Dennis Hopper is on the phone:
Pop Quiz. Your tax return arrived. You have a two hundred dollar check in your hand. What do you do? What do you do?
Today we will discuss Priorities:
- Long-term Investments
- Short-term Investments
- Liquid Assets & Savings
- Debt Management
This looks like diary about the basics of personal finance. It is, to a point. Sit tight because "the first rule of Investment Club is that we talk about Investment Club." I.C. is about sharing the knowledge and viewpoints we have on "Investing-with-a-capital-I" to help each other make good decisions. We build the community, and thus ourselves. This diary will be more valuable with your input. Other I.C. diaries: The Basics, Going to Disneyland, and The Highs and Lows of Index Funds. Consider contributing your own I.C. diary to help us keep this going.
Enough pimping, let's get started.
We start by establishing some basic principles for making good decisions about money.
Next we will review some of the competing forms of "investment" that we should consider.
Finally, we will construct, and deconstruct, the invesment priorities of a fictional person with a nod to the concepts of measuring opportunity costs and risk management, developing a strategy for allocating our resources.
So now you have that tax return in your hand, you payed your bills already and have a couple weeks till the next paycheck. How do we approach this basic scenario? In the abstract:
- Smile: you are holding raw potential in your hand. It may not seem like much. It may not be a large check. But you hold the potential to create jobs, to provide comfort (if not happiness) for yourself and others, and to insulate your loved ones from adversity. You even have the potential to generate more money, which could be brokered for even more of the above. Recognize that you have power.
- Measure where you are: This means getting out of the chair and gathering information. The purpose here is to find out what your current financial situation looks like. When you first try this you might make some minor errors: forgetting about a recurring bill, or not knowing the exact balance of your student loans, or maybe just a check you wrote for flowers for "Mothers' Day. Don't panic. It gets easier, until you become Warren Buffett. Then it gets tough again. (When that happens you can make thing easier for yourself again by sharing the wealth with the rest of us.)
- Identify some goals: what do you want to do? Making money, for it's own sake, can be rewarding. My view is that money/potential/power is only as valuable as what it can be leveraged towards achieving. Since "you can't take it with you," you might consider what you want to do. This requires long-range thinking and many folks haven't done this, yet.
- Look for paths: to get there from here. Options change, new doors may open, old doors may close. It pays to be flexible: your goals are defined but there may be many ways to get there. Don't rush into the first option that comes along. Get out there and do some hunting. Notice that those options whick knock most loudly at your door (junk mail, spam emails, and TV commercials) are likely to be sub-optimal for you. This is a time for collecting raw materials, not pruning choices, so don't be too picky about collecting ideas.
- Evaluate the options: This is where you settle on a subset of choices, measuring the value of one option against another to prune the field. Conventional Wisdom points to two factors you need to evaluate: risk and return, however you should use a yardstick that is meaningful to you. If you really care about the social, environmental, or political impacts of your investment choices, than you should balance that concern against the other measurements. We will talk about the factors we should evaluate later.
Now that we know how to smile at opportunity, we can try to put these principles to use. Smiling may make us feel nice, but will it help us get ahead? I suppose that depends on what we mean by getting ahead.
Conventional Wisdom says that we should look to pay off our debts, and sock away money for emergencies, and save money for upcoming expenses, and invest for The Future. Egads, but that is a lot of competition for such a relatively small pot of money. How shall we divide it among these four concerns? Some folks will get frustrated, ignore some of the competing needs, or just divide the pot equally. This begs the question: When you divide one slice of bread to feed four mouths, does anyone not go hungry? How many children should starve while a few thrive? The answer seems obvious to a progressive: a suitable balance must be found. By looking at opportunity costs, we can start to see which competing interest helps us most.
Investopedia(a good place to learn some of this stuff) says this about Opportunity Costs:
You may, for instance, forego ice cream in order to have an extra helping of mashed potatoes. For you, the mashed potatoes have a greater value than dessert. But you can always change your mind in the future since there may be some instances when the mashed potatoes are just not as attractive as the ice cream. The opportunity cost of an individual's decisions, therefore, is determined by his or her needs, wants, time, and resources (income). [...] This value is personal to each individual.
Wait a minute. Did they just dress up a simple idea with fancy jargon? Yup, and there are more where that came from.
