A bad financial decision can destroy your wealth. Most people do not think about that when they make one. They do not think about it because they are bad financial decision makers. But if you are not thinking about the risk of making bad financial decisions, you will never learn how to make good ones.
If you want to be a good financial decision maker, you need to know what you can’t do. You cannot get anywhere by trying to buy low and sell high every day. If you do that, you will get very rich, but no one else will. Almost every stock market crash has been caused by people who did just that: they made money by selling and then selling and then selling and so on.
Some of the most successful traders in history did what we call “value investing,” which means buying when the price is low but when it is likely to go up in the long run. Such investors may be able to make a profit in the short run by buying low and selling high, but over the long run they are going to lose money because they will not be able to sell before it’s too late….
A lot of people are afraid of making financial decisions. They are afraid they will make the wrong ones, or that someone else will be making them for them, or that they won’t understand the numbers, or that they’ll get into trouble if things go wrong.
It is human nature to avoid risk. But since decisions have risks, the only way to manage them is to know what they are. The good financial decision maker knows what he is doing. It’s all there in front of his eyes. And because it’s all there in front of his eyes, he can decide how much risk he wants to take.
You have to decide what you are willing to lose before you can decide how much loss to take.
Financial decision makers have to have a good feel for the kind of decisions they are making, and how to make them. They have to understand their own feelings about money and finance, and be able to verbalize them. They need to understand that there is more to wealth than money, and that their sense of security about money might not be reliable.
In short, they have to do what psychologists call “mental accounting”—that is, they have to understand the difference between money in the bank and wealth in investments or real estate. And they need a deep understanding of a financial concept called “discounting,” which is the way we decide what we will pay for things.
If you want to spend less than you earn, you need two things:
The first is a good financial system. The second is an ability to make good decisions.
If you are not in the business of making money, the best way to make money is not to make money. You can make money by selling stuff you’ve invented or produced for other people, but it’s not the best way. If one of your goals in life is to become rich, then making money isn’t the goal. It’s something that happens along the way, like getting hit by a bus or getting caught in a fire or being in an earthquake or getting cancer.
However, if one purpose of your life is to spend less than you earn, then making money is the main thing. The best way to do that, without having to invent things or produce anything, is to work for someone else.
The best way to understand what makes you money is to understand how much money you’re making. Unless you’re a hedge fund manager, there’s no point in spending a lot of time thinking about how to make more money.
If your investments are losing value, you need to figure out why. What can you do to raise the value? One option is to sell something that’s costing you money. Another is to buy something that will increase the value of your assets.
Other investments can be a distraction from the ones that matter most. If financial advisers want their clients’ money, they have an incentive not to tell them about all the other things they can do with it. They will point out an investment that promises a high return but doesn’t have any downside risk, and urge clients to put some of their money into it. A small amount will likely turn into a big loss as it grows, but if the client puts all his money into that one stock then he has nothing left for other investments that might make him even bigger gains.
It is useful to understand the difference between what you want and what you need.
You might want to get a new car or an expensive watch or something, but if you really need it, like for work, you will be happier if you buy it on credit. And if you don’t pay off your debt, interest rates will make your payments larger and larger over time. So even if the debt doesn’t eat up all your income, it will crowd out other things that are important to you.
A dollar in debt is not worth two in your pocket. That’s because the dollar is just a symbol of value that has been created by human consensus. If someone agrees with you that this dollar is worth two dollars, then when they have the dollar they are happy. If they have two dollars they are even happier. If someone else disagrees, then they can exchange their dollars for your dollars at some agreed-upon price.
Then again, sometimes money isn’t so much a symbol of value as a tool to get what you want. But when it does that too, it puts pressure on the value of the dollar itself.