The investing world is a distracting place. Should you invest in stocks or crypto? What if you have debt, should you even bother investing?
Sit back with a cup of coffee. I’ll explain how the Investing Pyramid can make every financial decision you make easier.
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Slow is smooth, and smooth is fast.
I love that saying because it goes against the instinct to go fast. Just as in any other field, there are fundamentals to personal finance that are tempting to skip.
There’s no place that’s as enticing to “go fast” as investing.
People want to trade individual stocks before learning about index funds, or worry about crypto when the obvious option is to pay off debt.
These fancy things are like the tip of the financial iceberg that people gravitate towards.
But don’t miss the rest of the iceberg. Skipping foundational parts of finance is how people get rolled over by credit card debt, miss out on long term gains, or put too much money in risky investments.
This is why I’ve developed the investing pyramid, a mental model to organize your finances. Creating an investment pyramid can help you…
- Create a healthy financial foundation
- Stay focused and avoid shiny object syndrome
- Figure out where, when and how much to invest
We’ve all heard stories of lottery winners who end up bankrupt. It’s because their approach to finances was in a state of chaos, making money hard to hold onto.
The financial pyramid brings order to chaos. It’s a system that provides a suggested order of operations so it’s clear, at any point, where to put money. And that’s exactly what I’m going to cover today.
🏔 The Investing Pyramid
The investing pyramid suggests an order of operations building from bottom to up. First create a good financial foundation, then have your fun investing without losing your shirt.
- Level 1: Build a financial buffer
- Level 2: Fund tax-advantaged accounts
- Level 3: Choose your own investments
- Level 4: Fund your dreams
Some meta notes about the pyramid:
- At the beginning, your money is playing defense. At the higher levels, they play offense.
- The higher the pyramid, the more risk you take on for more reward.
- From bottom to up, you’re going from capital preserver to capital allocator.
The pyramid suggests how to prioritize your investment decisions, but it’s not meant to be a rigid structure. You can cycle through the different levels of the pyramid. For example, someone who’s reached level 3 can decide they want to go back to Level 1 to build from 3 months to 6 months of living expenses.
All of this is a template—here’s nothing stopping you from investing however you want. Allow it to serve as a mental model to organize your finances.
Now I’ll tell you the what, why and how of each level.
🛡 Level 1: Build your financial buffer
If you’re in the Sahara dying of thirst, you’d pay almost any amount to get a life-saving sip of water.
A bit dramatic, yes. But emergencies are exactly the kind of situation that warrants a financial buffer. You want to create a financial defense against the things that life can throw at you, whether that’s a car repair or an unexpected medical expense.
Level 1 is the game of building cash flow and safety. Here’s what to prioritize at this level:
- Invest in yourself: skills, training, career development
- Build an emergency fund. Save 1-3 months of living expenses to start with.
- Pay off debt, especially high interest toxic debt
🧘🏻♀️ Invest in yourself
When you have less money, the returns on investing in yourself go much further than chasing returns on financial investments. $100 earning a great 10% return is only $10, but $100 spent on a resume makeover can lead to a job that pays thousands more.
At the beginning of your financial journey, the return on your time, money, and energy is probably not in stocks or investing. At this point you’re more concerned about building the financial engine that’ll keep the cash coming in. Do not feel FOMO about investing if your priority is to invest in yourself first.
That’s why Level 1 is about investing in yourself. The other levels are about investing beyond yourself – putting your money in the hands of others to grow that money.
🚨 Why prioritize an emergency fund before paying off debt?
Because emergencies are immediate and require cash now. Even if your credit card is gouging you with 23% APR, that’s not as urgent as a broken car that prevents you from getting to work.
Calculate average expenses using something like Mint. Let’s say you spend an average of $500/month on your car. An emergency fund should then take this into account, and perhaps you’d want to use a multiple like 2x your expenses. In this case that’d be $1000 to cover car repair costs.
Note: Mint.com is my favorite free finance tracker that lets you connect ALL your financial accounts and gives you a good overall picture of your finances. I have no monetary relationship with Mint.
How much debt to pay off?
Warren Buffett is known to say that the first rule of making money is to not lose money.
High interest debt is a fast way to lose money. Credit card debt is as toxic as debt comes, because of compounding interest and penalty charges. Prioritize paying off this type of debt compared to lower-interest, more forgiving types of debt like student loans. Attack this level with the help of government programs, refinancing, or community support.
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When to move onto Level 2?
In level 1, you’re building a money buffer that you’re intentionally not investing in order to prepare for emergencies and take care of day-to-day life things.
You don’t have to fully master each level to be able to go to the next—but you want to take care of the most important things.
For example, if you know that your debt is 20% APY and the average stock market return is 8% annually, then it’s clearer that paying off that debt is an immediate, guaranteed return on investment. This can be a helpful reference point if you ever feel FOMO about not investing.
💰 Level 2: Fund tax-advantaged accounts (401K and IRAs)
For all that Uncle Sam takes away in taxes, at least ‘Murica gives you a few breaks. Those breaks come in the form of tax advantaged retirement accounts like 401Ks, IRAs and college 529 plans if you have kids.
Here’s the quick summary of what to do in Level 2:
- Enroll in your company’s 401K if you have one. Even if you don’t, you can still contribute to IRAs (step 4)
- Pick investments: choose index funds or target date funds; skip the ones with high fees.
- Contribute to your 401K. Try to max this out, especially if you get a company match.
