I finished reading the results of a survey conducted by Harris Interactive Polls for the National Council on Economic Education and the numbers are not pretty at all. The poll asked students as well as adults basic questions about money and the students simply flunked out (the average score of teens was 53%) and the adults barely passed (adults got 70% which was a low D when I went to school) . What was really scary was over 40% of women compared to 15% of men flunked the test and over 50% of men got an 80% score of better while only 17% of women did. Boys and girls, can we agree that this is not good?
What’s going on here? Essentially what I have been saying on God’s Money for nearly 20 years is there are lots of people that do not know what they NEED to know to be financial literate and women and young people struggle even more than men. The emails and the phone calls we receive here at TCFin are a never-ending stream of stories of people overwhelmed by debt, poor financial decisions, no savings or investments and every other kind of financial calamity you can think of.
But just knowing the answers on this test does not mean you won’t make financial mistakes or get into financial trouble. Understanding economics and personal finance doesn’t mean you won’t make mistakes or face financial disasters. But you can lessen the odds and repair the damage faster if you know the rules of the game. However, if you know these basic rules, you can lessen the chances of making a big blunder and more important you’ll know how and why you are experiencing financial distress.
Here are the rules we all need to know:
There is a difference between needs and wants
Our actual needs are pretty limited: food, shelter, clothing, companionship. Just about everything else is a “want,” and our wants are essentially endless. Because our resources are limited (see “scarcity,” below), we have to make choices about which wants to fulfill.
Also, the way we fulfill our needs involves a lot of choice. Shelter, for example, can be a bed at a homeless mission or a $125 million Palm Beach mansion. Our food choices offer a similar range, from beans and tap water consumed at home to steak and Dom Perignon at an exclusive restaurant.
I’ve discovered many people believe they have to spend money in certain ways or in certain amounts, when in reality their spending is a choice — or is at least based on choices they made earlier. If you’re facing a monster mortgage payment, for example, it’s because you chose to buy that home and selected that particular mortgage.
Taking responsibility for our choices can be scary, but it should also be empowering. After all, if you have choices, you’re not just a victim of circumstance.
Scarcity makes the choice for you
It’s lovely to believe in a world of endless abundance, but the reality is that at any given point in time, our resources have limits. Whether it’s oil in the ground, our time here on Earth or the cash in our pockets, there’s only so much available to be spent.
People who ignore this reality are the ones who run out of paycheck before they run out of month, or who extend their unsustainable spending by relying on credit cards, home equity loans and other reckless borrowing. Their refusal to make the sometimes-hard choices needed to responsibly manage money means that they will have even fewer choices in the future. The money they spend on stuff and on interest can’t be invested to meet other goals, like retirement, so odds are pretty good they’ll wind up old and broke.
The pointlessness of the hedonic treadmill
This isn’t the latest workout device at your gym. The hedonic treadmill means that you quickly adjust to improved circumstances. A raise at work or a new possession may make you happy for a little while, but you soon take your situation for granted. Your expectations continue to rise: if only I could get another raise, or a better car, or a bigger house. Should those expectations be satisfied, again you’d adjust and quickly want more.
This has a lot of implications for personal finance and even the economy, but here’s something to consider: Maybe you need to look beyond your wallet for true happiness. Just saying…
Every money decision has a cost of its own
“Opportunity cost,” very simply, means what you give up to get something else. In every choice, there’s an opportunity cost. If you decide to go to college, for example, you’re giving up the income you could have earned by working full-time during those years plus whatever you could have purchased with the money used to attend school. You also may take on loans to pay for school, which will have to be paid back with future income that could have gone for other purposes.
The good news, of course, is that even with opportunity costs, college is a slam-dunk for most people. The average graduate makes 70% more over his or her lifetime than someone who stops with a high school diploma.
If, however, you train for a career that has little demand and wind up making the same amount as a high school grad or trailering huge amounts of student loan debt you can never repay, you may regret the money spent on school and the foregone income.
