legit.
- Best Case Scenario: After spending 1 week of research per crypto you plan to invest in, you find 3 that look legit and try to diversify between those 3.
- Note: "Crypto Index Funds" tend to be scams as well. It'd be very difficult to find enough legit cryptocurrencies to put together a proper crypto index fund. Whoever sells that will likely do things like hold the "private key" of a cryptocurrency wallet "on your behalf", to simplify things for you. They'll often leave you in the dark about how risky that is, and often have you miss out on forked currencies that are only accessible to private keyholders.
- The only way to protect against that is to own your own crypto wallet and manage the private key or secret seed phrase yourself. (A secret seed phrase is basically a long password that can be used to deterministically generate a public private key pair.) The most realistic way to do that in a manageable and maintainable way is to own a few non-diversified cryptocurrencies.
Meaning of Words
- Definitions of words and phrases are statements intended to clarify the meaning of words.
- If you encounter unfamiliar words or phrases, in scenarios where you're not able to ask someone to clarify their meaning, and you want to learn the meaning. Usually you'd try to look up the definition in a dictionary, or try to google the meaning of a word or phrase.
- When doing so, it's easy to forget
2 common problems of languages:
- Sometimes you'll see context clues, but usually those are only useful to people who already know the meaning of the word, and are insufficient for those trying to learn the meaning.
- This phenomenon often creates cognitive dissonance and is especially
common with vocabulary words related to Finance:
- If you want to experience this phenomenon first hand, then pick one of the following words/phrases: Asset, Capital, or Financial Independence.
- Then try to come up with an accurate paraphrased definition of the word after cross-referencing the definition across multiple sources.
- It's surprisingly difficult to do so. The surprising part is that you'd think a word would have a consistent definition, but if you compare multiple seemingly authoritative sources.
- You'll likely encounter this annoying experience where ten different sources give ten different definitions of the same word or phrase.
- Each definition will seem to be reasonably accurate and similar at first glance. Unfortunately, they'll often end up being just different enough to produce inconsistencies between each other.
- Or a definition will be generally correct, but easy to think of edge case examples that bring its accuracy into question.
- Explicit example of the common problem of failing to accurately define
- Investopedia's definition of Investment fell into the trap.
Investment: An asset or item acquired with the goal of generating income or appreciation over time.
- Investopedia is an authoritative source of information:
- They ranked 1st the last time I google searched "definition of investment".
- They have "invest" in their name.
- If you visit the page linked above, you'll find that in addition to being well written, they present a high degree of professionalism: Right after the title, they immediately clarify that their content has been recently updated, and that 3 different professionals have written, reviewed, and fact checked it.
- And yet I'd argue that their definition is not accurate for the reasons listed above.
- What they have is an accurate definition of a "Financial Investment" or "Investment (Financial Context)".
- The problem is, Investopedia has failed to explicitly state that they are
defining the word "Investment" in a financial context.
- This makes their definition inaccurate, as investment in a generic context has a different meaning compared to investment in a financial context.
- Let's use a counter example to intuitively prove my claim. An Independent Water Supply System comprised of multiple subsystems involving rainwater collection, storage, distribution, pressurization, filtration, sanitization, and waste water treatment can be considered an investment under the meaning of the word in a generic context.
- The installation and ongoing maintenance costs of a high quality Independent Water Supply System, would likely far outweigh any generated income or appreciation in value over time. So if someone acquired such an asset, they would have done so with a goal in mind that's not profit driven. Thus, we've identified a counter example that shows a flaw in their definition, or at least proves that it's not a generic definition of the word.
- Those who already know the meaning of the word, have at least a subconscious understanding of the nuance that this definition of what the word means is reasonably accurate in a financial context. The annoying bit is that if you're trying to learn the meaning of the word "investment" for the first time, you could easily mistake Investopedia's definition of the word as the only definition of the word or assume this is the definition in a generic context. In either case, you could easily develop a common misconception, and mistakenly conclude that all investments are profit driven.
- If you're curious about a more accurate definition of Investment, subscribe to the email newsletter, as it'll be covered by an article that's currently a work in progress.
- Investopedia's definition of Investment fell into the trap.
Fun fact about GuideScape's content: On several occasions, over 10 hours of caffeinated effort spread over multiple working sessions have been dedicated to meticulously wordsmithing 1-2 sentence definitions of individual words in the pursuit of near perfect accuracy.
- I've invested the time and energy to wrestle through the cognitive dissonance produced by trying to use cross-referencing to refine more accurate synthesized definitions.
- I've also purposefully left great content unpublished for months, because I felt compelled to rewrite it multiple times; until its quality reached the point of being good enough in terms of accuracy, correctness, usefulness, and relative safety in the event someone interpreted it as advice.
- The realization that 10 hours of focused time, tracked down to the minute, were often spent obsessively wordsmithing 1-2 sentences, dedicated to individual definitions, should give you an idea of the level of care and effort that has gone into developing high quality content.
- I share this in the hope that it encourages you to invest the time to go back and slowly read through sections in addition to skimming.
Assets vs Liabilities
Examples of Assets (Generic Context):
- Healthy mind, healthy body
- Supportive family, fulfilling relationships, social services
- Healthy environment, living in a safe neighborhood, stable housing
- Study habits, growth mindset, and good-tempered personality
- Highly skilled drama free supportive coworkers
- When someone owes you a favor or is willing to do you a favor
Examples of Liabilities (Generic Context):
- Mental illness, health conditions related to bad genetics
- Toxic family, toxic relationships, predatory cults in society
- Polluted environment, living in a dangerous neighborhood, homeless
Side Note: Rainwater worldwide was deemed unsafe to drink in 2022
- Gambling habit, drug addiction, fixed mindset, character flaws
- Incompetent coworkers with problematic behaviors that make them more trouble than they're worth
- Feeling obligated/indebted to someone like you owe them something
- 1st source of confusion about the topic of Assets vs Liabilities:
- These words each have a 2nd definition, with a slightly different meaning.
