We Americans, as a collective, under perform in our financial lives. Don’t get me wrong, I’m not saying we’re bums. Quite the contrary. We’ve created the world’s most dynamic economy; we produce life-enhancing innovations at a pace that has never been matched. We work hard, we work smart, we work creatively, and we are, in general, well rewarded for it. From 1967 to 2006, average incomes have jumped from $36,502 to $48,223 in constant 2006 dollars, according to the U.S. Census Bureau. (U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplements, 2006).
Yet I can’t help wondering, for all of the wealth that is produced, for all the income that flows through our checking accounts, why isn’t more retained by the average American household? In 2004, the average net worth was $93,100, according to the Federal Reserve Board’s 2004 Survey of Consumer Finances. The average 401K balance, net of loans, was $58,328 in 2005, according to a the Investment Company Institute and the Employee Benefits Research Institute, large enough to produce $243 a month in income at a 5 percent rate of withdrawal. ( Sarah Holden and Jack VanDerhei, “401K Plan Asset Allocation, Account Balances, and Loan Activity in 2004,” Investment Company Institute Perspective, Vol. 11/No.4, September 2005).
I am convinced that our under accumulation of wealth stems from a fundamental confusion about what constitutes sound financial management, a confusion of good business finance with good personal finance.
We’ve all heard the phrase; it takes money to make money. In business and investment this is certainly the case. We must spend money before any will come back to us. The basic paradigm is the agricultural model, which provided humans with our first movement into stable, self-sustaining societies. In order to earn money farming, a person must acquire money, either through savings or loans, purchase land and seed, then work the land, rely on a bit of luck that no aberrant or other catastrophe wipes out the crop, then work to harvest, sell the produce, pay off the loans. It is only then that the farmer earns a profit and starts the cycle again.
The bottom line: In business, we must spend money before we have it so that we can have it to spend it. Failure to spend will doom any business to stagnation and ultimate failure. Being too cheap will end an enterprise.
The fundamentals of personal finance, however, are the opposite. In personal finance we should wait until we have the money to spend it. We must earn, set aside 10 to 20 percent, and let the pile grow. It is only after the pile has grown that the prudent person indulges in spending to upgrade one’s lifestyle.
This pay yourself first rule is not new and certainly not revolutionary. It was first put to print in 1926 by George S. Clason in his classic parable, “The Richest Man in Babylon.” Yet far too few Americans accept Clason’s advice.
Instead, we tend to justify today’s consumption with expectations of future earning increases. Many of us actually use the business paradigm to rationalize spending on the personal side. We categorize personal consumption as an investment in business.
I may, for example, have a Toyota Camry that, while a decade old, is paid off, running fine and inexpensive to maintain. Not having a car payment of $500 enables me to invest an equivalent amount in a taxable account or far more in a retirement account, as I don’t have to pay taxes.
I want a Lexus. I don’t have the money saved. I will have to take a loan. No problem. I tell myself it is important for me to have a nice car for business appearances. Just as a dentist must have teeth, a financial advisor must drive an upper-end automobile.
I’ve rationalized personal consumption as a business expense, and diminished my future net worth--my ability to achieve real financial freedom--in the process. I could do the same with any number of nice -to-have lifestyle items including, a larger house, a vacation home, a country club membership, a boat, season tickets for the Yankees and Red Sox’s (I have clients who are fans of both teams,) private schools for the children, expensive suits, just to name a few.
Now some of these may in fact improve my bottom line. Dentists do need teeth and I can’t live in a tent and ride a bicycle to appointments with clients in second hand blue jeans. Some purchases, such as vacation homes, may be a great investment in family time. But each dollar must come from somewhere and I can justify almost any purchase as an investment, when, in fact, many will simply be lifestyle enhancing consumption.
Ultimately, there is no objective measure that can neatly pinpoint the optimal spot between the bicycle and the Rolls Royce or the second-hand jeans and the five figure suit where I should place my marker. The principles, however, are useful. They provide a gut check, the ability for us understand our spending habits, choices, and their consequences. Most important, they allow us to be honest with ourselves and make smart money choices.