The rocks, pebbles, and sand story asks us to reflect on what's essential in life. In the story, rocks represent our lives' core values such as relationships and moral standards. The sand represents distractions what Cal Newport describes as shallow work. Shallow work is the new show on Netflix or the mindless wandering in shopping malls.
If you had a jar, the fable continues, and you fill it first with sand, you won't have room for the rocks. But if you prioritize by first putting the rocks in the jar, then you will have no difficulty in pouring sand afterwards.
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Financials life has priorities, too. While most of the content on Pen&Paper, at least as of May 2020, is about business analysis, where we look at a company's fundamentals and strive to understand whether to buy into its business model, stock investing is not a priority for most of us.
What is a priority is to set financial goals and to plan a roadmap on how to achieve them. And the first step is getting rid of any credit card debt, funding an emergency fund, and paying off short term liabilities such as auto and school loans.
First, get rid of credit card debt. It's tough to get ahead in life when you owe someone a 20% interest rate. Hardly any skilled investor, including those reputable investors that watch businesses every day of the week, compound their capital at that rate of return.
There is a common rebuttal to the pay-off-your-credit-card debt argument, which is that having credit card debt builds your credit score. While payment history is important, it serves less than 1/3 of the total credit score. Also, there are no benefits to having several credits cards compared to just having one card .
In short, the proper way to use credit is to build a payment history. But (1) limit the liability to one credit company, and (2) pay off the outstanding debt every single month.
The second priority is to set up an emergency fund. The purpose of the emergency fund is to allow you to keep your lifestyle as life happens.
Typically, your financial advisor will recommend that you set aside three to six months of reserves. If your household has one provider, then six months of reserves are recommended; if there is dual incomes in your home, then, perhaps, three months of reserves suffice.
The Certified Financial Planner (CFP) board writes:
Saving is the process of putting cash aside in safe, liquid accounts, such as the emergency fund…Only after these reserves are established can you address secondary considerations for the balance of your clients have in savings - namely, keeping pace with inflation by investing.
Whether you set aside three or six months of reserves depends on how quickly you will be able to recover from the life event. It won't take long for a dentist to find employment. But it will take a long for a real estate broker to find work in a downturn. So the amount of reserves is subjective.
The emergency funds should be in cash or cash equivalents . I recommend that you exclude the emergency fund from your net worth. The funds are not to be used for vacation or any home upgrades.
After you paid off the credit card companies and set aside an emergency fund, your third priority is to pay off any short- to mid-term liabilities . These liabilities include auto loans and education loans.
While mortgage payments are tax-deductible, the interest payment on the school and auto loans is not deductible. There is no benefit of holding these loans - not from a tax perspective and not from a life perspective.
From my experience, especially when markets rise, it is difficult to pay off current liabilities instead of placing the money in the stock market. I often hear that investors feel that, in effect, they have a low-interest loan where they can earn a higher return in the stock market. But when they need the money, they risk that markets could freeze.
Equity markets, whether you buy individual stock or ETFs, serve to fund a portion of our long term goals. Those goals include retirement and income planning or buying a home. And then also, individual goals such as gifts to children.
Again, returning to the CFP board, in their words:
Investing involves using money, or capital, to purchase an asset that offers the probability of generating an acceptable rate of return over time, providing the potential for earnings while assuming more volatility. True investments are backed by a margin of safety, often in the form of assets or owner earnings.
Businesses compete for our time, money, and attention. And it is up to set to prioritize our goals to offset these pressures. To meet our goals, we have to set a road map. And to establish a road map, we have to consider tradeoffs: how one decision compares to the other.
Think about that next time you see rocks on the beach.
"If you want to improve the quality of decision," said Daniel Kahneman in an interview to Farnam Street, "Sse algorithms, whenever you can. If you can replace judgments by rules and algorithms, they'll do better."
Robo advisors or automatic trading promises just that. It is a software that calculates your risk and return profile. It shows you the right mix between stocks and bonds. It is an algorithm that attempts to answer how much you need to save today to live in retirement comfortably. You can now build a financial roadmap in a few clicks. Have we discovered the one recipe for success in financial life?
Not so fast. The term 'auto trading' gives the impression that our financial destiny is an airplane ride. Where all we need is to sit down, buckle up, and let the pilot set the journey on auto. But life rarely works that way.
What happens in practice is that life is full of surprises. And what sets you apart from others is how you will manage these surprises. In my view, to prepare for life events, you need to ask questions repeatedly.
For example, should you use your 2019 bonus to upgrade your home or to add to your savings? Or you may read about loan-backed funds and wonder if you should invest in them. Or, perhaps you want to help out a relative and need guidance on how best to manage the process.
Robo advisors will have little to say about these questions.
While I believe auto advisors serve a great purpose , they cause harm if not used correctly. From conversations I had with readers, I often see that auto investing creates an illusion. For example, a married couple boasted to me that they were on track for college education for their child and had enough safety nets. But they were taking far too much risk to meet their return objective.
Auto advisors are akin to Fitbit watches . But just as a heart monitoring device cannot create health ,to achieve your financial goals, you will need more support that what auto advisors offer.
Feedback mechanisms are essential.
Here is what Charlie Munger says on Matt Ridley's The Rational Optimist "
In the course of the book Ridley missed a major factor as to why capitalist economies outperformed all other forms of economics organization."
"It isn't just a division of labor that works so well. What communist Russia lacked was a feedback mechanism. The process of free capitalism drowns businesses in feedback. If you do things right, you win new customers, and if you do things wrongs, you start to lose the ones you've got."
We need feedback on our behavior - Just as thriving economies do .
A reader reached out to me about a year ago. She lived outside of the United States but wanted to buy U.S. real estate, an office building. But she had difficulty in understanding the tax consequences , and she was getting mixed opinions whether the investment was a good idea.
She wanted me to decide for her. But instead, we had multiple conversations about why she had wanted to buy a U.S. based property in the first place. She had never asked herself that question. We discovered she had one goal in mind: to help her grandchildren with college tuition. And once we understood that, we found a better investment vehicle.
Another story happened just a few weeks. A reader was working as an investment banker when we met. He said the hours were long and that his clients expected him to be available 24/7.
He was facing a dilemma. He was contacted by a large organization that offered him a secure job with additional intangible benefits . But he was unsure whether to accept the offer. He feared he was giving up on his dream as a self-made entrepreneur, and that there was no 'upside' to working at the large firm.
Instead of prescribing a solution, I said: "let's ignore the financial-side, and only consider the domestic-harmony-side between you and your wife and between you and your children. Which occupation would improve the latter side?
He took the offer.