IF YOU DROVE DRUNK but got home unscathed, you wouldn’t wake up the next morning and think, “I guess it’s okay to get behind the wheel after 13 beers.” Yet, when handling our finances, we do that all the time.
“Markets generate a lot of data, but they don’t generate a lot of clear feedback,” writes academic Terrance Odean in his foreword to Michael Ervolini’s thoughtful book, Managing Equity Portfolios. “Outcomes are noisy. Good decisions may have bad outcomes. Bad decisions may have good outcomes.”
The problem: We typically judge our financial choices by a single, crude yardstick—whether they make or lose us money. But that measure of success or failure can result in faulty feedback that validates bad behavior. Consider three examples:
- We bet everything on a single stock and it soars in value. We imagine we’re great investors. But in all likelihood, it was dumb luck—and our next big bet could wipe us out.
- We don’t bother with homeowner’s insurance, saving roughly $1,000 a year in premiums. Our home hasn’t burned down, so it seems like a wise decision—until we smell smoke wafting up from the basement.
- We dump bonds and foreign shares, because they’ve posted seven years of mostly lackluster returns. Instead, we make a big, undiversified bet on highflying U.S shares. The market cycle turns—and you can guess the rest.
What’s the lesson here? Dispassionate contemplation is a better teacher than personal experience—because contemplation leads us to consider the range of possible outcomes, while our personal experience represents a sample of one. So what happens if we consider the range of possible outcomes? We become focused not on whether a particular strategy has made us money in the past, but on how to improve the odds that we’ll make money in the future.
WHEN SHOULD WE CONSIDER OURSELVES RICH? Sure, income and wealth are important. But don’t focus just on dollar signs. Instead, think about money in terms of how it makes you feel, what it allows you to do and what your lifestyle costs. Here are eight possible definitions of rich—not all of which I agree with:
1. You almost never worry about money. This is a good one—but it probably has more to do with you than with the sum involved. Some folks would get a tremendous sense of security from $50,000 in the bank, while others warily watch the world from behind their $5 million cash mountain.
2. You’re satisfied with what you have and you’re never envious of others. This may not make you rich in the eyes of other folks. But it’s an admirable quality—especially when we consider the next definition.
3. You have more than your neighbors. Research suggests that we care less about our absolute level of wealth or income, and more about how we compare to others. This is unfortunate: Unless you’re the world’s richest person, there will always be somebody who is better off, so maybe you’ll never be satisfied with your lot in life.
4. “Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness,” opines the character Wilkins Micawber in Charles Dickens's David Copperfield. “Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” In other words, if you have enough to cover your living costs, you’ll be happier—and, presumably, you should consider yourself well off.
5. The Dickens quote packs a punch, but it begs the question: What are you spending your money on? I think it’s important to distinguish between needs and wants. That brings us to an alternative definition of rich: You can pay for what you need—and you aren’t consumed by what you want but can’t afford.
6. You don’t have to work. This is a good litmus test, though it raises a crucial issue: If you aren’t working for a living, what are you doing with your time—and are these other things making for a happier life?
7. You need a paycheck, but you have a job you love. This is closely related to definition No. 6: If pretty much every day is a pleasure, you have a rich life, even if you don’t currently have enough to retire and even if others wouldn’t consider you wealthy.
8. You have enough to lead the life you want. This is my preferred definition of rich, and it encompasses many of the definitions above: If you have the financial wherewithal to spend most days engaged in activities you enjoy and find fulfilling, you should consider yourself rich, no matter what your net worth.
MY HOPE: THE DISTINCTION between work and retirement--between being productive and suddenly being unproductive--gets a whole lot murkier. I make that argument in How to Think About Money and also in a new Money magazine article, which was posted online this morning. Want a happier retirement? Forget days of endless relaxation, and instead think about what will give a sense of purpose to your final decades. You might find that sense of purpose in part-time work, which may also ease the financial strain of retirement.
YEAH, I CAN’T BELIEVE I’m writing about holiday gifts, either. Still, here’s my offer: Want signed copies of my new book, How to Think About Money, to give to family, friends, colleagues or clients? To get your autographed copies, send a check—made payable to Jonathan Clements—to P.O. Box 247, Ardsley-on-Hudson, NY 10503-0247.
To cover the cost of the book, shipping and handling, I’m charging $16 each for one or two copies, $15 each if you buy three to nine copies, $13 each if you purchase 10 to 49 books and $12 each if you buy 50 or more. In other words, if you want, say, five copies, it would be $75. Be sure to specify where the books should be sent. To ensure delivery by Dec. 24, please mail all checks by Nov. 30.
Don’t care about having my scrawl at the front of the book? For $13.99, you can buy the paperback directly from Amazon.com or, alternatively, purchase the $9.99 Kindle or Nook editions. Got questions? Send me an email.
