Money Listens

When I took Dave Ramsey’s Financial Peace Class he had one lesson on investments.  He was careful to explain that he was not an investment expert.  Most of his advice concerned saving regularly and putting money away in IRAs and 401(k)s.  But several times he said that his investments in “good quality growth mutual funds” were returning 15% annually, and you, too, should expect that.  Probably at the time he wrote that lesson, which was during a very good stock market run, he was getting those returns.

Today, he might admit to being a victim of what’s called recency bias.  That means you look into your crystal ball and see recent events continuing into the future.  The most recent events carry more weight than those in the more distant past.

This happened to me in one of my first jobs.  I had a very good month; a difficult project finally came together, and my numbers were really high.  My annual performance review was the next week and I was expecting a great review.  But my manager didn’t just focus on the last month.  The 11 months before that weren’t so good, and the one good month probably kept me from being fired.  Recency bias caused me to be overconfident.  The next year I learned about another force called reversion to the mean.  An extreme event is temporary and the next event is likely to be closer to the average performance.  My extremely good month was followed by several more mediocre ones.  I didn’t last much longer in that job.

Reversion to the mean also explains why Manu Ginobili can have a very poor performance in one game and his teammates are confident he will have a very good game the next day.  If his average is 19 points per game, and he only scores 6 one night, he likely will revert to the mean and score 19 the next night.

What does this have to do with your investments?  It means that you can use the long-term averages for different types of investments to forecast the return of your particular portfolio.  If you have a diversified portfolio of  U.S. stocks, international stocks, and bonds, you can estimate the return for each category. You won’t be susceptible to recency bias and assume that a particular investment will always be going up (or going down.)  You won’t sell your bonds and buy foreign stocks if the internationals have an up year. And you’ll realize that if one part of your portfolio has done extremely poorly, it will probably revert to the mean and perform as expected the next few years.   And after what we’ve experienced so far this year, any reversion to the mean will be welcome.

This is the last post about elephants. Probably. I’ve been writing about Dave Ramsey’s tips for saving money on big purchases. You get to decide what’s “big.” In my mind, big is anything over $100.00. For you it might be more or less than that. In case you’ve forgotten, here they are:

1. Wait before making a purchase.
2. Consider your motive for buying.
3. Never buy anything you do not understand.
4. Consider the opportunity cost of your money.
5. Seek counsel before buying.

Today we finish up the list with number 5: seek counsel. If you’re married, this is very, very, very important. Ask your wife/hubby for an opinion. This list isn’t in a particular order. Asking your spouse might be the first or second thing you do. If you’re not married, and respect your parents’ opinion, you might seek their counsel. Maybe they never told you they had an elephant once, and it turned out to be a disaster. Or, if you’re older, and you did a good job raising level-headed children who are now grown, ask for their opinion. But be ready for the mid-life crisis lecture. “What! At your age! Why in the world do you want an elephant? Don’t you know how dangerous they are.”

Your wife/husband’s is the opinion that really matters, because they have to live with your purchase, too. “Honey, we just put in all that landscaping. And did you forget the kids are allergic to peanuts?” If your spouse wants to put on the brakes– slow down. If you ask for their opinion, be willing to listen and hear them out. Hopefully, what you’ll hear is, “That’s a great idea, I’ve always wanted an elephant. How about we get two?”

No doubt about it, except for your home and car, an elephant is the largest purchase you can make. We’re talking big money here. Anytime you contemplate making a major purchase you should consider the opportunity cost of your money. The opportunity cost is the loss of some other thing you could have had with that money.

We make decisions everyday involving opportunity cost. It doesn’t apply only to elephants. Anytime we sacrifice one activity in favor of another, we lose the benefit of one. On Saturday morning you can work out in the gym, or go visit a friend. Both are good choices, but you can only choose one. You lose the opportunity to do the other.

Same with our money. If you chose to buy something, you won’t have that money available any more. Before you make a major purchase, you should consider what else you could do with that money. Would something else be more beneficial to you? You’ve really wanted an elephant, but would that money be better used in your retirement fund? Or, you could put in a hot tub and go on a nice vacation. It’s a trade-off. We have a limited amount of money and must chose how we spend it.

An overall financial plan helps you evaluate opportunity costs. Let’s say you’ve paid off your credit cards, have an emergency fund, and are saving 15% for retirement. The next item on your plan, your next goal, is to save for your kids college. How important is an elephant vs. a college fund?

It’s a trade-off, but it’s your choice. There’s no right or wrong answer, but don’t fool yourself; consider what you’re giving up by buying that elephant.

So, you want to buy an elephant. You’ve already followed the first two suggestions to make sure it’s a good decision. First, you’ve waited. You’ve been wanting an elephant for a really long time. Last month you visited all the elephant dealers in town and found just the one for you. You’ve also done research on the Internet and have a good idea of how much you should pay. You wrote down “Elephant” on your wish list, and dropped hints like crazy, but nobody bought one for your Birthday.

You also followed suggestion #2 and examined your motives for wanting an elephant. An elephant is unlike anything you now own, and you can’t borrow one. It is versatile, and useful. You’re not buying one because it’s the “in” thing, or because of the little logo on the front, or because the kids have been begging for one.

You think you’re ready to buy. You have the cash in your savings account.

