Just like a Fortune 500 firm, the average consumer holds a certain balance of assets and liabilities. Assets include items like car, a house, cash, some stocks, some form of savings for retirement, and even the food in the pantry. Likewise, the typical consumer may carry liabilities such as a mortgage, some credit card debt, and/or some school loans. Therefore, each payday, the consumer is faced with a decision of what to do with the money he has earned. Pay the mortgage? Buy groceries? Pay the mortgage? Vacation to Las Vegas? Buy June Microsoft futures? Tuck it in the mattress?
 
Clearly some of these decisions are easy. If the window is broken during the wintertime, you will likely make it a priority to fix the window. Likewise, if you run out of food, you should probably get something to eat. If the rent is due, it needs to be paid. These decisions are simple. But other decisions, such as ‘Should I increase my 401k or buy options?’ or ‘Should I pay down my student loan or open an IRA?’ are not as simple.

We are inundated with articles, brochures, and phone calls advising us strategies for investing in stocks and bonds. From simple strategies such as buying a particular stock, to…. We hear theories like using your age multiplied by a particular metric formulate a ratio of stocks or cash that you should hold in your portfolio. Likewise, we hear of strategies like buy dollar cost averaging (investing in a particular fund or stock at a specified time such as each month). And the value diversity, etc.
 
While these strategies may be sound, they do not give you the full picture. Stocks and bonds are only one asset in a pool of assets in the consumer balance sheet. I maintain that there are other investments that you should make before you use your income to properly manage your personal assets and liabilities. (rephrase)
 
Before getting into the model, there are a few assumptions that should be made:
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Entering this investment hierarchy assumes that the individual has adequately provided basic needs for herself and family (if applicable) and of course any entertainment. Obviously examples are food, shelter, clothing, and transportation. One who is struggling to provide what one considers a basic need should not be sending $2500 to open an E*Trade account if the mortgage payment in 60 days overdue. This also includes looking out into the future. If you are living within your means today, but are expecting triplets in 3 months, you may need to reevaluate your strategy.
 
· Investment in insurance policies (for home, life, auto, or whatever) is not included in the model. Insurance a hedge against uncertainty in the future. Everyone has a different aversion to risk and different needs to protect the personal and family interests.
 
This model assumes that investments (in general) will appreciate in value over a period time, and that we will experience a certain degree of inflation. This assumption has been challenged of late, as the market has fallen for a few years in a row. Along these lines, this model assumes that the individual has access to “typical” investments and loans. For example, if a loan shark with a 45% annual interest rate financed your pool table, this would not qualify as a “typical” loan. You may consider paying off or refinancing this loan as at the focus of your investment strategy, instead of opening a savings account.
Finally, it is unrealistic to assume that this model will work for everyone. There are too many considerations: age, taxes, luck, risk, to name a few. In addition, there are external factors over which the individual has little or no control such as the possibility of an inheritance. Also, there are other types of investments such as real estate, etc., that may provide benefits to….. This model provides a guide for a typical investor.
 
 
Below is the model. If an item on this list does not apply to you, move onto the next step. An example would be if your employer does not offer a 401K plan (or a match), you should move to step #2.
 
 
1. Maximize 401(k) match (or equivalent such as 403(b). Employer 401K up to the amount that maximizes employer “match”. For example, if your employer offers a 401K plan that matches 50% of the first 4% of your pre-tax income (like Cambridge Technology Partners) set-up your 401K to invest 4% of your pre-tax income out of your paycheck. This doesn’t mean limit your 401K up to this amount, this is just the first priority in the hierarchy.
 
2. Roth IRA. Invest maximum amount allowed into a Roth IRA (assuming you qualify). Why a Roth IRA? The Roth allows the individual more flexibility for withdrawals, and allows for tax-free withdrawals down the road. Note that there are income restrictions limiting those who can contribute to a Roth IRA.
 
 
3. Credit Card Debt.  Payoff credit card debt. This of course varies on the APR on your credit cards, and this really assumes that you are “living within your means”, which refer to the first assumption above. This was placed here due to the severe problem many individuals face with credit card debt. Many would argue that this should be #1, whereas the savvy investor may determine that this is just like any other loan, and should be prioritized with #7.
 
4. Traditional IRA. This is very close to #5 in the tax benefits (being pre-tax investment), but usually allows the user more flexibility on when are where to invest. Note that you can currently invest a total of $2,000 in an IRA (Roth or Traditional), so if you qualify for a Roth, you should put your $2000 in your Roth and skip this step.
 
5. Additional 401K up to the maximum allowed by your company, or up to the maximum allowed by law. It is important to note that due the difficulty and penalties for early withdrawals from 401Ks, some investors will trade the tax benefits 401K’s provide, for the liquidity of after-tax purchases of investments such as stocks and bonds (see next step).
 
6. A portfolio of investments. This could include stocks, bonds, precious metals, hockey cards, cash, etc. The proper mix that is right for you is difficult to specify. Once again, this depends on the user and the risk one is prepared to assume. From playing a short-straddle on Amazon.com futures to sticking your money in a Citibank savings account at 2% interest per year, the range is limitless. This is why we are constantly inundated with brochures, commercials, phone calls – each offering their take on the ideal strategy when purchasing stocks and bonds. Despite the popularity of these instruments, note that I argue that you do not want to invest in these instruments until you have maximized your investment in steps #1-#5. Of course, this is the first place in the model where there is no “cap” on of funds to allocate at this step. Therefore, in theory, you need not move on to any other step.
 
7. Pay down “tax” loans. Assuming you are making the minimum payment each month for such loans as car, and other debt, the next step is to pay additional funds on these loans. Once again, this assumes these loans are of a reasonable percentage rate. If Big Louie gave you a $10,000 for a car loan at 33% per year, you should think about paying that off a little higher up on this list. (#1). But if you are paying a few points above Prime, you shouldn’t be concerned of paying additional until you have invested in steps #1-#6.
 
8. Make “extra” student loans payments- Because of some new tax breaks for student loans, often this money these loans cost less than others (such as those in #7). (need to expand)
 
9. Make “extra” mortgage payments - . – Paying “extra” on your mortgage should be fairly low on your list of investment priorities. This is not only because mortgages typically carry lower interest rates, but also because most real estate secured loans allow the interest to be deducted each year. It is not uncommon for extremely wealthy people to have “interest-only” mortgages. Think about it. The bank is not worried about the credit risk of this type of individual because the person likely has the assets to buy the house several times over. But why? Remember, this is not a free lunch by any means, you still have to pay interest in order to deduct it. But typically this cost is very cheap. This, once again, assumes Big Louie did not finance your house.
 
10. Pay down “interest free” loans. – Unless we are experiencing deflation (which violates one of my assumptions), there is never a reason to pay down an interest free “loan”. An example would be someone who pays rent each month. Unless there is a financial incentive in your lease to pay early, pay your rent went it is due (or within the grace period).