“PRACTICAL MEN, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist,” wrote John Maynard Keynes in his 1936 classic, The General Theory of Employment, Interest and Money.
The same can be said of U.S. investors. We grow up repeatedly hearing the same standard financial advice—and often we never question it. Yet, as I argue in How to Think About Money, there’s much conventional financial wisdom that isn’t especially wise. Consider seven examples:
1. Stocks are risky.
Reality: Sure, they’re risky. But the implication—that other investments are less risky—simply isn’t correct. Bonds and cash investments may not offer the rollercoaster ride that you get with stocks. But they leave you vulnerable to inflation, which is arguably an even bigger threat.
2. With hard work and intelligence, you can beat the market.
Reality: Reams of statistics prove that very few money managers beat their benchmark index over a 10-year stretch. What about the minority of managers who come out on top? There’s no surefire way of identifying them in advance—and their strong performance is no guarantee they’ll keep on winning. But don’t take my word on it: Check out both the SPIVA and persistence reports from S&P Dow Jones Indices.
3. You can’t go wrong with real estate.
Reality: U.S. home prices are still 0.6% below their level of 10 years ago, as measured by the S&P CoreLogic Case-Shiller U.S. National Home Price Index. But memories are short—as evidenced by the exuberant double-digit price gains over the past year in markets such as Portland and Seattle.
4. A mortgage is the best debt you can have.
Reality: If you have to borrow, a mortgage is more attractive than, say, a car loan, credit card debt or margin loan. But that’s different from saying it’s desirable to have a mortgage. Rather, consider mortgage debt to be a necessary evil—and look to get rid of it earlier rather than later.
5. When you’re in your 20s, you should pursue your passions.
Reality: If anything, devoting your days to activities you’re passionate about will likely prove more important in your 40s and later. At that point, most of us are less focused on collecting external rewards like pay raises and promotions, and more interested in taking on work that we find personally fulfilling. My advice: Go for the big paycheck in your 20s and 30s, and save as much as you can, so you have the financial freedom to pursue your passions later in life.
6. Money buys happiness.
Reality: Even as the U.S. standard of living has more than doubled over the past four decades, reported levels of happiness haven’t budged. Why not? People rely on conventional notions of the good life—and aren’t sufficiently thoughtful about how they spend.
For instance, if you use your money to buy a boat or a second home that involves a lot of upkeep, you may discover you have bought yourself a fistful of headaches. But if you use your spare dollars to take a trip, help your favorite charity or bring your family together for a special meal, there’s a good chance you’ll boost your happiness.
7. Retirement is a chance to relax after four exhausting decades.
Reality: Thanks to the instincts we inherited from our hunter-gatherer ancestors, we aren’t built to relax. Rather, we’re built to strive. Many of us get a lot of satisfaction from work. Retirement should be seen as a chance to take on activities that we think are important and we’re passionate about, without worrying so much about whether they come with a paycheck.
TWO MORE REVIEWS of my new book appeared last week: “How to Let Your Money Buy You Happiness” by MarketWatch’s Paul Merriman and “Money and Happiness” by the Chicago Tribune’s Elliot Raphaelson. Not in a mood to read? Instead, try watching “Insurance is a great invention, but is it a great investment?” This is a two-minute video I made for Creative Planning, where I sit on the advisory board.
WE’RE IN A WORLD of low investment returns. Bond yields are tiny—and bond investors can’t reasonably expect to earn anything more than those yields. Money market funds, savings accounts and other cash investments are even worse.
Meanwhile, economic growth is muted and stock valuations are rich, suggesting lackluster stock returns. My best guess: Over the next decade, a globally diversified stock portfolio might return 5% to 6% a year and a mix of high-quality corporate and government bonds could clock 2% to 2½%, while U.S. inflation runs at 1½% to 2%. And remember, those returns are before investment costs and taxes.
My low expectations don’t put me on the lunatic fringe: Many observers now expect modest gains from the financial markets. Vanguard Group founder John Bogle recently told The Wall Street Journal that, over the next decade, stock investors would be lucky to earn 2% a year after costs.
Problem is, a somewhat rosier view is baked into the financial calculators used by many investors. For instance, for its FuturePath and retirement income calculators, T. Rowe Price assumes stocks will return 4.9% a year more than inflation, bonds 2.23% and short-term investments 1.38%. (To T. Rowe Price’s credit, it also adjusts for potential expenses.)
The retirement planner at Dinkytown.net allows you to override its return assumptions. But if you don’t—and I suspect that would be most users—the calculator assumes your investments earn a generous 7% a year before retirement and a more reasonable 4% after retirement, while inflation runs at 2.9%. The obvious danger: Investors rely on those assumptions—and end up spending too much and saving too little.
