Sunday, March 7, 2010

Financial Illiteracy

This week's article has been written by my friend Jason Kelly. He is an intelligent, kind, and thoughtful human being who is well-versed in personal finance. He is the author of a great series of personal finance books called the Neatest Little... series. A list of his books (with Amazon links) are listed at the end of this article. His newest book is Financially Stupid People Are Everywhere: Don't Be One Of Them. It should be out very soon, so click on the name of the book and pre-order it. Not only are the books practical and easy to read, each one of them costs less than $15! The best bang-for-the-buck financial books anywhere.

Jason also has a great financial web site for the rest of us. He explains what is happening in the market each week, gives ideas for personal investing, and has a free financial planning newsletter. For a few dollars a month ($5.48 to be exact) you can get his invaluable weekly Kelly Letter. The purpose of this weekly email is...

To provide readers with clear investment guidance that maintains a long-term, steady growth path with the majority of the portfolio while taking advantage of medium-term trading opportunities with a minority of the portfolio.
Here's Jason:

Terry invited me to contribute the financial installment of his series on illiteracy. I've written about personal finance and investing for more than 15 years, so the angles I could take on this are numerous. The cloud of questions I've received over the years rose in my mind, with their attendant subjects: credit cards, bank rates, automobile financing, college tuition, budgets, mortgages, and so on.

You know what, though? That cloud itself is the problem. There's no lack of information, there's an overwhelming swirl of information. It's the endless details that make people think they can't possibly get their arms around this subject called finance. In that confusion lies opportunity for the shysters, which is why financial education will never take top priority in America. Ignorance is bliss — for those in the know. The ignorant themselves are fleeced.

Luckily, there's not a lot to the basics of finance.
I can tell you right here, right now the one rule that, if followed, will keep you out of financial trouble for the rest of your life. That's right: one rule. This is a blog about living free from worry, so we should aim for a simple rule that gets rid of a top source of worry in people's lives. Are you ready? Here's what I call The First Rule of Finance:

Spend less than 80 percent of your take-home pay.

That's it. Now, stop shaking your head and pooh-poohing this notion as overly simplistic, and consider how many of the common financial problems it solves. If you spend less than 80 percent of your take-home pay, you will never:
  • Pay too much for an automobile
  • Run up debt on credit cards
  • Collect more than one or two credit cards
  • Fall behind in household bills
  • Suffer buyer's remorse from impulsive spending
  • Commit to a mortgage payment you can't afford
  • Panic if you lose your job
The list is longer than that, actually, but you get the point. When you spend less than you earn, you save. When saving becomes a habit, your continued existence makes you financially better-off as time goes by. You'll be richer next month than you are this month, and you're richer this month than you were last month. It's easy to feel good about your finances when your net worth grows as long as you keep breathing.

Too many Americans, however, go in the opposite direction. They spend more than they earn, so each passing month finds them worse off than they were the month before. Time hurts them, because they're on the road to ruin. Steps ahead don't represent progress, they represent a countdown to collapse.

That's not hyperbole. Look at the subprime mortgage crisis. Sure, banks pulled a fast one on borrowers by offering loans with low payments up front and bigger ones later, zero-down deals, no-doc "liar's loans," and other such goofiness, but none of it would have hurt anybody if the population operated on the principle of spending less than they earn. They would have looked at the mortgage payment schedules, looked at their household spending, seen whether they could handle the payments, and made a decision. Instead, they just jumped in. Well, we've seen what happens when a whole population leaps before they look into murky financial waters. The economy swirls down the toilet.

Yet, I'll bet a good portion of people who find themselves unable to keep up with their credit card payments and mortgage schedule spent a lot of time finding the highest-interest-paying checking account in town, the best deal on frequent-flyer miles, and which gas station sells the cheapest gas (by a penny or two). Such tiny benefits against a backdrop of basic blow-ups are meaningless.
There's nothing wrong with choosing the best bank account, joining the best consumer programs, and saving money on gasoline, of course. Those are all good ideas, but they don't work unless they're part of a bigger strategy. The financially illiterate are tricked into thinking that "managing money" is a complex, multi-staged endeavor. Not really. It starts with spending no more than $8 of every $10 you earn.

There's more beyond that, but not much, and the returns on effort drop quickly. That first step, that first rule, is by far the most critical one. It alone is more important to your financial well-being, and certainly your financial peace-of-mind, than any sophisticated-looking credit card or surefire stock tip or consumer rewards program.

Notice that it's precisely the first rule that's most viciously attacked by corporate advertising and bank programs. That's no coincidence. They know that if they can get you in the habit of overspending, they can get you to open wide for all the other lures they've worked up over the years. Before you know it, you'll be chain-borrowing on cars that cost too much, buying everything you see advertised by using more credit on more cards, and signing on to mortgage loans that are sure to enslave you. Get the first step wrong, and that's the path in front of you. Get the first step right, and none of the other gimmicks will hook you.

Let's keep this easy. Financial literacy doesn't require lengthy explanations. It doesn't even require difficult math. All it really requires is knowing how to stop spending at 80 percent of your take-home pay.

Do that and you'll be a financial genius.

Thank you, Jason. If you want to stop being financially illiterate, you can check out each of his books by clicking on the link for each.
And don't forget to check out his forthcoming book mentioned above.
This finishes my series on illiteracy. I hope you have enjoyed it. Any comments you want to make about Jason's article will be forwarded to him promptly.

No comments: