Prudence and good money habits

Some people are good at earning money, others are good at spending less. Getting more from every dollar we spend is probably the right attitude, which I will discuss below. For today’s reading, I choose articles here, here, here, here, here, here, here, here, and here.

The black and white thinking

Some of the posts I write are a sort self-therapy. This is one of them. I have a not very bad case of GAS, which means gear acquisition syndrome. This is a well-known thing among programmers, gamers, guitarists, photographers, and artists. Basically, people buy stuff they want to call “tools” chasing some evasive scenarios and getting just the right thing. It is worse because I actually enjoy buying guitars for my kids, and as every Jewish parent knows, we MUST give our kids an abundance of parental love and money slightly above the sane levels.

What drives me to overspend is a well-known mental issue called “binary thinking”. I feel that if I have money, I can spend it and if I do not have money I need to save it. As a result, I am usually bouncing between the polar conditions of spending too much and not spending enough. Since my wife has a similar issue, we are locked in this cycle together. As we look for ways to break free, I want to share some thoughts with you.

Smart people make dumb money mistakes

No amount of superlearning can save you from dumb mistakes. I will give you an example I learned during my Ph.D. The Black, Sholes, and Merton work on pricing financial derivatives was one of the financial drivers of the markets from the early 90s to 2007 when the markets crashed due to crazy derivative trading. The markets simply change more than the formula can explain. The economists got their Nobel price, but every time they tried to use their formula themselves they actually lost money. Other people earned money because they corrected the formulas using their common sense each time the market misbehaved. And this is the issue: to be rich you need people skills, discipline, and common sense much more than economical and mathematical knowledge.

People who are smart think that they can outplay the market and get better returns (let us call it alpha). At the same time, they underestimate the irregularity of markets and risks (called beta). To get better returns in a given market, one has to improve alpha which is damn hard or to risk with beta. Smart people often do not come from the markets they want to outplay, they speculate and risk more than they can afford and eventually lose. Overconfidence is the biggest enemy of smart people.

Cognitive biases

In a way, highly disciplined people find ways to overcome the cognitive biases which smart people do not handle:

  • Thinking we know more than we really do.
  • The tendency to take credit for our successes and explain away our failures.
  • Operating on the belief that things will stay as they are.
  • The tendency to continue to do the same thing, despite evidence that it is no longer working.
  • Placing different emotional weights on gains and losses.
  • Basing decisions on the availability of information that comes readily to mind.
  • The tendency to look back on something that’s already happened as though it had been inevitable and therefore predictable.

Using rulebooks and common sense

The disciplined people use rulebooks to stay away from impulsive decisions and common sense to modify the rulebooks when the reality is different. There is no one rulebook to work in all cases. Definitely the rulebooks that apply to financial markets do not apply in other areas of life.

Quite often the most disciplined investors have an urge to break free from that discipline in other areas of their life. I have heard first-hand stories of substance abuse, impulsive shopping, chasing the wrong kind of sexual partners and so on.

While most of us will be very disciplined in our personal life and very impulsive investing, many investors are just the opposite. Probably we need to balance discipline and rebellious activities.

Prudence

My mother is a living example of frugality. When she can buy something, she usually tells “why do I need this?”. Frugal people rarely earn a lot, but they spend much less than they earn. What makes frugal people successful?