Understanding that your choices have opportunity costs, and examining what those costs are, should help you make better economic decisions.
Supply and demand rules
For the most part, prices are set by the interaction between supply and demand. If demand for something suddenly shoots up and the available supply of that something doesn’t change, then prices will increase. If demand drops or supply increases, prices typically fall.
Here’s an example. Say rock star Jessica Cool Babe is photographed wearing a cap with the brand name of a Midwestern seed company. Suddenly, all her fans and half the people reading People magazine decide they, too, need the Midwestern seed company’s hat. The farm supply companies that stock these hats figure out a good thing when they see it, and double, then triple, the price. The hat actually worn by Jessica sells for a mint on eBay, earning a notice in mainstream newspapers and furthering the craze.
The Midwestern seed company wants a piece of this action and starts cranking out hats by the ton. Suddenly you can find one in every Target and Wal-Mart. The retailers can no longer command a premium for having a rare item, thanks to the increase in supply. In fact, the hats start seeming a heck of a lot less cool, lowering demand; Target and Wal-Mart slash the price still further to get rid of their unwanted supply.
The interplay of supply and demand is also why one-day gas boycotts don’t work. Even if a lot of people participated, overall demand wouldn’t change; the boycotters would likely gas up before or after the selected day. Only a big increase in supply or a sustained decline in demand is likely to affect prices.
Supply and demand has a lot to do with your income as well. If you have rare skills that are in high demand by employers, you can negotiate higher pay. If, on the other hand, a lot of people can do what you do or the employer need for what you do is limited, your income is likely to be less.
Do not throw good money after bad
“Sunk costs” are expenses that have already been incurred and can’t be recovered to any appreciable extent. “Sunk cost fallacy” means an irrational belief that a further investment of time, money or effort will somehow resurrect the value that’s already disappeared.
A classic example is the person whose home value has plunged because the economy worsened. The person wouldn’t buy the same house today, yet continues to hang on to the home rather than sell it and take the loss. The person may offer the excuse that he or she wants to at least “break even” before selling, but of course the housing market doesn’t care about you getting your money back, and all the wishing in the world won’t bring the price back up.
By hanging on to a house that often you do not want or can afford, you are giving up the opportunity to own elsewhere at a reduced cost.
The role risk plays
Every human endeavor carries some risk, and investments are no exception. What differs is the amount and type of risk and how you’re compensated for taking it.
The 30-day Treasury bill, for example, is one of the “safest” investments around if you’re solely concerned with getting back your original investment. The T-bill is backed by the full faith and credit of the U.S. government. But the average return on a 30-day T-bill over the past 80 years is just 3.7%, according to Ibbotson Associates. The 30-day rate, today, as I write this is basically zero. When you factor inflation, you have probably lost money if you invest solely in T-bills.
Large-company stocks, by contrast, returned an average of about a 10% annualized return over the same period. That handily beats inflation, but as everyone who has invested in the past decade knows, stocks aren’t a sure thing. There were plenty of years along the way that the market for large-company stocks dived, and if you invested all your money in a single stock — say, Enron — you could be wiped out. That’s called market risk.
Here’s the point: You almost certainly need to take some market risk if you want to grow your wealth and beat inflation over time. But you should also be wary of “guarantees” of a high return on an investment. If you’re earning more than the going rate on a T-bill, in other words anything over zero, you’re taking risk, and you should understand the extent of that risk before proceeding.
The time value of money
This boils down to a relatively simple proposition: that the dollar you get today is worth more than a dollar you are promised sometime in the future.
There are several reasons for this. One is the “bird in the hand” reality: the dollar you get today is real, but the dollar you are promised in the future likely will be worth less (because of inflation), or you might not get it at all (the person or company might renege on their promise to pay you, the person might die, or the company may cease operations). Also, the dollar you get today could be alternatively invested and potentially create more dollars in the future.
Turn this around, and you’ll see why lenders charge interest for loaning money — and why the interest rate depends on your creditworthiness. Lenders want to be compensated for the erosion in their dollars due to inflation, and for the risk of lending money to you.