- Repeat these steps with IRAs
In less technical terms that other resources can explain, retirement accounts help you save on taxes and take advantage of compounding interest over time.
401K example: contributions reduce your taxable income up front, and the money you put in grows tax free for years until you have to withdraw money at retirement. The deal is even sweeter if you work at a company that gives a 401K match, which is basically just free money towards your retirement.
💡 But there’s a behavioral advantage to retirement accounts…
Retirement plans encourage passive, disciplined investing.
Most 401Ks and IRAs only allow you to invest in funds—not individual stocks. For example, you may be able to buy the S&P 500 index fund (low cost standard), but not Tesla stock. This might sound like a restriction, but it’s also an advantage. This ensures that your retirement dollars are invested in diversified index funds and prevents the losing game of stock picking.
Retirement accounts are also more “out of sight, out of mind” compared to apps like Robinhood that let you trade from your phone with a few taps of the finger. Studies show that the less you touch your investments, the better you perform. People tend buy high and sell low as a result of panic.
When to move onto the step 3?
If you’re not sure about investing (level 3), then just stick to this level until you max out your retirement plans.
Retirement contribution limits change every year. The trend has been increasing. 401K limits were $19,500 in 2021 and increased to $20,500 in 2022. The IRA contribution limit remains unchanged this year at $6000. This means for 2022, you can contribute a max of $26,500 combined.
Maxed out your retirement accounts and want to put more dollars to work? Let’s climb up to Level 3.
🌎 Level 3: Choose your own investments
Slow is smooth, and smooth is fast.
Building up the foundations in Levels 1 and 2 can be slow. But they serve as a bedrock from which you can explore and chase more exciting returns.
Remember this iceberg? People most react to the tip of the iceberg. It’s fun, it’s in the news, it’s Gamestop and all that jazz. Because of this, cynics will often make comments like “don’t gamble…the stock market is a casino!”
But gambling is only bad when you don’t have your foundations covered. If you have no toxic debt, have built a financial buffer, and already maxed out your 401K…then yeah, you can probably afford to take some calculated bets.
Before you put money into exotic investments, it’s worth mentioning that you can simply replicate the strategy from Level 2: invest any excess money into index funds.
For example, let’s say your 401K account with Fidelity offers the FXAIX, their version of the S&P 500 index fund. You can open up your own investment account (like M1 Finance) and use that same strategy to buy a similar fund, like Vanguard’s VOO.
I go more into depth about this in my beginner’s guide to investing.
There’s a power to simplicity: Warren Buffett has advised his own estate to invest most of his wealth in the S&P 500 when he dies.
The more you pick individual investments, the more risk you take on. With that in mind…
Outside of the simple “buy the stock market index” strategy, the whole world’s your oyster. You can…
- Pick individual stocks
- Buy up to 20 of your favorite companies and allocate 5% to each stock. This Motley Fool strategy can be easily achieved with a platform like M1 Finance.
- Dip your feet into crypto investing
- Alternative investments like art, farmland or real estate
Start with small amounts to get comfortable with these higher-risk forms of investing. Most platforms have an option to drip money in over time. Subscribe to my newsletter to learn more about my experiments with alternative investments.
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When to move onto Level 4?
The investing pyramid suggests priorities, but it’s not linear. Level 3 is expressly for putting your extra money to work. However, it’s not mandatory (well none of this is).
If you’re already clear on the dreams you want to fund, you could’ve skipped this level altogether. The investing pyramid is all about giving you a financial buffer – which changes drastically from person to person – so that you can confidently chase what you want to do in life.
🔮 Level 4: Dreams, or “Don’t forget to live”
What’s the point of financial success if it doesn’t support your dreams? This level is a creative, expansive space. Perhaps your dreams include…
- Starting a business or non profit
- Traveling
- Buying a house
- Quitting your job to become a digital nomad
These goals are all connected to the previous levels. Let’s go through a couple different examples:
Buying a house: you may decide to go back to Level 1 (savings) and Level 3 (investments) to save for a down payment.
Traveling: If you want to backpack for 3 months, and decide to contribute less to your 401K (Level 2) so you have more in your savings for your travel budget.
Side hustles: Perhaps you find a side hustle you enjoy that helps fund all levels of your pyramid. Extra income can provide financial buffer, opportunities for investing, and/or is the thing you want to be doing anyway.
If your dreams include building a business, then the financial pyramid offers a point of comparison. Look at how your investments perform. If you were able to make 10% on your money pretty reliably, then you’d hope to at least beat this return on investment (and time) in your entrepreneurial endeavors.
Even successful entrepreneurs who can plow cash into their own business choose to diversify into other investments. You don’t have to be Elon and buy billions of dollars worth of Bitcoin for Tesla. But you can spread the risk from your entrepreneurial ventures by allocating money into the general stock market.
Put it this way: “I have some confidence I can generate X% return on my business. But the stock market historically has generated 8% annually, so I’ll spread out my risk.”
We can invert the whole pyramid and think about your goals and dreams first, then work backwards.
- What’s on your bucket list?
- How much freedom do you want?
- What does a rich life look like to you?
- What would you regret not doing in 1 year? 5 years? 10?
Just don’t forget to live. Don’t live to just to earn; earn to live.
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Other notes: beyond the pyramid
Conquering each level equates to increasing financial freedom. Covering all your basic needs is financial freedom. Having no debt is financial freedom. And starting to invest is financial freedom.
Consider that the road to financial freedom is long, personal, and varied. But I hope that the investing pyramid helps provide a mental framing around what to do with your money, and when.