- Examples of the 2 definitions leading to contradictions:
- If someone owned a luxury mansion, boat, car, or recreational vehicle:
- By interpreting the definition in a generic context, one could argue that these are liabilities that drain wealth.
- By interpreting the definition in a financial context, one could argue that these are assets that can be sold.
- Debt and Lines of Credit:
- Under a financial context, the definitions would consistently label any form of debt as a liability, since debt represents owing money.
- Under a generic context, where the definitions are viewed more in
terms of advantages and disadvantages. Debt and lines of credit can
be leveraged to generate value or advantages.
- If you have access to a paid off LOC, you have an advantage. If it's paid off, it's not actively triggering any interest or causing expenses. You also gain the advantage of being able to substitute a high interest loan with a LOC's interest rate, which would then save you money.
- If you have access to a 21-month interest free loan of $10k. In theory, you could leverage it to allow you to buy $10k worth of bonds at 5% ROI, with negligible risk, you'd effectively be earning interest by re-loaning out your interest free loan. You could earn ~$750 in interest after 18 months, sell the bonds to immediately pay off the loan in full, and keep the interest you made.
- If someone owned a luxury mansion, boat, car, or recreational vehicle:
- 2nd source of confusion about the topic of Assets vs Liabilities:
- If you're interested in self-improvement, it's a reasonable idea to try to take inventory of the assets and liabilities present within your life from the perspective of the generic definition.
- An intuitive self-improvement strategy is to try to become aware of your advantages and disadvantages, and then set self-improvement goals around trying to increase one and minimize the other.
- If you try this thought exercise, it's actually problematic in practice,
as it becomes equivalent to trying to classify life in terms of good and
- Examples of items that are hard to label as an asset or a liability
(from the perspective of the generic meaning):
- This 2-min YouTube video explains how a house can be an asset or a liability depending on circumstances.
- If you invest in a new stock that could gain or lose money within a years time, wouldn't you need the ability to predict the future to label it an asset or a liability?
- What do you call mixed blessings? (simultaneous advantages and
- If you grew up in a rough environment, but it made you tough and resourceful, did it turn out to be a bit of an asset?
- If a person lacks skills from growing up in a sheltered environment, did that become a liability they need to overcome?
- Cash held with the purposeful intent of leveraging it to avoid negative outcomes is an asset.
- Cash held without purposeful intent has negligible value, and is in fact a liability when you take inflation into account, as the cash will lose value/purchasing power over time.
- Keeping some inventory on hand is an asset to a business.
- Having excess inventory is a liability for a business. They have to store it, manage it, organize it, and carry the risk of not being able to sell it.
Asset Liability Modeling
$Net_Worth = $Assets - $Liabilities
The above is a common formula used by accountants. They identify assets and liabilities from a financial context. An advantage of the definitions used in a financial context over the meaning of the words in a generic context is that ambiguity is eliminated. This consistency of classification in turn enables consistency in financial reporting, and allows entries to fit neatly into a mathematical formula.
Asset Liability Modeling:
- Is good at helping you visualize where you stand at a given point in time.
- It's bad at helping you visualize where you're going.
- It pairs well with Value Flow Modeling, which is a complimentary system that's good and bad at the reverse. (The earlier 2-min YouTube video, about how a house can be an asset or a liability depending on circumstances, was basically analyzing homeownership from a value flow perspective.)
Value Flow Modeling
Value Flow Modeling is a way of organizing assets and liabilities (according to their generic meaning) into 4 categories:
- Positive Value Flow
Estimate the value brought in or advantages generated by an asset along with a description of the asset.
+10% ROI/year:Long term investing in a total stock market index fund
+ability to invest $5k/year:Budgeting and living $5k/year below your means
+opportunities:Habit of forcing yourself to study X hours a week
- Negative Value Flow
Estimate the value drain or disadvantages caused by a liability along with a description of the liability.
-2.8% ROI/year:Money in a +1% ROI savings account against -3.8% inflation
-60% value/5-years:Depreciation from buying a new car
+assholes in society:Compulsory Education Systems that:
- Fail to view life skills, ethics, and moral character development as essential subjects to include as part of a mandatory curriculum and graduation requirements.
- Fail to emphasize the necessity of systematically investing in
developing, ingraining, and maintaining life skills and positive
(Acceptable behavior, social skills, social etiquette, social expectations, common courtesy, good manners, personal accountability, self-discipline, self-management, conflict resolution, emotional intelligence, etc.)
- Aren't given the option of implementing drastic measures when warranted.
- There's a time and a place for everything, including ass whoopins.
- Aren't given the support, autonomy, and authority necessary to implement consequences necessary to maintain discipline and accountability.
- Indeterminate Value Flow
Risky things that could go either way, but you'll need to wait for the future to judge if it was a good idea or not. Should include a prediction and context.
Could go either way:Short Term Investing, starting a garden.
Probably not worth it:College with loans and without a guaranteed job or pay bump.
- Negligible Value Flow
This is a catch-all for anything you deem isn't worth trying to optimize. Things like hobbies that are mixed blessings in that they cost money but help you relax.
This modeling system is useful for setting personal finance self-improvement goals. Rather than taking inventory of where you stand today. It helps you take inventory of where you're going. Once you do that, it becomes easier to set goals that will optimize the velocity of your net worth.