So we know that you will want to pay your higher-interest debts before your lower-interest debts. We know you want to choose a higher-return on your investment before a lower-return. Right? Not exactly. To illustrate how this thinking is incomplete, we can examine an extreme example. If you have a credit card charging 29.5% APR with a balance of $500 (min payment of $25) and a personal loan charging 12.25% APR with a balance of $650 (min payment $150), and you have $200. Would you write a check for $200 to the credit card company and not make the loan payment? Of course not. The "correct" answer is to write a check for $50 to the credit card, paying as much as you can afford while meeting your other obligations. Why? Because it would be bad for your credit rating to get behind on the loan payment. This is an opportunity cost in action. You must balance your credit rating against your net worth. This example helps us see the first factor in allocating our investments: Factor 1: We must act to protect our credit rating.
Our credit rating is important, even if we never use credit directly. It is used to influence your insurance rates, is used in measuring job applicants, and housing rental applications. We may be faced with many decisions in our investment career that could impact our credit rating. Take note of them and be careful. Credit ratings are fragile.
Readers may wonder if I have also revealed the second factor as well: we should work to protect/build our net worth. I say no. Money is not an ends to itself. We have defined financial goals. By obsessing over net-worth, we may fall into the trap of idolizing money. That can distract you from your goal. I say, bugger your net worth. No, the value of our things does not define our value as people. But sadly, your credit rating does. (That's a joke, by the way.)
So now you understand that you must act to protect your credit rating. You are paying your bills. It still doesn't feel like we are investing with a capital I. We are paying off debt, but not saving for emergencies, upcoming purchases, or long-term investment. Well lets take this one step at a time. You can see that you are helping your financial position by paying down debt. You are trading $150 for the elimination of $150 of debt. That particular debt grows at a rate of 12.5% in total every 12 months. If you stuck $150 in your mattress, it would grow at a rate of 0%. If you stuck it in a CD (certificate of deposit) it might grow at 3.5% every 12 months. After one year, you come out with a greater net-worth by paying the debt specifically because the cost of the debt is creater than the rate at which the money would grow if stuck in a matress or a CD. Paying your high-interest debt is a form of investing.
I hear a murmur from the audience: "So, maybe we are investing by paying off credit cards, but it isn't fun or exciting." I don't know about you, but I find the prospect of earning a 29.5% return guaranteed is pretty exciting to me. Still, we are out of balance: only servicing debt, but still ignoring the other three investment forms. Maybe cutting a $50.00 check to the credit card isn't the best idea than. Time for another opportunity cost: What happens next month when you have to pay that $5.00 parking ticket. (Feed the meter or risk a ticket? Welcome to the poor man's casino!) How can you protect yourself credit rating from emergency expenses? Put some money in savings. How much? It isn't like you can predict emergencies, so it can be hard to anticipate their costs. There are risks inherant in life. I am not a big advocate of living in fear, but it is foolish to avoid reality. That brings us to the second factor in allocation: Factor 2: Know Thyself. [props]
Again, quoting from Investopedia, this time on the topic of measuring risk:
Peter Lynch, one of the greatest investors of all time, has said that the "key organ for investing is the stomach, not the brain." In other words, you need to know how much volatility you can stand to see in your investments. Figuring this out for yourself is far from an exact science; but there is some truth to an old investing maxim: you've taken on too much risk when you can't sleep at night because you are worrying about your investments.
I dare say that Peter is dead right. Not only should we measure risk with our stomachs, we should satisfy our conscience. Personally, I don't elect to tie myself exclusively to socialy responsible funds. I find them too narrow and volatile. I indirectly own shares of WalMart, and it does shame me. I can sleep at night, however. I continue to atone by advancing progressive causes as I can. I do have some money tied up in more "green" choices, just enough to give myself comfort.
I sense unrest from the crowd. We have paid our bills this month, put a tiny bit away in savings (enough to sleep at night), and thrown all the surplus back on our high-interest debt. We are still not building short-term or long-term investments. This is true. I am afraid that in this case, it is the correct answer. Those two investments are not going to lead you from where you are to where you want to go efficiently. This brings us to the last factor in allocating your investments. Factor 3: don't daudle.
After all, the sooner you get where you are going, the sooner you can begin enjoying the view! Am I contradicting my earlier admonishment about net-worth? Not exactly. We should retain our focus on the prize, not on the race. But if we don't pay attention to our direction, it may take a lot longer to get there if we achieve the goal at all. For more information on the psychological aspects of investment, and how to avoid the trap of inefficiency, take a look at this.
To review:
Q: "What do you do?"
A: Start with a SMILE. To evaluate our options we will seek to: Protect our credit rating, know ourselves and our values, and we won't daudle in reaching our goal.