Personal Finance: 2
The Science & Art of Personal Finance
Success in Personal Finance requires doing a number of smart things and avoiding big mistakes. Proverbs tells us "The blessing of the Lord brings wealth . . . " (10:22) and warns ". . . give me neither poverty nor riches . . . otherwise I may have too much and disown you . . ." (30:8).
We are not going to talk about getting rich, for it probably contains more dangers than blessings, but we are going to explore the process of good money management, how to do smart things and avoid the big mistakes.
To do your own personal financial planning–successfully–you need goals, knowledge and discipline. In the next article we learn how to establish specific goals. Throughout all the articles we hope to reveal biblical principles and financial factors that will motivate you to exercise the requisite degrees of discipline. We start the knowledge part with an understanding of the dynamics of personal financial planning. What is science and what is art? We will build on this knowledge in each article.
Dynamics of Finance
Risk, Return, and Time are the variables that, when in appropriate balance, give us the level of return we need to accomplish our goals.
We tend to start with return, but we should start with risk, the most subjective of the three variables. You should consider risk when evaluating various rates of return over specific periods. Institutions compensate you for taking risk with either guaranteed returns (interest on term investments) or the potential for return (ownership of equities such as stock and stock mutual funds). You earn return by taking risk and they should go up together. You can envision the risk/return relationship like this.
The 90 day U.S. Treasury Bill is the world’s definition of zero risk. The holding period is too short to have a liquidity risk and nothing in the financial world is more secure than a U.S. Treasury Bill. Liquidity is the ability to sell or liquidate a holding so liquidity risk is what you take when you give up that ability for a period of time. The other end of the risk spectrum is more difficult to establish.
Suffice it to say, there are many examples of investments that offer huge potential returns and even greater risk. We will eliminate the extremes and consider the type of returns that, over time, can be expected to offer a reasonable return for a risk that lets you sleep and will not threaten your financial security. We will look at these in articles 4 & 5, "Phases of Planning and Portfolio Theory" and "Investing and Markets."
For now, let me say that risk exists at three levels. First, you fail to achieve the return you planned on to reach an objective. Usually, you have to save/invest more. Second you lose part of your principal and have to modify several elements of your plan: save more, delay or downsize objectives. Finally, you lose so much that family security is jeopardized. You probably have to change objectives and significantly modify lifestyles. Few, if any, objectives justify risking family security, unless you hear it clearly from our Lord.
Time is the third variable to be balanced with risk and return. With term investments, you lock up money in investments (like certificates of deposit) that either reward you with regular competitive returns or penalize you if interest rates rise and you are stuck with what has become a non-competitive rate of return.
We call this liquidity and because you give it up on a five-year CD, institutions pay more to compensate for this risk. Still, you have taken another kind of risk, an opportunity cost that your money invested elsewhere might have returned more. We will look at balancing these factors in the next three articles.
Time can also reduce risk in the case of mutual fund or stock holding. The volatility of the markets can cause losses over relatively short (one to three year) periods, but during none of the thirty-one ten-year periods, 1960-99, has the market (as measured by the S&P 500) had a negative period. Only two of thirty-six five-year periods have shown losses (1960-69 is a ten-year period. 1961-70 is a second and so on).
In fact, time, combined with interest, presents us with both the best and the worst scenarios. It can work for you, producing spectacular results on your investments, or against you, costing you dearly on your debt. First the bad news.
Three quick points, then three typical scenarios. Borrowing allows us to buy things we may not be able to afford. Paying to use money (i.e. interest) makes those items even more unaffordable. Mismanagement of credit is the number one financial trap hurting the American family. The average American family ended 2000 with seven credit cards in their pocket and $7,500 in consumer (credit card) debt.
The first scenario is the "monthly balance interest method" where a credit card holder pays off part of the balance and lets the remaining balance accrue with interest. Rates are high, making things cost significantly more, but if you don’t add charges and work to pay off the balance, it is a minor mistake from which you can escape.
The second is a variation where you pay off part of the balance each month, but keep charging and adding to the balance. If you add $200 a month to a $1000 balance on a typical eighteen percent credit card and make payments of $99.58 per month, you will pay $195 on the original $1000 and $214.50 a year on the monthly additions.
