Growing Your Wealth with a “Personal Financial System”

Katie: Welcome back to The Money with Katie Show, Rich Girls and Boys. I'm your host, Katie Gatti Tassin. And today we are talking about what it means to build a healthy financial ecosystem. Let us begin today with a story. The other day I was reading a post on r/personalfinance, the subreddit, wherein someone described their financial situation as follows: I have $5,000 in a 401(k), about $10,000 in my Robinhood, $15,000 in Chase, and $1,000 in stocks and then some cash. Now, the person was seeking advice. They generally wanted to know if they were on the right track or what else they should be doing. And it struck me that they were mentally chopping up their finances by institution, as in, I have X dollars at X bank and I have Y dollars at Y bank. And then occasionally deviating from that structure, like saying I have $1,000 in stocks, because presumably the money in the 401(k) and in Robinhood were also in stocks.

And while this mental model is logically reasonable since you're physically putting money in these various locales that feel a little more concrete than the slippery investment vehicles themselves, it reminded me of just how powerful it can be from a planning perspective, but also from a financial confidence angle, to think about the structure of your finances accurately. Now, one of the clearest ways to gauge someone's understanding of their financial situation isn't quite what questions they're asking, but specifically how they're asking them. My favorite example of this is the question, "Should I invest in my 401(k) or in the stock market?" which really reveals a disconnect in the way someone is thinking about investing, because this question is a little bit like asking "Should I eat fruit or an apple?" There's a mental wall between two interrelated topics such that they're being treated as opposing forces rather than concentric circles.

And while they're technically asking about what they should invest in, the question reveals that they might be misunderstanding their overall financial ecosystem and what their priorities should be. So this redditor is going to be our muse today, as they were defining their finances by institution: some money with Robinhood or with Bank of America. That doesn't tell us much about their financial picture in the same way that 25% S&P 500, 25% small cap value, 50% UST bonds in a Roth IRA would have told us a little bit more about what they were investing in. Someone with a $1 million portfolio that's entirely invested in Tesla is in a very different position than someone with a $1 million portfolio invested in the S&P 500, because owning just one stock is far riskier than diversifying.

Now, you can look at your financial position through a few various lenses and these lenses become increasingly granular, but each level of specificity is important for gauging the big picture and crucially, figuring out where to go next. We'll get into it right after this quick break.

So today's episode is about how I imagine the system that governs your financial well-being, and the most holistic way to assess where you are and where you're trying to go. Let's dive in.

Lens number one is offense and defense. Now, this is just a fancy sports metaphor for assets and liabilities, because I am nothing if not a sucker for analogies. Now through this offense and defense lens, you can view your financial behavior as fitting into one of two camps. Defense mode is the one where most people get stuck. This is what most personal finance advice focuses on because defense is the only thing most of us really ever learn about, and with good reason, I suppose, because good defense is what prevents you from experiencing financial catastrophe. But good defense includes paying off debt such that you are actively lowering your liabilities. It includes building a strong spending plan and saving cash such that you are building your emergency fund cash cushion. It includes being properly insured and making sure your ass...et is covered. When we talk about solid financial practices, most of us are going to default to activities that fall into this category. We'll focus on paying off our debts really quickly or adding more money to cash savings or cutting back on Uber Eats or shopping around for a better rate, because your car insurance company just screwed your premium and you had a sideswipe.

But defense, when played correctly, is a little bit more of a one and done game. Once you've set up your automatic debt payments—now that's whether you're just paying the minimum or you've decided to take a more aggressive approach or you have your debt paid off entirely. You've built your emergency fund, you've locked in a spending plan, and you've signed up for the proper levels of adult insurance—this arena of your finances shouldn't really be receiving much additional energy.

And if those arenas of finance are where you are currently focused, we will link some episodes that dive a little bit deeper into those topics in the show notes, because of course we want to avoid financial catastrophe, but that's not where we want the progress to end. That's only the beginning, and it's what enables us to get to the good part, which is offense. 

Now, offense mode is where things get fun, right? There's really one major category that we're going to concern ourselves with here. And I would say the easiest way to put this is that it boils down to making your money go out and make more money for you. Now, this can take many forms, but we're going to talk about it in the specific framework of investing today, because while defense was about protecting your wealth, offense is about growing it.

There are a few ways that I think about timelines and goals for investing. The first is medium-term investing. So think goals that are roughly five to seven years away, and this will generally be less aggressive than your long-term investments. The second is long-term investing for your eventual freedom, your departure from corporate America en route to the Amalfi Coast. And finally, the third is investing in alternatives for cashflow today, aka think buying businesses, think rental properties, other things that are going to produce reliable cashflow right now as opposed to an investment portfolio that you might be thinking, "Okay, this is going to provide income for me 30 years from now."

I'd also add that there's a layer of offense that I'm just now starting to dabble in personally, which is investing in riskier ventures that have a high risk, high reward outcome. But we aren't going to focus too much on those today, though if you would like the deep dive on one such example, the episode from a couple of weeks ago about angel investing and startup capital has you covered.

So those are your various timelines, your goals, and it's funny, I have this theory that most internal financial turmoil occurs because most people neglect to do this type of assessing and table-setting before they dive into the deep end of all the financial jargon. So they find themselves just inundated with compounding return charts and by recommendations and tax hacks without ever sitting back to determine whether they should be playing offense or defense. And if they're playing offense, which type of offense? Most of us will be doing a little bit of all of it at some point, sometimes simultaneously. For example, when I started my financial journey, I was solely focused on early retirement. So I didn't really invest any money for the medium term. All of my accounts were very aggressive, and because I'm still not personally sold on the idea of buying a house in the next few years and I have no intention to leave work, I haven't made any moves to adjust my asset allocation away from that aggressive risk profile.

I am primarily focused in my financial ecosystem on funding my own golden parachute and figuring out the rest later, with the confidence that if I can grow that nest egg as large as possible, I'll have the option to flexibly withdraw a down payment-sized amount of it at some point in the future if I need it. But ideally, and I think this is what all of personal finance boils down to, once your defenses are fortified and your offensive strategy is established, the only remaining lever to continue directing your energy toward is earning more money so you can funnel more and more cash into the top of your system, like a sick late-stage capitalist version of that game Plinko.

Sure, you should check in with your spending, make sure you are vaguely on track. You'll reassess your emergency fund if your roommate accidentally burns a hole in your couch during candlelight takeout night gone wrong, but tinkering with your subscriptions budget or driving three towns over where gas is 4 cents cheaper, probably no longer worth your time by that point. You would almost certainly be better served finding ways to crank up the cash flow faucet such that the entire system that you have devised will work faster and more efficiently.

Now the hardest part might be analyzing honestly where you are in that process and having the patience and endurance to commit to that level for as long as it takes to ascend to the next one, during which your biggest challenge will not be technical know-how, but fending off the boredom that accompanies long periods of chugging along and chipping away at your objective with very little action and excitement, I would say, if you're doing it correctly. So that's lens number one: It is the most big picture way to think about your finances, in my opinion.

Lens number two is asset location and allocation. Now, these are two frustratingly similar words that technically describe different elements of your aforementioned offense. So we're drilling down a little bit there. This is the lens through which the anonymous redditor who inspired this episode was probably trying to look by describing the whereabouts of all their money.

Now technically, asset location describes strategically structuring how your assets will be taxed. So for example, someone who's really concerned with asset location may decide to hold high-yield bonds in a tax-advantaged account rather than a taxable one, because they know that those bonds are going to be throwing off interest every single year that will be taxed annually if it's in a taxable account and that if they had it in a tax-advantaged account, it's going to be allowed to grow tax-deferred. Broadly, though, I like to stretch the definition of asset location and think about it more as the tax status of your money more generally. So this quality, the tax status, that's what we're concerned with rather than the specific type of vehicle, which could be a 401(k), a 403(b), an IRA, a 457(b), an HSA. Because yes, with some notable exceptions, the vehicle itself does matter slightly less at a high level than the tax status of the money within those vehicles when it comes to planning for the future, as the tax status is what's going to determine the level of flexibility you have later.

So for example, having $10,000 in a Traditional IRA and $10,000 in a Traditional 401(k) are not meaningfully different by nature of the account type. The important thing for your future tax planning knowledge is that you have pre-tax dollars, dollars that are going to be taxed like earned income later in life when you withdraw it. One example of an exception that I would note here is the Roth IRA versus the Roth 401(k), because you are able to access your contributions to a Roth IRA, your cost basis and that's not true of a Roth 401(k). So that is kind of a consideration. There are also some funky things with traditional IRAs and backdoor Roth IRAs, but that's all on the margins.

For the big-picture planning purposes, this distinction between Traditional, Roth, or taxable generally holds true. Similarly, whether I have $1,000 in a Chase checking account or $1,000 in a Bank of America savings account doesn't really make a difference unless they have meaningfully different APYs, because regardless of where the money is, it's all liquid cash, it's all easily accessible, it's all kicking off taxable interest every year. So when you're imagining your financial system holistically, it can be helpful to think about the distribution broadly as follows: How are your assets spread amongst pre-tax dollars, tax-free or Roth dollars, taxable dollars, which in this case I'm kind of referring to the way that any money you have in a standard taxable brokerage account would be treated. And we covered that topic in a lot of depth a couple of weeks ago. So we'll link that in the show notes.