RISING LIFE EXPECTANCIES, coupled with slower population growth, have a huge impact on how we should manage our money. Indeed, I devote an entire chapter to the topic in my new book. Here are seven key financial implications of today’s momentous demographic shift:
1. Economic growth will be slower. Over the past 50 years, half of the economy’s 2.9% annual growth has come from increasing the number of workers and half from increasing the productivity of all workers. But with the labor force projected to grow at 0.5% a year, rather than 1.5%, economic growth will almost inevitably be slower. That means slower growth in corporate profits and hence lower stock returns. To compensate, we need to save more for retirement and our other goals.
2. We can’t all retire in our early 60s, because there won’t be enough folks in the workforce to produce the goods and services that society needs. Economic pressure—which might take the form of rising taxes, cuts to Social Security and Medicare, higher inflation or lower investment returns—will keep many of us working well into our 60s and perhaps even our 70s.
3. We’ll need more than one career to get through our working years. Even if global competition and technological innovations don’t force us to change careers, we’ll likely want to. Four or five decades is an awfully long time to do the same thing.
4. Retirement is becoming more expensive. With median life expectancies heading toward age 90, folks will need larger nest eggs to pay for an increasingly lengthy retirement, including the hefty health care costs that accompany it.
5. The big financial risk isn’t an early death. At that juncture, all of our financial problems will be over. Instead, the big risk is living longer than we ever imagined—and running out of money before we run out of breath. Delaying Social Security benefits, to get a larger monthly check, is looking smarter and smarter.
6. As life expectancies grow, so too does our investment time horizon—which means stocks are more appealing. Yes, their returns will probably be modest. But stocks are still likely to outpace bonds and other more conservative investments.
7. Faced with the prospect of navigating multiple career changes and a lengthy retirement, it becomes more important than ever to start saving as soon as we enter the workforce. That way, we buy ourselves some measure of financial security early on—and that could save us from a lifetime of financial anxiety.
MONEY MAGAZINE just posted an excerpt from How to Think About Money to its website. Also check out the accompanying video, which is located halfway down the article. Meanwhile, Vanguard Group has a Q&A with me on its website.
MANY OF US ENGAGE IN MENTAL ACCOUNTING, thinking of our mortgage as separate from our savings account and our job as unrelated to our portfolio. But these are all pieces of our sprawling financial life—and, as I discuss in my new book, it’s important to understand how everything fits together. Here are 12 examples:
1. If you have plenty of cash in the bank, you can probably raise the deductibles on your auto and homeowner’s insurance.
2. If you’re inclined to buy bonds, you’re likely better off paying down debt instead. After all, the after-tax cost of your debts is typically higher than the after-tax interest you can earn on bonds.
3. If you’re married, you have less need for disability insurance. Why? If you can’t work because of illness or injury, your spouse’s income may keep the family solvent. But if you’re single, you won’t have that financial backstop—and a disability could cause your finances to quickly unravel.
4. If you work in Silicon Valley, your family’s finances are heavily exposed to the tech industry, so you should think twice before investing significant sums in tech stocks. The same logic applies to doctors and health care stocks, realtors and rental real estate, and investment bankers and financial stocks.
5. If you have children, there’s less money for everything else. One result: You’ll likely retire later.
6. The more wealth you’ve accumulated, the less need you have for long-term care insurance, because you may be able to pay nursing home costs out of pocket.
7. If you have a steady job with a decent salary, you can take the risk of investing heavily in stocks, because there’s little or no need to own income-generating investments.
8. The higher your fixed living costs—we’re talking items like car payments, property taxes and rent or mortgage—the less financial breathing room you’ll have. That means more financial stress and potentially more difficulty if you find yourself out of work. One precautionary step: Build up a larger emergency fund.
9. If you save a large percentage of your income, you need a relatively small nest egg to retire in comfort. The reason: You’re used to living on a modest portion of your salary, so you might be comfortable retiring with just 60% of your preretirement income, rather than the 80% that’s often recommended.
10. While insurance needs tend to wane as our wealth grows, umbrella liability insurance is the exception: The rich make a more tempting target for the litigious.
11. If you’re retired—or no longer have a financial need to work—there’s no need to keep much, if any, emergency money. Why not? The No. 1 reason to have an emergency fund is to cover costs during a spell of unemployment.
12. If your adult children have high incomes, you may want to spend down your traditional IRA and bequeath them other assets. The reason: If you leave them your traditional retirement accounts, they’ll have to pay taxes at a steep rate when they draw down the accounts.
HOW SHOULD YOU think about money? Check out three articles that have appeared in the wake of my new book’s publication. StableInvestor.com ran an extensive Q&A with me. NextAvenue.com reviewed How to Think About Money. The review also appeared on Forbes.com. Finally, MarketWatch.com picked up the main article from my latest newsletter.