This is a slippery slope, but if you control the additions and make regular payments, you can escape with a moderately expensive, but not disastrous lesson.
The third scenario is where someone already mired in debt makes only the minimum payment on the monthly bill. With a typical card charging eighteen percent and paying the minimum payment, an example balance of $1000 will take you 190 months (15.8 years) to pay off. You will have paid $1,483.41 in interest or 1.48 times as much as the debt, and certainly you won’t remember what it was you bought for $2,483.41 to start with. Some cards that compute the minimum as less than 2.2 percent and charge over eighteen percent can push the interest payment to over twice the principle.
Three things are very clear. The credit card companies are making huge profits, the card holder is paying them, and the companies count on the debtors lacking the discipline or brains to figure it out.
I can’t find any place where the Bible prohibits debt, but it has many warnings (Prov. 22:7, Ps. 37:21, Rom. 13:8, Matt. 18:32-35) about the dangers of debt and the requirement to be honorable with it. The dollar cost is terrible, but worse is the heartache and disruption to families and relationships caused by debt. There is no way to measure this cost, but the waste of money on interest is only part of that cost. Periods spent in debt also prevent you from taking advantage of having interest work for you over time. "In the house of the wise are stores of choice food and oil, but a foolish man devours all he has" (Prov. 21:20). Now for the good news (smart things).
Time Value of Money (TVM)
One of the most critical "smart things" is one of the most under-appreciated. We all understand basic compounding of interest, but few fully grasp the awesome power of regular compounding over extended periods of time. Let's look at a couple of examples:
A 20 year old puts $50 a month away for a 45-year period. At age 65 he has saved $27,000. If the payments had been drawing eight percent it would then be worth $263,726. That is a nice sum, but if he then withdrew $1,873 per month from that amount it would continue to pay out until age 100 and would have paid out a total of $786,719.
Fifty dollars a month isn’t much, but the 45 years sure are. Of course if this worker increased the monthly payment over time, the retirement fund could be well over a million dollars. Unfortunately, a more normal pattern is to do nothing for many years then try to make up for the time with larger contributions.
At age 25 investors A and B consider investing in an IRA. Investor A puts in $1000 a year for 10 years then increases it to $2000. Investor B waits until age 35 when he can put away the entire $2000 per year. At age 65: A has invested $68000 and at 8% it is worth $370,334. B has invested $58000 and at 8% it is worth $224,566.
The $10K difference and the ten year head start makes a difference of $145,768 at age 65, and still more in payout and lifestyle over their projected lives.
Have you ever seen the popular chart "Cheapest Way to Make a Million"? Look at the dynamic of time at work at ten percent within an IRA. Now consider that any young person smart enough to earn and invest at age fourteen, would probably continue saving and have $3 million at age 65 or have the option for early retirement whenever he pleases. That option is the real value of this example. It doesn’t seem fair, but as Proverbs tells us, "Listen to advice and accept instruction, and in the end you will be wise" (Prov. 19:20).
While the numbers can amaze, the computations can tell us a lot more. A TVM calculator lets you project returns into the future, determine what you have to save at what rate of return to reach a future goal, or to work back from a future goal to determine a present value that will grow to the desired future amount. There are five variables and with any four, you can find the fifth.
These calculators do much more than solve problems; they give you a wide range of specific "what ifs" for planning. TVM is a remarkable dynamic and the calculators give you a window into its workings. Most of you have access to one within programs such as Quicken or Excel. Handheld calculators are available from Hewlett Packard (10B) or Texas Instruments (BAII Plus) for about $28 or in various forms at most financial websites.
Knowledge and tools are great for your head, but you also need a heart to shape experience into judgment and wisdom. Learn to understand the numbers and balance them with what you value in your heart. Learn to respect the money you are earning and understand the real cost of decisions.
You need a financial philosophy that places values on–and puts in balance–the possessions of this world and the actions that make up the paths of our lives. A successful family financial plan involves many trade-offs. There is no better guidepost than your faith played out in a consistent Christian witness and walk. In fact, your feelings about money are almost as important as your budget.
