2008-02-26

What Do I Supposedly Know About Personal Finance?

That’s a pretty easy one to answer. Nothing. That’s sure what it feels like, day to day. When I have the TV or radio on, and someone is expounding on historical P/E ratios of a company or industry, how many years in a row a company has been raising its dividends, or something that they gleaned from reading a footnote in a company’s annual report, I might feel like I have a general high-level understanding of what they’re saying. And I might. But I am mostly absorbing maybe 50% of the content—and retaining less than that. I think I’ve read Benjamin Graham’s The Intelligent Investor twice now, and I’m pretty sure that I still have not retained more than 25% of the substance. I like to think of myself as a reasonably smart guy; and sometimes my wife will even humor me and tell me so. I feel like some types of things come quickly to me—but finance and investing are not those things.

Nevertheless, I finally feel like I have figured out some of the basic concepts. I may or may not be applying them—but I think I understand them and even retain them now. I pretty much learned them by reading books on personal finance—and getting reinforcement from reading magazines, from TV and radio, and more recently, from reading blogs. When I first started reading personal-finance books, I had a voracious appetite for them, no doubt trying to feed my fantasy of starting down the path toward riches. But a funny thing happened on the way to the forum. All the books started sounding the same. There were long aisles of books at Barnes & Noble packed full of personal-finance books, with new ones being published seemingly every day—and they all sounded the same to me. Some were written in a style that was more attractive to me; some had more clever examples; but it was getting to the point that I could turn to the table of contents and pretty much guess what was going to be there and in what order. So I am going to summarize it all here.

Here are the main points of a substantial portion of the books in that personal-finance aisle of your bookstore or library:

  • Get out of debt—stay out of debt.
  • Start saving earlier—as early as possible
  • Save and invest more.
  • You can’t beat the market.

The first point on debt does not really need much explanation. According to the books, debt—particularly credit-card debt at high-interest rates—is very bad. That about sums it up, don’t you think? Okay, most of the books go a little farther than that. They also chide that most of us do not budget, do not really know where our money is going, and are consequently spending too much—leading to things like credit-card debt. They also consistently warn that we should put away money for an “emergency fund.” An emergency fund allows us to weather unanticipated storms—such as losing a job or having health issues; and by consequence, it helps us not run up debt should one of those unfortunate incidents occur. I’ve seen ranges as far as how big an emergency fund is appropriate. Some folks suggest that three months of living expenses is enough; quite a few espouse six months; and a few recommend even more. A few books also talk about insurance as a backstop behind an emergency fund—particularly homeowners (or renters) insurance and particularly life insurance (with term almost always recommended over whole or universal).

The second and third points are often illustrated with stories or examples on the magic of compound interest (or compound gains, if you will). There are stories of little old ladies who saved $50 a month for 30 or 40 years—and ended up with ample nest eggs for their retirement. I must admit that I always found these illustrations compelling—in part because my next thought was always that I could save more than the $50 a month (or whatever the number was in the example), which again meant that I must be able to start down the toward riches.

One of the more well-known illustrations is “The Latte Factor,” by David Bach, who has written several personal-finance books. (He has even registered “The Latte Factor” as a trademark!). Here’s the gist of it. Lots of us buy something small—like a latte—every day. Figure each latte at $5. Consider if that $5 a day were invested instead of spent on the latte. Using Bach’s assumed annual rate of return of 10%, in 30 years, you have $339, 073; and in 40 years, you have $948, 611. You can read about this in more detail on Bach’s website (which includes a calculator).

It’s a cute example—and ties in several of the messages. It reinforces that many of us do not know where money is going; it reinforces the power of compound gains; and pragmatically, it reinforces that you want to start early, since the big numbers only come after 30 or 40 years. Oprah even picked up on “The Latte Factor” on her show and website.

Coming back to the third point—saving and investing more—the books frequently recommend implementation by “paying yourself first” or making the saving or investing “automatic.” This means setting up a program by which some fixed portion of your paycheck or some fixed amount out of a designated bank account is automatically moved to the investment vehicle of your choice on some regular basis (such as twice a month or monthly). Typical choices discussed for the investment vehicle would be low-cost index funds or a high-yield savings account. The idea is that most of us will never miss the money and will just naturally spend less. I’m a big fan of doing it this way.

The final point about not being able to beat the market is sometimes shown with data and sometimes by citation, as there is a lot written about this. Finance and economics professors often write articles and books on the mathematics and statistics behind this; and other examples come from the idea that even professional mutual fund managers often do not beat the S&P 500. I’ve seen sources peg it that 75-80% of the actively managed mutual funds do not beat the S&P 500; and some of those sources say many of the remainder only keep pace with the S&P 500 (which may mean lagging it again, once fees and expenses are factored in).

The message is pretty simple: most of us probably have no business trying to pick individual stocks. From there, the books’ most-common recommendations break out as:

  • Stick mostly to low-cost index funds (or in some cases ETFs).
  • Diversify your portfolio.
  • Check your portfolio regularly (some folks saying annually is enough) to rebalance it back toward your desired diversification.

Now the types of books that I am trying to summarize in this post are really only one portion of the bookstore aisle—as there are quite a number of books whose titles obviously emphasize getting rich quickly, which always entails beating the market. But let’s put those outside the “basic concepts” and save them for future discussion!

By the way, I have listed some of the books that I have read on this blog; and I have found that one of the personal-finance blogs that I have started reading is a great source for reviews of personal-finance books—Get Rich Slowly. Check out the post with a list of 25 of the best books about money, which link out to separate reviews.

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