FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
Thinking About Money
This work is licensed under an Open Educational Resource-Quality Master Source (OER-QMS) License.
For a lot of people, money isn’t something you think about. You just spend it when you have to (such as paying bills) or when you want to (such as going to a movie). When you run out, you try to make some more as soon as possible. Most of us simply don’t think about money beyond the fact that it’s great and we want more of it. Perhaps the most important secret to building wealth is understanding your money. One of the biggest mysteries for most of us is where our money goes.
Mr. Buffett’s Philosophy
Just by looking at the ideas in this book, you may be under the mistaken impression that I am wise in the ways of finance. That couldn’t be further from the truth! Most of the ideas I put in this book came from a small group of brilliant investors that took the time to write down how they did it so that we too can prosper. Among these, Warren Buffett is perhaps the best-known name. Mr. Buffett wasn’t born to poverty, but he wasn’t filthy rich like he is today. He is regarded by many as the world’s greatest investor, and today he is worth many billions of dollars (yes, that is a “b”).
Many people find it peculiar that he hasn’t changed his lifestyle very much from the time before he was a billionaire. He is legendarily frugal. He doesn’t drive a luxury car, and resides in a modest home in Omaha, Nebraska, that he bought in 1958 for $31,500. He may be worth billions on paper, but he chooses to live on a salary (that he set!) of $100,000 per year. He likes to watch sports on TV and eat junk food. He, in other words, is a real human being like us. I think that’s why I admire him so much.
That dedication to frugality is not merely an eccentricity of a billionaire genius. It is the very foundation of his wealth. Mr. Buffett, you see, is a value investor. When people ask Mr. Buffett the secret to becoming a great investor, he is fond of saying, “The first rule of investing is don’t lose money; the second rule is don’t forget Rule Number 1.” The basic foundation of his philosophy is that money should be put to work and not wasted on pointless luxury. In his business and personal life, Mr. Buffett is always looking for authentic value.
When a CNBC reporter asked him about his financial advice for young people, his advice was to “stay away from credit cards.” Paying interest on credit cards not only suggests that you are living beyond your means, but it also means that you are losing money. Both of these bad habits run contrary to Mr. Buffett’s philosophy. Mr. Buffett is free from the stress and worry of keeping up with the Joneses; he would likely dismiss the idea, noting that the Joneses are broke. Mr. Buffett is not alone in being critical of debt. Most of the Forbes 400 (a list of the richest 400 people in America, compiled by Forbes magazine) would tell you the same thing. If you think rich people often use debt as a tool, you have been misled by fancy credit card commercials. Most wealthy individuals will tell you that the best way to get wealthy and stay wealthy is to avoid debt like the plague. The more you can avoid making payments to anyone for anything, the quicker you can amass real wealth.
How much of what we desire in life is “conspicuous consumption?” Conspicuous consumption is a phrase that academic types use to refer to buying goods and services just to demonstrate that you can indeed afford such things. Some evolutionary psychologists would tell us that such “status seeking” behavior is hardwired into our brains. If that is so, you have to have the force of will to overcome your nature. If you are a helping professional, the only way to become wealthy is to abstain from the trappings of wealth.
You can either appear to be wealthy or actually become wealthy, but you can’t do both on a helping professional’s salary. This doesn’t sound quite right does it? That’s because almost nobody does it this way. Like Mr. Buffett, you have to dare to be different and go your own way. The average Joe has $5000 invested and drives a $40,000 car. If you try to be average, you’ll be broke (which is, after all, the typical American today). You want to be the frugal investor with $40,000 invested and driving a $5,000 car.
Why does Mr. Buffet choose to live on a mere $100,000 given his enormous wealth? His philosophy dictates that you should reinvest your profits. I’ll talk about the miracle of compounding interest in a later section. But let’s get the gist of an idea from a little riddle. You ask me to hire you for a month’s work. I offer to pay you $500 daily in cash, or I’ll give you a penny for the first day and double your pay every day for the month and pay you as a lump sum on day 30. Which do you choose? If you are like me, the first time I heard that scenario I said: “I’d take the $500 per day for sure!” If you do the math on the penny on day 1 and double it every day, you earn $10,737,418.23 for the month.
Think Longer Term
Poets and philosophers have told us for eons that we should live in the moment–seize the day! Again, the wealthy person applies the Greek idea of the Golden Mean to balancing past, present, and future. We do not want to dwell exclusively on the past, but we do want to contemplate our past successes and failures and learn from them. We want to take time to live life to the fullest in the present, but we must consider our best interests and the best interests of those we love going forward. As personal finance guru Dave Ramsey tells us in The Total Money Makeover, “IF YOU WILL LIVE LIKE NO ONE ELSE, LATER YOU CAN LIVE LIKE NO ONE ELSE.”
