The 6 variables you can actually control

Personal finance can be overwhelming. Us financial advisors like to make it seem especially complex (so you’ll need us). Here’s the good news. There are only six variables you can actually control. Everything else is out of your hands. Do what you can with those six variables to give yourself the best chance of pursuing your financial purpose, and from there, life will be what it will be.

Below are the 6 variables, how each will affect your financial life, and what you should be doing at a minimum.

1. Savings

2. Liquidity

3. Insurance

4. Estate Planning

5. Investment Allocation

6. Taxes

1.  Savings

For most of us, we trade our time for money and go to work. If someday we want our money to work for us so we can stop working (aka “retire”) then we’ll need to set aside some money today (aka “save”). The same goes for other goals like sending kids to college or buying a second home. Unless we can pay for all of this out of cash flow, we’ll need to save money.

While saving 20% of your income is ideal, at a minimum you should be saving 10%. If you’re not saving at least 10%, I recommend you start tracking your spending to see how you can make it possible to save more.

2.  Liquidity (Cash management)

Having access to the right amount of cash is a crucial balancing act. Too little cash on hand and you risk disaster by having to sell assets at a discount or borrow at high interest rates. Too much cash and it can be a drag on your investment returns.

Think through:

• why you might need cash

• when you might need cash

to help you determine how much cash you should have and where you should hold it (e.g., checking account, High-Yield Savings Account (HYSA), brokerage account).

Make sure you have access to enough cash to cover 1) daily/monthly expenses 2) potential expenses like insurance deductibles, property taxes, home maintenance, etc. 3) an emergency fund in case of unemployment or disability.

Money you need soon should be in a checking account. Money you’ll need soon but not immediately can be in a HYSA. Money you might need someday but isn’t imminent can be invested in a brokerage account.

3. Insurance

In order to win the game you have to stay in the game, and to stay in the game you have to avoid being taken out of the game. In other words, you need to eliminate the potential for huge financial losses that could derail you from pursuing your financial purpose.

This is where insurance comes in. Insurance allows you to trade a small amount today (premium payments) for a large payment in the future if something “bad” happens (you get sick, your house burns down, you wreck your car.)

You don’t have to insure against everything. You want to insure against risks that you can’t afford. “Afford” doesn’t mean you have the cash available. Afford means you can pay for it without impacting your ability to pursue your purpose. I can “afford” to replace my car out of pocket, but that’s going to set me back from pursuing my long term goals, so I can’t really afford it. Since I can’t afford it, I insure it.

At a minimum, make sure you have the following kinds and levels of insurance:

• Health - cover major medical expenses

• Homeowner’s - replace the value of your home or roof if destroyed

• Auto - replace the value of your car if damaged (comprehensive), someone else’s car if you hit them (collision),  or make someone whole if you hit them (liability)

• Liability - cover you in the event of injuries, property damage, certain lawsuits, and personal liability situations

• Life - enough to leave the people depending on your income to be okay if you die and your income disappears

• Disability - enough to make sure you can live the life you want if your income disappears because you’re disabled and can’t work

4. Estate planning

Estate planning helps you ensure that what you want to happen will happen when the things you don’t want to happen happen. Did you follow that? Estate planning involves drafting documents that give instructions for when you die or become incapacitated, like where your money will go, who will make decisions for you, and who will take care of your kids. We draft these documents and make these decisions beforehand because if you don’t decide, the state will for you, and you may not like what they choose.

The basic decisions you should make and documents you should have drafted are:

1. Where your money will go (Last Will and Testament)

2. Who will coordinate the distribution of your assets (executor)

3. Who will make financial decisions for you if you can’t (Financial Power of Attorney)

4. Who will make health-related decisions for you if you can’t (Advance Health Care Directive)

5. Who will look after your kids for you if you can’t (Guardianship Nominations)

In addition to these, make sure your beneficiary documents on insurance and retirement accounts are updated. You can also add Payable-on-Death (PoD) and Transfer-on-Death (ToD) designations to non-retirement investment and bank accounts.

5. Investment allocation

Investing is about putting your money to work to a) beat inflation (otherwise we’d just put all our money in the bank), and b) save you time from having to work for money in the future by having your money go to work (grow) now.

Deciding what to invest in is about balancing the relationship between risk (chance of losing money) and return (potential of gaining money). Take too much risk and you might sell at a loss. Take too little risk and you might leave gains on the table.

While we can all afford the upside (for our investments to grow), we must first make sure we can afford the downside (for our investments to shrink). That means when determining your investment allocation, you must start with risk.

To determine your investment allocation, define these three variables (steps):

1. Purpose of the account (what the account is for, e.g., retirement, vacation)

2. Time horizon (when you will need the money)

3. Risk preference (how much you can afford for the price to move around)

Money you can’t afford to lose and need “soon” should be in cash or something steady. Money you won’t need for a while can be invested more aggressively since it won’t matter if it temporarily loses value.

Make sure you can answer those three questions for each investment account you have.

Important note: There is a difference between volatility (the price moving around) and risk (the chance of permanent losses). Volatility is the price of returns. If the price of an investment doesn’t change much, then it won’t have the potential to grow much. That means if you don’t need the money you’re investing for 25 years, you shouldn’t care if the price moves around temporarily. But if you need the money in the next year, then you should invest in something safer because you risk turning a temporary drop into a permanent loss.

6. Taxes

We can only control taxes up to a certain point. What we can’t control is what tax rates and brackets will be. What we have some control over is the type of accounts we save into (tax-free, taxable, tax-deferred) and when retired, what types of accounts we pull from.

The essence of tax planning is very simple. Try to (legally) shift income to be taxed at the lowest rate possible. That means if you’re in a higher tax bracket now, defer as much as you can. If you’re in a lower tax-bracket now, recognize that income and pay tax now.

More than anything, it’s important to be aware of how you will be affected by changes in tax laws. Look at your assets and determine how much of your money is in Taxable (checking, brokerage account), tax-free (e.g., Roth), tax-deferred (e.g., traditional 401(k) or IRA). Also take a look at your income and see if you are eligible to contribute to tax advantaged accounts like Roth or Traditional IRAs.

Summary

So that’s it. You can control how much you save, how much cash you have on hand, what you invest in, what types of accounts you save into, what insurance you have, and what decisions you’ve made beforehand (estate planning). You can’t control whether you’ll get sick or your house will get destroyed. You can’t control what the markets will do or how taxes will change.

Be clear on what your purpose is. Control the six variables in a way that gives you the best chance of pursuing your purpose. Then let go. As life changes, you can adjust your plan.