A simple bit of philosophy (used by many financial institutions) is found in the fable of the richest man in an Egyptian village who, when asked how a common man became so rich, explained. "I pay myself first, not the tent maker (mortgage) or camel merchant (GMAC) or other merchants (VISA)." We might modify that as per Malachi 3:10 to "Bring the whole tithe into the storehouse (church)." Pay the Lord first, but then you should pay yourself, then the other claimants. Doing that requires a working budget. "All hard work brings a profit, but mere talk (intentions) leads only to poverty" (Prov. 14:23).
Budgeting is the critical first step. Without a budget, it is almost impossible to save the capital that is the foundation for all you wish to do. But wishing isn’t enough, you need a plan to guide your work or you won’t like the results. You will have a financial status, but it may not reflect you and your values; it may not enable you to do what your heart says is important.
Your philosophy about life will guide you through the many important issues you need to decide about before you can do a family financial plan. The Lord is in charge, but He gave you free will and you need to be proactive to shape a life that reflects your values. You make the decisions which balance a second income against being a full-time parent, selects Christian schooling and private Christian colleges, or saves money for early retirement.
Do you capitalize on military retirement to allow you to go into Christian, public or community service or do you continue to seek more lucrative employment? Have you allowed for having options, or are your lifestyle decisions today limiting your future choices? I know too many Christians in their fifties and sixties who are in conflict over the need to work while their hearts are called to service.
People often ask my advice on many either/or decisions. I try to give them considerations, but habitually end up telling them to "work the numbers." I know most decisions are made in the heart, but you should sit down with pad and calculator to figure the cost. There are no cookie cutters for most decisions; you have to develop alternatives and work the numbers. Like military courses of action, there are quantifiable advantages and disadvantages, but decisions are made based on certain non quantifiables. Do the head work, pray, and then decide.
What are the real costs of financial decisions? Every day doors are closing because of financial decisions. They can be decisions based on your plan, or defaults based on desires and temptations. Every expenditure has a future cost, and if you don’t know the cost, why are you committing to it? Remember, $50 a month can return three quarters of a million in value over a lifetime. Often there is no $50 and no return. You should know the best use of your next available dollar: savings, investment, IRA contribution, consumer purchase, a child’s education account, or gift. Your plan gives you the data to make the tough decisions, but also you need balance.
How do we find and get into balance? Ron Blue, in his wonderful small book, Generous Living, talks about "Generosity as a Lifestyle" and the "Secret to True Contentment." He concludes we should give to acknowledge God’s ownership and our trust, not as a reflection of our wealth, but as a reflection of our relationship with God. As I discussed in the "Stewardship For Us" article, it is a matter of your heart. That means two things: First, that you actually deal with the concept of ownership, and second, your action reflects where your heart is. "For where your treasure is, there your heart will be also" (Luke 12:34).
To paraphrase an old saying, if your lifestyle was evidence in a trial, would there be enough to convict you of being a Christian? Often we consume and live a life that is not consistent with our values. Larry Burkett, in talking about indulgence says many Christians, ". . . seek fulfillment through the same channels as non-Christians and then wonder why they have a fruitless Christian walk" (Money Matters, May 1988).
The challenge is to blend science and art into a plan that fits our family and honors God. Then, identify investments which let us fulfill that plan. "But seek first his kingdom and his righteousness, and all these things will be given to you as well. Therefore do not worry about tomorrow . . ." (Matt 6:33-34). Not to worry, but to ". . . open your eyes and look at the fields! They are ripe for harvest" (John 4:35).
For we have been equipped by God to be stewards of all he has given so that as Austin Pryor reminds us in the verse which inspired the naming of his ministry, " For God did not give us a spirit of timidity, but a spirit of power, of love, and of self-discipline" (2 Tim. 1:7). Now let us build a family financial plan to care for our families, support a consistent lifestyle, and reflect His love.
Generous Living by Ron Blue. 1997 Zondervan Publishing House, Grand Rapids, Michigan 49539.
Money Matters Newsletter, May 1988. Larry Burkett.