  • Strong focus. Frugal people overspend only on the things they care about, and even these things are cheap. Taking a hike in the mountains is cheap and healthy. Watching TV all day long, not very healthy but very cheap.
  • Minimalistic mindset. We do not need many things to be happy. In fact, we do not need most of the things we have. Frugal people take pride in having few material possessions and not needing more.
  • Reducing the level of comfort. When frugal people travel, they can stay in budget countries in budget hotels. They use public transportation rather than their cars. Their furniture is old and looks cheap. They do not have the latest gadgets. They simply care less about these things.
  • Strong community links. Frugal people often love to spend time with each other since they share similar values. Frugal people often form communities that focus on certain spiritual or social needs. For example, certain deeply religious Jews form closed communities that focus on Torah rather than anything else.
  • Zero waste policy. Something that cannot work in its current form, can become a part of something new. If some vegetables do not look good, they go into a soup or a stew. When fruits go bad, they can go into a jam.
  • DIY mindset. If you need anything, the required components can be pretty cheap. For example, the Queen guitarist Brian May made his guitar literally from garbage and the guitar still serves him. Many hardware projects start literally from garbage and people with high IQ and no money.
  • Appreciating learning and skills above other things. Being self-sufficient often requires a lot of knowledge and creativity. It is very hard to know everything, but if you are good at learning, everything else will come. A skillful person can do a lot from very little.

I guess that without having this skillset, a person would not be happy with frugality. Personally, I used to be frugal in my 20s before I got married. My wife used to be frugal before she decided that all of our kids need a lot of extracurricular activities. People who come from poor immigrant families tend to be prudent in their core, but then something breaks and the behavior changes.

Social status and perceived success

Prudent people typically do not earn a lot and are focused on a specific goal. If this goal is spiritual, they can probably stay prudent forever. When the goal is more tangible, there is a certain chance of actually reaching the goal. Then a different set of skills kicks it.

“I deserve this” mentality is a way some prudent people justify their success. They spend money on things that make them feel good because now they have enough money for them. All those things they deemed not important when they used to be poor, suddenly become important. They spend money on how they look and on what they eat, where they live and what kind of car they drive. Basically they lose focus and start spending money on comfort.

“We are as good as our friends” mindset means spending money on appearances. Some give irrationally large tips and presents. Others buy incredibly expensive brands. The social circle also changes to people who have more and are not afraid to show off. These people tend to have deeper pockets and to earn better, so these social connections may result in higher earnings.

“Having the best tools for the job”. This is what started the post. While prudent people focus on skills and learning, the more successful people often invest in better tools that make their job easier. This does not always result in earning more. For example, a guitar top can be made from different kinds of maple. Some kinds of maple look better and are significantly more expensive, but the more expensive guitar does not sound a lot different. Beyond a certain point, investment in better tools is not cost-efficient. These tools are cool and that’s why we want them.

“We live only once” or “our kids must have the best of everything”. People who win lotteries or get more money than they can imagine, often spend their money on unique experiences or luxury goods without proper justifications. Quite often this comes as compensation for years of financial suffering. For example, my wife feels she did not see enough of the world, so she always wants to spend our money on traveling. Since these spendings are not really justified, they are also the easiest to eliminate.

Getting into debt

People who get into debt often assume they invest the money wisely. There are several common scenarios for smart people getting into financial debt. For example:

  • Buying things associated with comfort, fun, status, and experiences expecting a certain level of income in the fluctuating markets.
  • Optimizing credit scores and seasonal deals, borrowing money from other resources.
  • Emotional and impulsive spendings, e.g. shopping to feel good.
  • Spending money on a liability. E.g. if you buy a house, a car or a horse you pay a certain amount upfront, but monthly upkeep is much higher.
  • Inability to fire people or discontinue services we cannot afford.
  • Speculations. Buying something low expecting it to go up. Especially with real estates.
  • Multiplying sunken costs, e.g. investing more and more after losing some. For example, if we get something very cheap or free but invest our time, it is reasonable to expect that we will invest money next.
  • Going into a new business or investment channel with high hopes and little experience.
  • Investing in productivity tools when productivity has little effect on sales. Alternatively, investing in marketing without tools to judge the return on investment.
  • Taking loans to finance activities backed up by contracts that are not respected by the end clients.

    How does it feel to be in debt?

    Well, it is not a good feeling. Most people will do almost everything to get out of this situation.

  • Every month a lot of stress goes to balancing the accounts until the next paycheck
  • The interest rates on the debt are often so high that they may at up a huge part of earnings.
  • There is a constant feeling of failure as the debt stands between you and your dream.
  • The brain does not process the situation. It does not seem real that the harder we work the deeper is the hole we dig in our pocket.
  • Eventually, our net worth gets negative and some very important changes need to be done. Often we lose something we built for years.