But how much do you really know about elephants? Do you understand everything about them? Sure, you know the latest model numbers and accessories. Do you know what it takes to maintain one? How often do they need servicing? How long will it take to learn how to use it? Are you good with large mammals? Where will you put it? Do you have the time and energy to take care of another thing? Or will it just hang around the garage?

Don’t buy anything that you don’t fully understand. If you don’t know how to work all the bells and whistles, maybe you need something less elaborate (like a hedgehog.) If you don’t understand how it compares to other similar items, don’t buy it. This goes for complicated items like insurance policies, investments, and funeral plans, and for simple items, like elephants.

Why do you want to buy an elephant?

Because everyone has one. I’ll really be cool if I have one. Those families on TV riding together on an elephant look so happy. I know I’ll look good on one. Because my kids have always wanted one. I need it for working in the yard. It’s on sale today. My old one doesn’t have an iPod jack.

Are there any hidden motives behind your purchase? See if you’ve been influenced by an advertisement, or a desire to keep up with the Jones’. Will an elephant make you feel good?

Some questions to ask yourself before buying something new are:

1. Is my old one still working fine?
2. Do I own anything else that will do the job?
3. Can I borrow one?
4. I this something that I am going to use often?
5. Can I wait a little longer before buying this?

You’ve just saved yourself some money. And you’ve probably realized you have a hidden motive for wanting the new item. The one that always gets me is about the kids. I’m more likely to spend money if it’s for someone else. I want to make them happy. But I know more stuff isn’t the way to do it. Stuff (even elephants) won’t make me happy. And buying things for the wrong motive won’t get me to financial peace any quicker.

The only reason a great many American families don’t own an elephant is that they have never been offered an elephant for a dollar down and easy weekly payments. — Mad Magazine

Maybe you haven’t been tempted to buy an elephant, but I bet there are a lot of other things you’ve bought on impulse. In Financial Peace Dave Ramsey sets out five ways we can develop power over our purchases. There are plenty of salespeople who will tell our money what to buy, if we let them. The five steps will keep us from buying elephants.

1. Wait before making a purchase.
2. Consider your motive for buying.
3. Never buy anything you do not understand.
4. Consider the opportunity cost of your money.
5. Seek counsel before buying.

Number one can save a lot of money. Just wait before making a purchase. How long? Dave says at least overnight. I’m going to say a week, but a month is even better. Say you’re online ready to buy, or in line with the item already in your shopping cart. Don’t buy it. Instead, write it down somewhere, perhaps where you keep your spending plan/budget. Title it “Things I’m Considering Buying.” I keep my list in my Palm.

After waiting, if you really need/want it and it works with the budget, go ahead and get it. With cash, of course. If you’re like most people, after the impulse wears off you decide you don’t really need it. After a few weeks, you’ll find you’ve acquired a tidy wish list of things you can live without. (Or maybe it’ll only take a few hours for you shopaholics.) Now you have a great list of suggestions for gifts. Post the list on your fridge before your Birthday.

Don’t go overboard on this, I’m not talking about groceries or those things you’ve already considered and planned to buy. I’m talking about those impulse purchases that seem like such a good idea at the time. Things like going to Academy for a fishing license and coming out with an Avet Pro 30 Wide tournament class reel. Or getting your sister’s favorite perfume for her birthday and coming out of the mall with Ralph Lauren 400 thread-count sheets. From now on, don’t buy anything without waiting first.

Remember spring break growing up? Do you have any snapshots from the beach or lake? When I look at those black and white pictures with the fluted edges (yes, now you know how old I am), I can see back in time. When you take a Financial Snapshot it does the same thing. You are preserving a moment in time so you can look back and remember how things were. You can also see how you’ve grown.

The balance sheet of a company is often referred to as a Financial Snapshot. Rather than showing money and inventory flows, it captures a summary of what’s important. Families and individuals can create one, too, it’s not just for business. A Financial Snapshot is a helpful tool to monitor how well you are progressing toward your financial goals. Dave Ramsey’s Financial Snapshot Form mainly asks yes or no questions, with just a few questions about amounts of money. Here are Dave’s questions:

Do you have a working budget?

Do you pay necessities first?

Have you cut up your credit cards?

Are you living on the envelope system? How many envelopes?

Do you have a baby emergency fund?

How much have you saved during the class?

Are you giving to worthy causes?

Are you using the buddy system?

Are your debts paid?

How much have you paid off during the class?

Do you have a fully funded emergency fund?

How many months of expenses have you saved?

Are you saving for major purchases?

What types of major purchases?

Are you funding your pre-tax savings options?

Did you start saving for college?

Are you paying extra on mortgages?

Are you walking in financial peace?

It’s up to you to decide how often to take a snapshot of your finances. It should be at least monthly, perhaps every 2 or 3 weeks if you are actively seeking to reduce debt and/or save. If some of these questions don’t apply to your situation, for example, you don’t have kids so you don’t need to be funding college, substitute your own questions. Did I balance my checkbook since I received my last statement? Did I accomplish any of my short-term goals?

Each time, compare the snapshot with the last form. Ask yourself, “Am I making progress? Could I go a little faster?” The first time I did this, it was pretty depressing. Some months it can seem like slow going, but it is an excellent accountability tool. Now I can look back and remember what it was like before I had a budget and a plan for my money. Go ahead and complete your Financial Snapshot—are you still smiling?

The Financial Snapshot form can be found in the Financial Peace University Workbook or online from the Member Resource Center at http://www.daveramsey.com/fpumember