The two most important lessons in personal finance

I am gradually learning how to create clickbait titles. I think this one is a step closer.

There’s a lot of advice available on managing your wealth and most of it is rubbish. After thinking over several years about money, I have come to the conclusion that the following two lessons are the most important ones. Ignore everything else and abide by these lessons.

Lesson #1: Focus on earning; not on saving.

The following fact is true: the quality of one’s life is better measured by the total amount of money one spends as opposed to the total amount of money one saves. You enhance your life by spending money on life-enhancing experiences, not by stashing it in a bank account. And yet, 99% of advice on managing your money focuses on how to spend less on your groceries.

Just do the calculations. To make things slightly simpler, say you are 18 years old right now so that lots of career options are available to you. Let’s think about two versions of yourself. The first version puts in serious effort into finding the best career for your skill set and the second one half-asses an average career. What’s the difference between the average amount of money the two versions make per year? For any given skill set, if you start seriously optimizing your career at the age of 18, you can easily rake in upwards of a few hundred thousand dollars per year averaged over your life time. But with a half-assed career you will likely never make more than $100k. So that’s a difference of a few hundred thousand dollars per year. Now, let’s think about how much money you will save by carefully optimizing the grocery store you shop at. Suppose you shop once per week and save $100 every time you shop because your arduous research has found you the cheapest grocery store in town. Since there are about 50 weeks in a year, that’s $5,000 saved in groceries. Let’s be generous and multiply this number by five because you are doing the same level of optimization in your phone plan, your hair cuts, your clothes, and food. That’s still a mere $25,000. Comparing this to the rewards of optimizing your career properly, it’s clear which one is worth your time.

Things might be slightly different if you are older because your career is not very flexible any more. But most people spend way more time trying to save than trying to earn. I think at any age there is some reward to be drawn from shifting your focus from saving to earning.

In fact, for the benefit of the reader, let me make this really clear. I think even if you spend absolutely zero mental energy on saving on groceries, phone, cabs, and food, but are aggressively optimizing your career, you will do orders of magnitude better financially than someone who is aggressively finding the best deals in town but just picks whatever career comes his way.

Lesson #2: Realize that there are many different forms of wealth and most of them are interconvertibile.

Once a friend of mine told me that he only spends money on things that appreciate in value. This was his justification for not buying a car. Of course, if you buy a car and then try to sell it back, you will get less money than its original price. Thus with time, it’s value decreases. But if you buy Apple stocks, it’s very likely that you will be able to sell it for a higher amount in future thus making more money. So isn’t it obvious that you should spend money only on things like Apple stocks and never on things like cars?

The flaw in this argument is that it’s overly focused on one specific kind of wealth, i.e., money. Wealth comes in many forms, including time, convenience, happiness, relationships, pleasure, luxury, status, knowledge, expertise etc. Sure buying a car will reduce your monetary wealth, but that’s only because the monetary wealth is being converted into (a) time, because you will save on your commute, (b) convenience because now you won’t have to carry your groceries in the subway, and may be (c) status in case it’s one of those cars that enhance your status. Why should we look at these other abstract kinds of wealth? Because of the inter-convertibility of one form of wealth into another! Even if you only care about money, it will be easier for you to earn more money in future if you have time, convenience, and status in your hands now.

Many people ignore this when they drive 3 hours to go to a city where the discounts are 5% higher on clothes. Should you stay in your city and pay 5% extra or go to the next city and save it? Stated this way, it seems clear that you should drive to the next city. But the statement above does not represent reality. The real comparison is between 3 hours vs. 5%. Depending on 5% of what, the 3 hours might be more expensive.

A similar reasoning can be applied to going to elite universities. At the face of it, it’s just a sink of money. But why do people still go to university? Because even though you spend money in your tuition fee, you gain wealth in the form of a network of future successful people, and expertise in economically valuable skills. This wealth can later be converted into other forms of wealth, including money!

 

Advertisements