And finally, cash, whether that's in checking or savings or physically under your mattress, though I would not recommend that last one. Now, it's probably more technically correct to think about cash as an asset allocation decision, but I still think conceiving of cash as a category in your system at this level makes more sense. And this is my podcast, so I make the rules. Thinking through the location of your assets in this way can help reveal to you where you may be over- or underweight. Most people, when they chop things up this way, they realize that they're actually holding a lot more cash as a percentage of their overall net worth than they realized, or maybe they'll notice, "Oh my gosh, wait, I have way more money in pre-tax funds than Roth and the next time I have a low income year, I'm going to really focus on that Roth 401(k) to try to beef up those Roth dollars." So there are a few different realizations you may come to, but in my mind it's a more helpful way to think about your overall position. We'll be right back after a message from the sponsors of today's episode.

Now, asset allocation is same same but different. Asset allocation refers to the types of assets you're invested in, and in what proportion to one another. Now, nine times out of 10, this is going to refer to stocks, bonds, cash, real estate. So maybe you're 90% stocks, you're 5% bonds, 5% cash, maybe you're 50% real estate, 40% stocks, 10% cash. Asset allocation is going to vary widely depending on your strategy. A rental property investor may not have any stock exposure and may be primarily real estate and cash because they're about to buy another property, and someone who has chosen to build wealth in the stock market may have no exposure to real estate and barely any to bonds and cash, and your age will also play a role here. So someone in their 30s is probably going to have a much larger portion of their net worth invested in stocks than someone in their 80s.

Now, of course, within these broad categories you can get more granular. Stocks encapsulates everything from GameStop to low cost diversified index funds like VTSAX. Knowing which indices of stocks or bonds you own can similarly reveal where you might be leaning too heavily into one area or where you actually might need to double down. So we did an episode about building a diversified portfolio that we'll link in the show notes if you want to dig a little bit deeper there. But importantly, your location and allocation lenses layer on top of one another because the decisions you make about allocation informs decisions you make about location. For example, someone who sees their withdrawal phase on the horizon might prioritize buying high growth stock ETFs in their taxable account, because they know any capital gains that they earn in that account will be taxed using the favorable long-term capital gains brackets versus long-term capital gains that are accruing inside of a traditional IRA, which are going to be taxed like earned income.

Of course this has to be balanced with the reality that most people do use these buckets to differentiate between timelines. So a young investor might be buying high growth stocks in their 401(k) because they know that that account is associated with a super, super long timeline. They want it to be aggressive as opposed to maybe a taxable account that they have that's earmarked to use five years from now. But still having a general idea of why one might want to invest in certain asset classes in some vehicles and not in others can be useful context. And moreover, when you're visualizing your finances like a pie, it's helpful to imagine all of your assets together as opposed to separated by the boundaries of different account types or brokerage firms. So tools like Personal Capital and Copilot can do this, but I found it's actually a little challenging to do with software just because of the nature of financial products.

So for example, if I own VTI, VTSAX, VOO, VFIAX and SPY, these are all different tickers for index funds and index ETFs of US-based large cap growth or large cap blends that contain, for most intents and purposes, basically the same holdings in different accounts. Most software is going to treat all of those things as different holdings rather than grouping everything together as like, "Okay, you have X percent in large cap growth." So if anyone knows of any killer software that can do this and gets it right, let me know. I just manually calculate this for myself in a spreadsheet once per year, which is not the best way to do it, but it's the best solution I have right now. Now, from there, the idea is that you would strategically create little mini asset allocations that may vary widely in each individual account based on your asset location best practices, but that the entire overall asset allocation still creates the right breakdown for your risk tolerance.

So let's put it all together, let's build an ecosystem that you can supercharge in the future with more income. Now that we've covered the different lenses through which you can think about your money, these concentric circles, I love that word, of varying levels of detail, we can talk about how to systematize your results. So we touched on this a little bit in our taxable investing episode, but I really find it helpful to sit down with a pen and paper like it's art class and sketch out a literal flow chart of how money flows through your system based on what you find upon reflecting on these different lenses. So for example, if you realize that, okay, you're still in defense mode, that's great, and you've got two sources of income, you might draw a flow chart that shows your primary source of income, perhaps one that offers a 401(k), and draw a dotted line from that source to the 401(k) that represents the match, because you want to get that 100% return on your money even if you're in defense mode.