Getting out of debt

Budget crunch does not build lasting good money habits. If we delay certain purchases until the time is right, we are likely to make them once we are out of debt. Furthermore, we can lose a lot of money simply reducing our debt. If we buy a house, a car or guitar during the times of plenty, and try to sell it during the less favorable time we are almost guaranteed to lose money. When the good times return we are likely to through more money trying to regain the lost possessions.

It makes sense during the times of plenty invest in resource-saving things: more efficient light and energy sources, hybrid cars, closing expensive loans, reducing alcohol and nicotine consumption and so on. When getting out of debt we usually cut the things we want but do not need: restaurants and concerts, extracurricular activities for our kids. We often cut the stuff we do need like quality food, physical activity, and sleep which is not so good.

It would be ideal to work on the skills contributing to frugal behavior: financial management, strong focus, self-sufficiency, values that are spiritual or social. Unfortunately, very few people see in financial crisis a wake-up call and an opportunity for self-improvement. We are often too busy caring for immediate threats and feeling pity for ourselves.

Aggregated investment

Ideally, we want to spend much less money than we make. It is relatively easy to spend less before we have children or after the children leave the house.  Life is not easy. We take our biggest loans before having children, and our earning potential is ofter reduced soon after the kids leave the house. The main idea of getting rich slowly is building up some aggregated investment as we get older. Possibly this means being frugal at the beginning of our career, focusing on high earnings at the peak of our career, and using the investments wisely afterward. This also means reducing the costs of living each time we can.

The whole issue is discipline. If we have a rare opportunity to take a vacation, can we pass on it? When a member of the family is sick, what are the chances we will not spend our money to cure him?

The cost of opportunity

Each opportunity we have comes with a cost. Since this article started with the example of guitars, I will stick to it. My children are in a jazz band, a rock band, and in the conservatorium. Currently, only two boys are playing, with me and my daughter planning to join. Since each music style favors a different kind of strings and every guitar can lose a string and require repairs, this means we need 3 sets of 3 guitars. To widen their education, my firstborn also plays piano/keyboard and my second son plays bass guitar/contrabass. This is a lot of equipment and a lot of training.  Fortunately, a huge part of training is free of charge and my children are very good kids.

Ideally, we would like to focus on something specific and put more resources into it, but the kids do not show overwhelming success or failure. Three different channels mean three kinds of experiences and three kinds of different opportunities. We wait for something to happen and make the choice for us.

We all have a fear of missing out and a fear of passing on a better opportunity. These fears cost us money and focus, but no matter which path we choose we might regret it.

What can be done?

It is easy to say that every expenditure and investment move needs to be planned well before we make our moves. We can definitely try and teach our kids this way.  I have recorded a course about it (currently in video editing), so I will not go into details. The reality is more complex.

The reality strikes again

Suppose we are focused and prudent. Does it mean that our spouses and other family members share our values? We need to negotiate and synchronize family budget and family goals which is hard.

Each family member may snap and buy something unexpected. The spouse worked extra hours and there is no dinner in the fridge, so the family goes to a restaurant. Some friends arrived from a distant location or some distant family had a wedding and we need to spend some money we did not intend. A family member becomes obsessed with a certain item, let us call it a toy, and will not sleep or do his duties before he puts his hands on the toy… Or even worse, there is a sickness or a traffic accident. Once one family member snaps, the others may snap to in a sort of financial chain reaction.

Good planning tries to factor in these unexpected issues by building buffers, but these buffers can fail. I go back to the beginning of the article: if three Nobel prize winners lost a couple of billions on stock market derivatives, we are much more likely to miscalculate our family budget.

Is there a bottom line?

No, not really. It is better to be calculated and focused, earn more and spend less. This is a constant struggle for everybody. All I can say: bring every tool and weapon you can get and do not give up no matter what.

 

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