Sunday 5 November 2006

The Eight Best and Worst Money Moves You Can Make

Here is a list of the eight best and eight worst money moves you can make, and why:

Eight Best Moves:
1. Pay Yourself First - no matter how much you earn, you should put aside a fixed percentage of your income as savings each pay day. This will develop good savings habits. You can start off with a small and painless percentage and build up slowly to a significant amount, for example when you get a pay rise.
2. Cut up your credit cards and pay cash for everything. This will ensure you never run up credit card debt.
3. Borrow against your home equity. You can borrow at very competitive interest rates and invest this money in high-growth assets, boosting your returns using gearing. Home equity loans also have an advantage over margin loans because they aren't subject to margin calls.
4. Invest in index funds. The market is reasonably efficient, and studies have shown that very few professional fund managers can "beat the market", after allowing for the higher fees compared to index funds.
5. Invest in managed funds. Some managers (Buffet, Lynch) have consistently produced superior returns, so it is worth seeking them out.
6. Diversify to reduce risk without reducing your returns. Your portfolio asset mix should be on the efficient frontier.
7. Put all of your eggs in one basket and watch the basket carefully. You should spend enough time and effort to identify a few excellent companies and buy them at the right price for the long term. This is what Warren Buffet does.
8. Borrow to invest. Also known as "gearing" this will boost your returns and can provide tax benefits if the interest on the loan is tax deductible and long-term capital gains are taxed at a lower rate than current income (dividends).

Eight Worst Moves:
1. Pay Yourself First - if you have any "bad" debt (loans for non-investment items such as clothes, toys, cars, holidays etc.) you should pay this off before you even consider a savings plan.
2. Cut up your credit cards and pay cash for everything. Several reasons you should keep your credit cards and learn to use them responsibly
- they can act as your "emergency fund" so you can be fully invested without having to keep an "emergency fund" in a low-interest cash account.
- they are much safer than carrying wads of cash around, and are especially convenient overseas.
- by paying off the balance in full each month you can get up to 55 days interest free credit on your day-to-day purchases, so you can keep an extra month worth of expenditure invested.
3. Borrow against your home equity. People who borrow against their home equity or against the 401K to pay of credit cards often run up the credit card debt again. Others use HELOC to spend more than they earn on things like cars, holidays and lifestyle. You can end up still having a mortgage when you retire, or, in the worst case could put your home at risk.
4. Invest in index funds.You are condemning yourself to mediocre (average) investment returns. Some managers (Buffet, Lynch) have consistently produced superior returns, so it is worth seeking them out.
5. Invest in managed funds. Although some managers (Buffet, Lynch) have consistently produced superior returns, you have Buckley's chance of picking who are the superior managers - last year's (or five year's) performance is no guide to next year's winners (but everyone can identify them in hindsight).
6. Diversifying your portfolio (also known as "di-worse-ification") will drag your investment returns towards back down to the average.
7. Put all of your eggs in one basket. If you make one or two bad calls you'll put your portfolio in the toilet. Do you really think you're the next Warren Buffet?
8. Borrow to invest. Gearing will magnify any gains or losses, but, if the market tanks you can get a margin call and be totally wiped out, so you never get to benefit from the magnified gains when the market recovers.

Confused? Well, it just goes to show that there are no "one size fits all" answers in personal finance. Some would argue that this is why you need to get help from a financial planner. My view is that you need to learn enough about yourself, your position, and available options to form an educated financial plan. The fees you'd pay a financial planner are high enough to eat into your investment returns, and, at the same time are too low to buy enough time and effort from a professional financial planner to really get to know you and your situation well enough to give an optimum plan customised for you. The best you'll get is a fairly vanilla plan that is "reasonable" for your situation.

OK, these probably aren't the top eight anyhow - I just wanted to make the point that in personal finance there are many shades of gray. If you read about technical analysis and want to try day trading, first read all the evidence supporting the weak version of efficient market theory, and, remember, in day trading it's a zero-sum game, so you have to be smarter than more than 50% of other traders (allow for trading costs) to hope to make a profit. If you like fundamental analysis, remember that companies makes honest mistakes in their reports, they sometimes obfuscate (or downright lie), and, even if the figures are correct, they are historic, so are a pretty poor guide to the future.

I spent a lot of time for my first decade of investing learning everything I could, and trying to find out the "truth" about investing - what is the "correct" way to invest, and the "best" strategy. What I've come to realise is that no-one knows - especially not what is best for YOU. So, just keep learning all the time, and remember, it's always just going to be your "best guess", so always evaluate and manage your investment risk.

At the end of the day, you've really got no-one to blame for your investment performance but yourself. On the bright side, at the end of the day, we're all dead, so it doesn't really matter anyhow ;)


Anonymous said...

After reading the best 8 moves, I had mentally composed a comment to dispute them. I thought it was interesting that #4 contradicts #5 and #6 contradicts #7 for the most part. That gives away a bit of the suspense.

I don't believe in cutting up your credit cards unless you are unable to pay them off every month.

I use my home equity as an emergency fund, I have never seen someone responsible suggest using it to fund your investments.

As for managed funds, I have a bias here, but there are very few Buffet, Lynch, Millers, out there - it's probably best not to gamble on finding them.

Put your eggs in one basket and watch it carefully? That's one of the best moves? You really have to know that basket and be able to control it's outcome for that. By that I mean if that "egg" is investing in your own education, I'm okay with it. If it's putting it on some other company or asset that you don't have control over -- I'd say it's a bad idea.

That said, I'm not a professional, just a guy on the Internet, so the advice is worth what you paid for it - zero. You make a great point on how things can be viewed differently by people in different positions though. said...

I was probably a bit too toungue-in-cheek with this post. Careful reading will show that every one of the eight "Good" ideas is restated as a "Bad" - just with different explanation around why it is a good/bad move.

The point I was trying to make is that there are lots of investing ideas out there, and most of them will suit "some of the people some of the time" - but no one idea is right for everyone. said...

Update: now that I am a registered financial planner (in Australia) I'd amend my advice to 'learn enough and DIY' to only do so if you have the time/interest/ability to do so. Depending on your situation it may well be worth paying for a professional to provide personal financial advice (but you still have to find a suitably qualified financial planner, that will provide the services you require for a fee that provides good value). Then again, I have a fairly low fee schedule and don't have any clients yet, so what do I know ;)