But then you'll show the rest of the money flowing into your checking account. Now, your second source of income might flow partially into that same checking account while a small portion might be set to direct deposit to the account that you're building your emergency fund in. So from there, you've got the money and the checking account to work with, which you can demonstrate in your sketch as being partially devoted to aggressive debt paydown, maybe 25% of your take home pay, while the other 75% is going toward bills that are paid out of checking and various credit card auto-pays. But by that point, your savings have already been taken care of and you can see how they're being funded. I love getting the system on paper because it takes something that is incredibly abstract and it makes it real. Does the flow chart you are staring at on the paper in front of you reflect a plan that's likely to get you closer to your goals, or further from them?

And regardless of the answer, why? Do you see any areas of opportunity that you hadn't considered? Are there any areas where money is leaking out? As another example, maybe you are in offense mode and you have this intricate flow chart of income funneling into your employer-sponsored retirement accounts as well as through your checking account such that you are sitting on a bloat of cash and savings when money is left over every month. If the money is pooling in the account after all your bills are paid, it's probably a sign that you should look into something like a Roth IRA, taxable brokerage account, potentially both, in order to put that money to work. Because if it's pooling in the account at the end of the month, you obviously can afford to invest more than you are. At which point you would start considering the questions that we highlighted around asset allocation, asset location, and your goal timelines because you are ready to face that level of complexity a little more seriously.

And finally, you might not really know what mode you're in, you might not be contributing to any investment accounts, but you also might not be in debt, either. You might be treading water financially, and your flowchart is basically just one square—your income—that pays your credit card bills. And in that case, the question to ask is, can you account for where all of this money is going? Do you have a spending plan in place? Do you know what your save rate is? If you don't know what your save rate is or what percentage of your income you're spending on your rent, your car, your groceries, it might be time to take a closer look at fortifying up the holes in that armor before you march into battle to open a brokerage account.

So I'm going to go on a small little tangent about spending as part of your defensive strategy because I often talk about how once your spending plan is locked and loaded, you can mostly move on and focus your energy on other things. And sometimes I fear that that translates to your spending plan is not all that important. On the contrary, it is incredibly important, and it's an area that I find most people skip. I think there's a reticence to track one's spending and to look at that spending month over month honestly and transparently to kind of face the music. This is probably because the majority of the time you're going to find you're spending a lot more than you think you are, and who wants that? But I have tracked every single transaction over the last five years. I've been using Copilot for the last three, and I checked today: I have classified 2,771 transactions in Copilot.

So I write down my category totals at the end of every month such that I have years of data, right? I'm trying to express the fact that I do this religiously and I still find myself routinely surprised by the numbers staring back at me basically every other month. I'm like, "Whoa, really?" Which just goes to show that even when you're tracking, it's still really easy to get misaligned with what you think you're doing. And I just find that doing this helps me stay accountable. I love having the data to diagnose trends, particularly at the end of the year. It is really my favorite holiday tradition, which is cool and also sad, but I've said it before; I will say it again. It is remarkably difficult to accurately intuit these things unless you are someone who's just incredibly gifted with numbers, because it's easier to see the big picture if you're just one person using one credit card or one debit card.

But once you have multiple credit cards on different timelines, racking up charges that come due at different points in the middle of the month, or you're in a couple wherein there's double of everything, it is just almost impossible to know how much you are actually spending and on what. Moreover, I find that we have a tendency to mentally write off abnormal spending as though it doesn't count or that it was a one-off. But the reality is the one-offs are going to happen every month. It's more unusual to not have one-offs. So it's more helpful to you if you know generally how much that one-off category is going to cost you.

Now, if you're serious about your financial system, I would recommend spending at least 90 days tracking your spending using an app like Copilot or Mint. And if you want to be really hardcore, the Money with Katie Wealth Planner, too, and then make a plan for the margin between your spending and your income. And if you finish the 90 days and you say, "Oh, yeah, but see, these months were abnormally high because [insert any reason here]," I would officially challenge you to do 90 more days to prove to yourself that that's true. Because my guess is that what you'll find is that life is just expensive, which is the reality that most of us have to face head-on.

And while that does kind of suck, it's better, I think, to have a realistic grasp on what your life costs so you can make a realistic investment strategy, too. And then as you level up your income, you can turn up that dial. All that to say, there are definitely levels to this game. But I do hope that this episode has given you a little bit more to think about, potentially a few tools, tactics for fleshing out your own financial ecosystem a little more fully, such that the progress you are going to be making with each incremental unit of effort is going to go as far as it possibly can for the highest possible ROI.

That is all for this week. So I'll see you next week, same time, same place on The Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact checking comes from Kate Brandt.