When it comes to the consumption culture of contemporary America, we want cool stuff, and we want it now! When it comes to delayed gratification, we fall short. We, as a nation, are a bunch of red-faced children screaming for what we want RIGHT NOW. As Dave Ramsey points out, mature adults are capable of delayed gratification, and that capability is a sign of maturity. It is the immature child in us that is willing to go into debt to prevent having to wait in order to achieve a better financial outcome.
Short-term thinking is probably the biggest enemy of your plan to build wealth. “Having it right now” is a recipe for financial ruin. Short-term thinking leads you to rationalize the decision to get ripped off by predatory lenders. You must break the cycle of short-term thinking that leads us to a place where we “buy things we don’t need with money we don’t have in order to impress people we don’t like.”
Impulsive & Emotional Spending
Simply put, our rule is to avoid conspicuous consumption. For most of us, conspicuous consumption is all about impulse buying and emotional spending. Impulse buying is a powerful marketing strategy that brick and mortar stores use all the time. Are the items by the checkout line carefully selected for your convenience? Absolutely not. They are a collection of things calculated (by some very smart people) to get you to buy items that you really don’t need or want at an inflated price. Consider what a cold soda in that tiny fridge beside the register costs versus going back to the back of the store and buying a bulk pack of soda. The markup can be in the neighborhood of 500%!
“Winning at money is 80 percent behavior and 20 percent head knowledge.”
The basic premise, then, is that impulse buying and emotional spending are great enemies of wealth. When you do these things, you are failing to Minimize Spending. Some things you can do to prevent impulse buying and emotional spending:
Make a list and stick to it. Force yourself to live by a rule that you will never buy anything that is not on the list. I personally make the exception for things that should have been on the list; if you didn’t put deodorant on your shopping list and realize you need some once you get to the store, please buy some. The types of things you want to avoid are DVDs of the latest movie to be released. I’ve grabbed a movie and tossed it in the cart because I remember thinking it would be cool when I say the trailer months before. It may be cool, but did I really want to own it? Could I have streamed it for a couple of dollars, or rented it from Redbox? I have many, many DVDs that I have only watched one time. If I had all that money back, I could do something really fun with it!
When it comes to food, snacks, and convenience food can be an incredibly bad value. Not long ago, one of my children tossed a bag of jerky into the cart. I didn’t think much of it. When we got to the register and it rang up over $13.00 I thought a lot more about it! I like jerky as much as the next guy, but at that price point, I’ll have to pass!
Don’t choose convenience over value. The corporate managers at Walgreens are some of the most brilliant folks in retail. They often don’t have the best prices, but they have mastered the art of being convenient for their customers. Have you ever wondered why every Walgreens store seems to be in a terrible location that is impossible to get out of? My belief is that this was done intentionally to place the stores close to very busy intersections. The more of us that have to drive right by a store on the way home from work, the more people are likely to stop by a convenient location and buy something at a higher price than if we had just gone out of our way to go to the big box store and waited in line for thirty minutes.
A theme that I’ll repeat throughout this book is that convenience comes at a very high price and almost always represents a terrible value. Think about convenience stores. The word to watch out for is right there in the name! Unless there is some sort of marketing gimmick going on, convenience stores are the absolute worst place to buy anything except for fuel. Buying a beverage and a snack from a convenience store while on a road trip is not frugal, but a trip is a rare event and the convenience may be worth it to you. What I want you to be on the lookout for is habitually poor spending choices. If you stop by the convenience store and buy a Mountain Dew for $1.69 and a snack cake for $1.49 every day on the way to work that comes to $3.18 per day.
This is where not doing the math hurts you! I can imagine many readers saying, “It’s only three dollars you cheapskate! Big Deal.”
Multiply that small sum of $3.18 by five days per week for fifty weeks per year, you get a whopping $795.00 per year. On the other hand, if you buy a $12 pack for $4 ($0.33 each) and a box of snack cakes for $1.20 ($0.24 each) from Walmart, you’ll only spend fifty-seven cents per day, or $142.00 per year. So planning ahead and buying in bulk at the best price can save you $653.00 per year on your morning commute. Of course, if you really want to save money and promote a healthier lifestyle, keep a fruit bowl in the kitchen and buy a reusable, insulated water bottle. This is just one small example of how thoughtless spending can hurt your bottom line. I challenge you to analyze all of your spending and discover just how much money you can save over the course of a year by sacrificing the time it takes to plan your spending and make sure you are receiving value for your money.