The higher the perceived rate of future inflation and/or the more lenders doubt your promise to pay the money back, the more interest they’ll charge to compensate for the risk.
The miracle of compound interest
This is a concept best illustrated by example. Let’s say you give me a penny today, and promise to double the amount every day for a full month. How much money would you be giving me on the 31st day?
The answer: $10.7 million. Check it out:
|
It all adds up |
|
|
Day 1 |
$0.01 |
|
Day 2 |
$0.02 |
|
Day 3 |
$0.04 |
|
Day 4 |
$0.08 |
|
Day 5 |
$0.16 |
|
Day 6 |
$0.32 |
|
Day 7 |
$0.64 |
|
Day 8 |
$1.28 |
|
Day 9 |
$2.56 |
|
Day 10 |
$5.12 |
|
Day 11 |
$10.24 |
|
Day 12 |
$20.48 |
|
Day 13 |
$40.96 |
|
Day 14 |
$81.92 |
|
Day 15 |
$163.84 |
|
Day 16 |
$327.68 |
|
Day 17 |
$655.36 |
|
Day 18 |
$1,310.72 |
|
Day 19 |
$2,621.44 |
|
Day 20 |
$5,242.88 |
|
Day 21 |
$10,485.76 |
|
Day 22 |
$20,971.52 |
|
Day 23 |
$41,943.04 |
|
Day 24 |
$83,886.08 |
|
Day 25 |
$167,772.16 |
|
Day 26 |
$335,544.32 |
|
Day 27 |
$671,088.64 |
|
Day 28 |
$1,342,177.28 |
|
Day 29 |
$2,684,354.56 |
|
Day 30 |
$5,368,709.12 |
|
Day 31 |
$10,737,418.24 |
Each day, the amount you pay me compounds and requires you to pay me more. At the beginning, the amounts are nominal, but by the end we’re talking serious money.
Of course, no one’s going to be able to double their money every day. But this concept explains how people who save relatively small amounts over the years can build rather substantial nest eggs. After a few decades, their actual contributions represent only a small part of their burgeoning wealth — it’s mostly their returns that are earning returns.
But this also illustrates how debts can quickly balloon out of control. If you’re paying interest, rather than incurring it, and you’re not diligent about paying off the finance charges in full every month, the unpaid amount will incur additional interest charges, increasing the total amount that you owe. This is why so many families who incur credit card debt eventually find themselves in trouble as the amounts they owe explode past their ability to pay.
There is a reason they call it interest. It was meant to come in, rather than go out.
Summary
So, in summary, the rules about money we all need to know are:
1. There is a difference between needs and wants. Not even Donald Trump can buy everything they want in the mall. Nor would he want to.
2. Scarcity makes the choice for you. We all have limited resources. Know what you own, what you owe, what you earn and where it goes.
3. Get off the hedonic treadmill. You do not need to buy into the Madison Avenue dream. Just because you can does not mean you should.
4. Every money decision has a cost of of its own. This is huge! Opportunity cost needs to be considered before you purchase anything. Indeed developing a power over purchase is priceless.
5. Supply and demand rules. Prices rise when more people want to buy than want to sell. Prices drop when there are more sellers than buyers. Be a contrarian – sell when others buy and buy when items are out of favor.
6. Do not throw good money after bad. Kenny Rogers was right. You’ve got to know when to hold ‘em and know when to fold ‘em. Don’t let the fear of losing cause you to lose even more.
7. The role risk plays is significant. You almost certainly need to take some market risk if you want to grow your wealth and beat inflation over time. But beware of inordinately high guarantees, nothing is risk-free!
8. The Time Value of Money. The sooner you are paid, the better because the dollar you get today is worth more than a dollar you are promised to receive in the future.
9. The Miracle of Compound Interest. Albert Einstein is credited with saying compound interest is ”the greatest mathematical discovery of all time”. Enough said.
Begin to use these simple rules in your daily life and the chances of your financial situation improving will increase exponentially.