Personal finance literacy is acquired haphazardly
The unfortunate reality is that personal finance is not adequately taught in schools. Young people usually learn personal finance behaviours either from their parents or by doing. Not surprisingly, the lessons learned are of variable quality and, in many cases, perpetuate practices that are not conducive to developing a healthy long term relationship with money.
Clients often ask us to spend some time with their adult children, who have entered or are just about to enter the work force, to provide them with some personal finance basics. In this article, we share twelve of the ideas we discuss with our clients’ children. If they are understood, accepted and practised, we are confident that they will see money relegated to its appropriate place in the children’s life i.e. as a valuable servant rather than a domineering master.
Twelve personal finance essentials
In no particular order, our twelve personal finance essentials are:
1. Understand that unless your after-tax income exceeds your spending, you are going backwards. Without winning Lotto or receiving a large inheritance, no matter what your income if you don’t earn more than you spend you can never be financially independent. We define financial independence as having sufficient investment wealth to support your desired lifestyle without the need to work;
2. If you don’t know what you are spending your money on, then it is difficult to know what to change if you need to adjust spending behavior. At least for a few months, keep a detailed record of where your money goes. This could then provide the information to establish an annual savings target and spending budget;
3. If you have difficulty sticking to a budget, then implement the practice of “paying yourself first”. This involves having an amount consistent with your savings target immediately subtracted from each pay cheque (and directed to an appropriate savings account/investment), leaving you to live off the residual until your next pay cheque;
4. For major expenditures (e.g. car, holiday, apartment), first work out whether they are affordable and how they are going to be paid for before committing to the expenditure. A “live for today” attitude is generally not consistent with a responsible approach to personal finance;
5. If your credit card or a personal loan is the only source of payment for an expenditure, you can’t afford that expenditure. If you are continually paying interest charges on your credit card, you do not currently have the money maturity to own the card. You should get rid of it;
6. Understand the difference between apparent financial wealth (i.e. the “things” money buys, such as cars, holidays, houses) and real financial wealth (i.e. investments). It is the latter that is necessary for financial independence;
7. Don’t confuse consumption with investment. The monetary value of a consumption item either falls to zero as soon as it is purchased (e.g. a holiday) or declines over time (e.g. a TV, furniture, car). However, investments are expected to produce income and, hopefully, increase in value over time. Consumption detracts from financial wealth, while investments aim to increase it;
8. As your income rises over time, don’t let your lifestyle rise commensurately. Otherwise, what you regard as financial independence will be elusive. Just as you feel you are getting closer, it moves away as you continually adjust your lifestyle expectations upwards;
9. Don’t try to “keep up with the Jones’”. You should measure your success in terms of your financial objectives, rather than trying to keep pace with other people who almost certainly have very different objectives. And keeping up with the Jones’ may only be a recipe for going broke as quickly as they are;
10. Don’t make any major expenditure decisions on the assumption that you will remain healthy or that nothing will go wrong. Make sure you have adequate disability and life insurance and that your major assets (e.g. car, house) are appropriately insured. If you can’t afford the insurance, you shouldn’t be making the expenditure;
11. Pay attention to your superannuation. Consolidate your holdings into one fund and take full advantage of super’s tax effectiveness as soon as possible. While retirement may be a long way off, the tax savings offered by super contributions plus the benefits of investing in a low tax environment can significantly enhance your long term investment wealth; and
12. Relatively small and consistent saving over your entire working life will negate the need for much larger sacrifices later in life to build a desired retirement nest egg. For example, investing $10,000 at 5% p.a. (after-inflation) will grow to $698,000 over 30 years. To accumulate the same amount over ten years requires investment of $52,800 p.a.
Personal finance: as much psychology as economics
Effective personal finance is as much about coping with emotional and psychological pressures as it is understanding the economics of finance. Even for hard headed rationalists, the emotional pressures sometimes hold sway.
For young adults who are just entering the workforce the temptation to make money decisions that are not in their best long term interests is overwhelming. Retirement is too far away to even contemplate, while here and now they have “cash to splash” and want to enjoy having more money than ever before.
But the earlier they understand that the decisions they make now will affect how they live in the future and the more skilled they become in weighing up the often conflicting emotional and economic/rational factors affecting those decisions, the sooner they will attain personal finance maturity.