Don’t’ borrow from the future. Unfortunately, one of the quickest ways to feel good is to buy something cool, especially if it is a gift that we know the recipient will be excited about it. For example, I am absolutely positive that my wife would just beam if I stopped by the jeweler on the way home and purchased her a diamond necklace. Such excitement and happiness are contagious, and I’m sure I would feel really good about it. Unfortunately, a diamond necklace is not in my budget. If I were to buy something like that, it would have to come out of savings or, worse, be put on a credit card. I would be borrowing from the future to gain a pleasurable experience today. What I must consider in this situation is how I am going to pay for it later. This is the step that compulsive, emotional spenders forget! When that bill comes due and it takes away from other things, it will not seem so great.
Special occasions are special because we have an emotional attachment to them. The pervasive sense of nostalgia that surrounds occasions like Christmas and birthdays can lead to big problems with emotional overspending. Of course, we all want our kids to have wonderful memories of the Holidays and their birthdays! Spending on gifts is fine, but it must be done logically according to a financial plan that makes sense. A heart full of joy, a platinum card, and a Black Friday sale is a disastrous combination!
Be sure to never let “teaser” financing lure you into making a purchase that you do not really need. “Ninety days same as cash” is a common tactic to lure you into expensive purchases. These are never a good idea! The fact is that most people (around 90%) will never pay the debt within the allotted time frame, and the “special offer” terms will revert to regular debt with an exorbitant interest rate.
Once this happens, the interest rate spikes and your monthly payment will barely cover the interest. Interest rates can be as high as 38%! You are then stuck in a cycle of paying minimum payments and letting the principal role over from month to month. The only way to break this cycle is to make lump sum payments that will pay off the principal. You also lose negotiating power when you take the deal. Many retailers will be willing to make concessions when you flash cash, but charge their highest prices when you are using “special financing offers.”
Shop with military precision. If you are a fan of action movies, you have most likely learned that the key to a successful operation is to get in, accomplish the objective, and get out as quickly as possible—no mistakes. My advice is to approach shopping with this same discipline. If you go to a store, have a list, obtain the items on the list, and leave. Don’t allow yourself to get distracted and add stuff to the cart that you didn’t really need or want. Avoid places that are pure distractions, such as—the ultimate wealth killer—shopping malls.
I must confess that Amazon.com has perfected the art of getting me to buy stuff that I really don’t need. The Amazon AI is spooky good at predicting stuff I’d love to have! One click ordering is also responsible for separating me from too much money. Shopping online can be great (especially if your favorite retailer doesn’t charge taxes and has a free shipping program), but it can also be a spontaneous waste of huge amounts of cash. Approach any spending opportunity with military precision and you’ll save many, many dollars over time.
Think of costs in terms of your life. One of the most unpleasant truths that we’ll face in our journey toward building wealth is that we all have to die. It follows from this that time is a finite resource. Some of us get more than others, but, in the end, we all have a limited amount. For most of us, the old adage “time is money” is absolutely true. At least part of the reason we go to work every day is to make money. Making that money takes up a certain number of hours from our lives. Knowing that your position pays $42,000 per year misrepresents the actual cost in terms of lost time.
If you factor in the time that you don’t get paid for (commuting, lunch hours, etc.) and the colossal chunk the government takes, you are really only taking home about $14 per hour. Let’s say the latest greatest cell phone is out and you really want one. It costs around $800. Don’t just ask yourself “is it worth $800?” ask yourself if it is worth 57+ hours of your life. The numbers are really thought provoking with big-ticket items. That $40,000 car sure is exhilarating, but is it really worth 3,570+ hours of your life? That big, beautiful home is awesome, but at $250,000 is it worth 35,700+ hours of your life?
You absolutely must reach the point where you don’t really care what other people think.
Banks go by many different names, but the core of the business is always the same; they take your money, and pay you same rate of interest while they keep it. Whether you realized it or not, they are not just putting it in the vault. They are doing things with it to make a higher rate of interest than what they are paying you. The difference in what they pay to get the money and what they get paid to lend it out is called the spread. Banks make their money on that spread. It’s a pretty sweet gig for the ban, and it is often convenient enough for us that we don’t mind. It is worthy of note that most bank deposits are very safe because they are FDIC insured, which means we tax papers pay the insurance tab for protecting our own money while it is in the bank.
Many of the personal finance tools necessary to run your life in today’s high tech economy are available from your local bank. Back in your Grandpa’s day, you usually picked a bank based on whether you knew the management or not. The services were pretty much the same. In today’s world of corporate conglomerates, it pays to shop around and get the best deal on the services that you desire. This is not limited to the brick and mortar world; online financial institutions often offer competitive rates because they don’t have the overhead that brick and mortar banks often do, and they can pass along those savings to the customer in the form of lower fees and higher interest rates on deposited money. If you can’t get everything you want for free at your local bank, then start shopping around. When it comes to finances, fees are the enemy of wealth, and that idea applies to local banks as much as it does to the stock market.
