Personal finance has always been an interest of mine, but I haven’t always done a good job of it. Turns out, I’m not alone. The Atlantic recently published an article that leads out with the following simple quiz:
Do you understand money? Let’s see how well you do with the following questions. 1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After five years, how much do you think you would have in the account if you left the money to grow? A) more than $102; B) exactly $102; C) less than $102; D) do not know; refuse to answer.
2. Imagine that the interest rate on your savings account is 1 percent per year and inflation is 2 percent per year. After one year, would you be able to buy A) more than, B) exactly the same as, or C) less than today with the money in this account?; D) do not know; refuse to answer.
3. Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.” A) true; B) false; C) do not know; refuse to answer.
The correct answers are 1-A; 2-C; and 3-B. How did you do? Did you respond correctly to all three questions? If you did, then you belong to a surprisingly small global minority.
The article proceeds to document that only 30% of Americans got all three right and in Europe, about half of the Germans and the Swiss got them all. They did the best of all nations, but half is hardly much to brag about. There’s more analysis, but the basic message is that people’s ability to handle their own finances is, well, dismal. I’ve been pondering the in’s and out’s of money for a half century now and I think I’ve got a lot of it figured out. (Turns out, studies find that most other people feel that way too as they age, even if they’re wrong about it. Glad I’m not one of them!)
I would like to impart some of my knowledge to my children and grandchildren, but that’s hard to do. Kids aren’t interested and when they do get old enough, they too come to think they know more than they do about it. But just on the off chance they might someday read this post, I’m taking a chance and offering some observations and advice here. You can eavesdrop if you like.
1. The basic secret of financial security is actually easy and simple. Avoid unnecessary debt and spend less than you make. Do this routinely and resist temptation to make big purchases. I think it was Ben Franklin who said not to be “penny-wise and pound-foolish”.
2. Compound interest is powerful, both positively and negatively. Currently, interest on savings and money-market accounts is effectively zero, and that means that inflation, while historically low, is still eating away at your savings’ value. But, someday, compound interest will again be offered on savings. Think money-market funds, government treasuries, and top-rated commercial paper.
3. Stock investing is a lot like gambling for the majority of people, and as in gambling, the average bettor is destined to eventually be on the short end of the deal. One reason for this is that it’s counter-intuitive. Stocks look their best when they’re near the end of an impressive run-up in price, and that’s usually the worst time to invest in them. Growth can not be maintained indefinitely and even Walmart stock eventually plateaued. (Man, I wish . . . ) I tried buying individual stocks for a few years – it was discouraging. I found that although the broker’s fees seemed like a small percentage, they worked just like compound interest, nibbling away what few gains I had. My final conclusion: buy mutual funds, and of those, index funds are best because all funds charge fees and index’s have the lowest. Fees work like compound interest too, you see. Think of it this way: stocks historically appreciate about 8% per year and if your fund is charging you 2%, it’s taken a quarter of your gain already. Fees vary wildly among mutual fund companies, so pick carefully. Some charge 5 to 10 times less than others!
4. When investing, use dollar-cost-averaging. This means, set aside some of your income every month for savings, treat it like a bill, and send it in. If you think can’t manage that, get some finance software and track every penny for a while. You’ll probably be amazed where your money’s going.
5. Planning for retirement is especially hard because it always seems so far away. Deferred gratification is not natural. Also, pensions are going the way of the dodo bird, although there is still one good source: the military. Don’t try that just for the pension, however. It’s very competitive and making a grade eligible for a pension is far from guaranteed. Thanks to Uncle Sam, FDR, and some good-old American socialism, most people can count on enough Social Security to keep them from becoming homeless or starving, but not much more. But it is indexed to inflation and immune from market dips. (That’s a precious gift from Democrats.) But if you want to actually enjoy retirement while fending off health problems, and everybody has them as they age, you need to save and invest for that goal. The rule of thumb for drawing out savings over your retirement, so that you don’t out-live your reserve, is only between 3.5% and 4% per year, so the earlier you start saving, the better.
6.Managing your money is something you have to do yourself. If advisors were all that smart, they’d just manage their own money. Anything that sounds too good to be true, is. But also, sometimes you get what you pay for. Do your homework and don’t mix money with emotions.
7. If you get some kind of windfall, such as an inheritance, do not treat it as a different kind of money. It isn’t, it’s all the same. Money is fungible. Look that word up, memorize it, and make it part of your thinking.
8. Life insurance is important if you have dependents who would otherwise suffer if you get disabled or die, but it is a poor savings vehicle. Buy only as much as you need, and buy the cheapest (from a reliable company – they have ratings). It’s called term insurance.
Good luck, kids,