MANY PARTS of our financial life look like bonds, with their steady stream of income. For instance, you can think of receiving a regular paycheck as similar to collecting interest from a bond portfolio. Ditto for the income you might collect from Social Security, a traditional pension plan or an immediate fixed annuity. If you receive a lot of income from these bond lookalikes, that can free you up to invest more heavily in stocks.
Our financial life, however, may include not just bond lookalikes, but also “negative bonds”—in the form of mortgages, auto loans and other debts. When we own a bond, somebody else pays us interest. But when we’re in debt, we pay interest to others. Because we are considered less creditworthy than, say, the federal government and major corporations, we typically pay a higher interest rate on our debts than we can earn by buying bonds.
This has two key implications, which I discuss in my new book, How to Think About Money. First, suppose we want to put more money in interest-generating investments, like bonds, savings accounts and certificates of deposit. Often, it makes more sense to pay down debt, because the after-tax interest cost we avoid is greater than the after-tax interest we could earn by investing.
Second, when we look at our finances, we should subtract the amount we owe on various loans from the amount we have in bonds and similar investments. Suppose we have $100,000 in stocks and $100,000 in bonds. It might seem like we have a conservative portfolio.
But if we also have a $100,000 mortgage, our effective bond position is zero—and our finances are far riskier than they appear. My advice: As you head toward retirement, lower the riskiness of your financial life—by paying off all debt. That will increase your net bond position, while also lowering your cost of living, by freeing you from a major monthly financial obligation.
LOOKING TO GET MORE HAPPINESS from your dollars? That’s a subject I tackle in my new book, How to Think About Money. Here are nine super-simple strategies that you can put into practice today:
1. Buy a gift for somebody else. Research says we get more pleasure from spending on others than spending on ourselves. Want extra credit? Give a gift when it isn’t expected. The recipient will be especially happy—which means you’ll be, too.
2. Start planning next summer’s vacation. That’ll give you a long period of pleasurable anticipation, which may prove to be the best part of the vacation.
3. Do something fun—with somebody else. Go out to dinner. Go to a concert. Go for a hike. Just as everything is better with French fries, (almost) everything is better when it’s enjoyed with a companion.
4. Whatever you do, take photos. That way, you can revisit fun moments and squeeze a little more happiness out of them.
5. Too much choice creates uncertainty and uncertainty can be the death knell of happiness. What to do? Look for ways to limit your choice. Struggling to settle on an investment strategy? You might restrict yourself to, say, the mutual funds offered by one major fund family.
6. Don’t hang around rich people by going to ritzy resorts or wandering into high-end stores. Even if you are comfortable financially, you’ll feel relatively deprived.
7. Make many small purchases, rather than one big one. Buying stuff may bring an initial thrill, but the thrill often fades quickly. By making many small purchases, you will—at least—get the initial thrill many times over.
8. Before buying an item, consider its virtues—but also consider the upkeep. The more upkeep involved, the more likely you are to regret the purchase.
9. Pause for a moment and admire your car, your latest remodeling project or your spouse—and think how lucky you are. What matters is what we focus on, so focusing on your good fortune can bring an extra shot of happiness.
Want more ideas for a happier life? Check out my latest newsletter, which includes five key insights from the research on money and happiness.
MY NEW BOOK is now on sale—and my latest newsletter was just published. The newsletter, which is free and appears bimonthly, includes nine ways to think differently about money, plus five key insights from happiness research.
Those articles are drawn from ideas in my new book, How to Think About Money. Folks who have read it say it’s the best thing I have ever written (though that may reflect their dim view of my earlier writing). I’m anxious for the book to garner a large readership and have priced it accordingly. The paperback costs just $13.99, while the Kindle and Nook editions are a mere $9.99.
WE’RE SPENDING the final two weeks before Labor Day on Cape Cod, staying with my in-laws. Everywhere we turn, there’s another delightful home with a wonderful water view. “Wouldn’t it be great to live there?” my wife and I muse, as we imagine how much happier we’d be if we lived in this place of apparently permanent vacation.
We are, of course, completely delusional.
Being in a beautiful spot can be a great joy for a week or two. Soon enough, vacationers are contemplating purchasing a second home or a time share. We’re fixated on a vision of enchanted daily life, forgetting that the humdrum of existence—mowing the lawn, buying the groceries, going to the dentist—will quickly intrude, no matter how spectacular the view.
Even when we’re at home, we devote great energy to creating special places—a remodeled kitchen, a new deck, lush landscaping with a bench where we can sit and contemplate our transformed garden.
Yet the bench almost never gets sat on, because simply being isn’t enough. Instead, what brings us great joy is doing. The real pleasure in the new garden is the planning and planting. Once it’s done, our sense of satisfaction quickly passes, and we’re on to another project.