Financial planning is about choices. Almost to the exclusion of anything else. You can spend a given dollar just once, so your spending choices should reflect what gets you the most value. Utility as the economists call it.
The spend it just once issue creates several conditions that people handle poorly. There are conflicts that impede the orderly development of a useful plan.
The first of these involves the present versus the future. In homage to the, you can only spend it once, rule any money you spend today cannot be saved for the future. There is a psychological problem here. Our reward system doesn’t handle the future very well. Saving pays off in the future, but spending pays off now. We use very high discount rates when comparing future value to spending now.
Growth versus security follows next. Again psychology harms us. We value losses about twice as highly as a win of the same size. The loss need not be real. Downward market fluctuations look like losses and we respond. Upward variations are expected so we are not as happy about up 5% as we were fearful about down 5%.
People act on urgency and are less inclined to act on important. Most important problems, like saving are not urgent. Most urgent things are not important. People need to distinguish and assign a way to deal with them.
People work at efficient and forget effective. According to Peter Drucker, efficient is doing things right and effective is doing right things. No amount of efficient will fix a poorly developed strategy. This leads to the problem of confusing tactics with strategy. Advertising often joins the two and people are conditioned to believe things that may harm them.
The discipline and impatience conflict often get in the way. It is part of all the other conflicts. Impatience is a killer of saving and investment. It rises from people not understanding compound growth. People must learn about doubling. The rule of 72. The time to double is roughly 72 divided by the rate of return. So 12% will double every six years. In 48 years, eight doubles. 256 times your money. $4,000 is a $1,000,000. Here’s the problem. You are not a quarter of the way there in 12 years. Actually only two doubles, so $16,000. People quit because they don’t understand the process. We are all linear and need a tool to address this. The rule of 72 works.
You can practice this art and begin to recognize how it works if you watch The Antiques Roadshow. If someone shows up with a piece of art their grandparents bought in 1957 for $100 and they find it is now worth $200,000, is that a breathtaking rate of return? Two thousand times your money sounds good, but 2,000 is roughly 11 doubles. Each double took, 60 years divided by 11 or about 5.45 years. So 72 divided by 5.45 gives you a rate of return around 13.2%. The precise answer would be around 13.5% but it is hard to find that using mental arithmetic.
Very nice but not spectacular.
How much was it worth in 1979 when Grandma left it to her daughter? $1,621 right? Again nice, but it had better fit the decor when daughter gets it.
No one is intuitive about compound interest so most quit too soon. You must do the calculations and have a way to convert to something you can fit to reality.
Linear growth observations will cause you to make mistakes. Seek help if you must.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772