If you had a bank account growing up, the odds are it was a savings account. The idea of a savings account is pretty simple; you put your money in the account, and the bank pays you interest while you save up to buy something. The interest rate paid to you by the bank is based on the prevailing interest rate, and your savings account will pay a better interest rate than a checking account (if the checking account pays interest at all). The vast majority if interest rates that you both receive and pay are based on the federal funds rate, which is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight. Usually, you take that number and add something to it to get the interest rate that you receive or pay. When the federal funds rate is low, then any interest you earn will be low. At the present time, the federal funds rate is just above zero, and that is about what you can expect a bank checking or savings account to earn.
When interest rates are high and inflation is low (which doesn’t happen very often!), savings accounts are a great deal. You make a good return (profit) on what is essentially a risk-free investment. These days, that is certainly not the case. The only money you want in a bank savings account is money that you may need in a hurry, so the bank is a great place to keep your emergency fund. With the financial world being almost completely electronic these days, you can get fairly quick access to funds stored in a variety of places, several of which will pay better interest than banks. If you have a brokerage account, for example, you can keep a portion of your emergency fund in a money market account and liquidate (sell) those assets and transfer the money from your brokerage account to your bank account in less than a week when you need it. Some brokerage accounts have blurred the line, and now offer checking services and debit cards. The key thing to remember with a brokerage account is that your emergency fund money should be mentally kept in a different “bucket” than your investment money.
Even in today’s high tech world, you need a checking account. Most employers require you to have one so that your paychecks can be direct deposited, and it is often to get cash from online payment services unless you have a checking account into which your funds can be transferred. While living off the grid may sound cool, it is likely t0 cause you problems if you take it to the extreme of not using the banking system. It is difficult to buy or rent a car, buy or rent a house, or do pretty much anything else that requires a credit check if you do not have a checking and savings account.
When it comes to checking accounts, not all banks are created equal. Some banks have a lot of fees and limited services, and some banks have no fess and many services. My bank gives me free checking, free ATM access, free transfers between checking and savings, fraud protection for my Visa debit card, and several other perks merely because my paychecks are direct deposited into that account. Often college students can get the same perks just by virtue of being a student; banks and software companies want to groom you while you are young so that you use their services when you start making a regular paycheck.
Traditionally, the cheapest way to do banking was often a credit union. Credit unions work pretty much the same as banks, except that they are owned by the depositors—called members—and not a corporate conglomerate. When it comes to punitive fees—such as overdraft fees—credit unions really shine. These days, you may still get the best deal with your local credit union, but you may find commercial opportunities that meet your needs better.
In these days of internet banking, it is very easy to neglect the health of your checking account and balance it by “eyeball” based on check your bank’s app every couple of days. This works fine for most students and young people in general, but when you become a bona fide professional and take on “adult” responsibility, you will have a constant stream of rather large obligations coming out of your checking account every month. These may take days or weeks to process (although that time shrinks dramatically every year it seems), and you are likely to get into trouble if you don’t actually balance the books. If you use Dave Ramsey’s envelope system that we will discuss in a later section, it makes it much easier to keep your checking account balanced and in good order. If you mess up and forget about an outstanding obligation, your bank may refuse to pay the item. If that happens (your check “bounces”), you will have to settle the debt with whoever you wrote the check to, and they will usually charge you a large fee. If the bank covers the debt for you and lets you repay them with your next deposit, they will usually charge you a fairly large fee for the service. Many very small debit card transactions can cost you hundreds of dollars if your mental accounting is incorrect.
Today, almost everyone has an ATM card, which is more commonly called a “debit card” these days. If you have a debit card that is on one of the major financial networks, such as Visa, you can use your debit card as a credit card and the money comes out of your checking account rather than becoming debt. If you are serious about becoming wealthy and swearing off debt, you can go the rest of your life without a credit card. Nearly everything you would need a credit card for can be taken care of using a Visa debit card. ATM cards that you can use at every convenience store on the planet are a double-edged sword.
ATM cards make it convenient to make purchases, but they also make it convenient to make purchases. If you want to grow wealthy, you have to control your spending and spend only what you have budgeted. If you “swipe and go” 4 times per day and have no idea how much you are spending, then you are shooting yourself in the foot when it comes to building wealth. Studies have shown that consumers spend more money when they use a card than when they use cash, and the type of business doesn’t make much difference. Most of us are better off giving ourselves an “allowance” of cash and not spending more than our allowance.
References and Further Reading
Trent Hamm provides a thought-provoking set of articles entitled “31 Days to Fix Your Finances” on http://www.thesimpledollar.com/31-days-to-fix-your-finances/