AskDong

MoneyMonk posted the other day about how boring personal finances can become. I know exactly what she’s talking about. I’m sure after reading about Leona Helmsley’s dog, David Bach is penning “Smart Pets Finish Rich.”

I like reading personal finance magazines such as Kiplingers, Money, and SmartMoney. I like reading personal finance books. However, most of time reading them gives me a sense of deja vu. So what do you do when you still want to know more about personal finance but the typical article bores you to tears? The problem isn’t that there isn’t more to learn, but that most personal finance books and articles are often written for a broader and new audience.

I believe that for many people personal finance knowledge grows in pattern that might follow something like this:

If you’re bored with personal finance magazines, you’re most likely at the “What’s Next?” stage. I think I’m there myself. This doesn’t imply I’m out of the rate race. I’m not. It just means I have a plan, and generally know what I need to do, and want make sure I execute as effectively as possible.  I get the most of my 401K plan.  I contribute to my IRA account.  I save and invest outside retirment accounts.  Getting out of the rat race doesn’t even imply that you hate your job, but rather that you truly want to work for the work itself. A job should not be a tether. As you can see from the diagram above, underlying all these steps is the the notion of valuing and maximizing time. I firmly believe personal finance is more about time than it is about money. I also know I still have a lot to learn about both money and time.

So what is next? I think it really depends on the individual. Since my educational background is in Economics, I probably lean toward economic and investment topics, but for other people it could be driven more by environmental concerns. Some people approach personal finance from desire for self sufficiency. This desire can manifest itself gardening, or car and home repair. Last but certainly not least is the desire to give back. When you know how to have plenty, there should ideally be strong impules to want to share the wealth so to speak.

So if you’re bored with the generics of personal finance, here are some related subjects off the top of my head I would suggest looking into.

• Economics
• Stock Investing - Learn how to value companies, Understanding Derivatives
• Real Estate Investing - Landlording, Home Repair
• Green Technology
• Charities - Learn about local non-profit organization and how to get involved

Opportunity cost, and sunk cost are two terms from economics that have become an accepted part of the mainstream vocabulary. Generally speaking, most people understand what each means, but what the economic underpinning of both terms? Understaning both of these of costs and how they should or should not apply to our decision making leads to better financial decisions.

Opportunity Cost
The concept of opportunity cost underpins much of what is considered microeconomics. It’s one of the most important concepts there is. Opportunity cost is the cost incurred by doing something because it removes the option of doing something else. The best example and simplest understood example of opportunity cost is how it applies to education. For instance if I were to choose to attend graduate school for y dollars, the cost is not only y dollars, but also x dollars in forgone salary. Opportunity costs apply to any situation in which there is any kind of choice. The cost may be monetary, or it could be just as likely time or experiential. When we pick entree from a menu we experience both accounting and opportunity cost acutely. The accounting cost is the price of the entree, and the opportunity cost is not having being able to eat the next best dish (assuming that we can only eat one entree). The opportunity cost is not opportunity of eating all the items on the menu, only the best alternative. An economically minded person understands that the true economic cost of deciding upon one specific entree is both the price of the entree and foregone experience of eating the other dish. Thinking about opportunity costs leads to better decision making.

Sunk Cost
Sunk concept is in some ways the mental flip side of opportunity cost. Whereas we often forget or ignore opportunity cost to our detriment, we don’t ignore sunk costs when we should. Sunk costs are the cost already incurred that cannot be recouped. Sunk costs do not represent any value, they purely represent the money, time and effort already put into a cause. Keeping sunk costs in mind generally leads to good money being thrown after bad. Another example of sunk costs can be seen in the commercials supporting the war in Iraq. While I personally don’t agree with the current war, I believe it’s perfectly rational to disagree with me on that point. However, my inner economist cringes at the one commercial I’ve seen which features a brave veteran who lost his legs in Iraq. The commercial ends by saying something like, “don’t let my sacrifice be made in vain.” Any reasonable economist understands rational decisions going forward should not be based on costs incurred in the past, sunk costs. These commercials are effectively pitching the consideration of sunk cost. The pitch to economist must be made on the benefits outweighing the cost going forward. If an economist were directing the commercial, the pitch would identify the opportunity cost of staying Iraq vs leaving which are innumerable - stability in the middle east, lower terrorism, increase American credibility, etc. Regardless of where one stands on the issue, arguments should at least be made on sound and rational thinking. Consideration of sunk costs is irrational.

The more common (and much less political) example of sunk cost is the cost of a movie ticket. Once the the ticket has been paid for it’s a sunk cost, and should not be heeded in the decision to actually watch a movie. So if you’re watching a movie, and it’s bad there’s little reason for you to stay. The price of the ticket is sunk, and staying and watching the movie has an opportunity cost of watching another movie or doing something else. If watching the movie is not producing value, the cost of watching (the opportunity cost) should be the only consideration and not the fact that one’s already paid $10 for a ticket. Yet, how many of us will continue watching a bad movie? Or even worse, stay in a investment because of what we’ve already paid?

I think many of us who blog about personal finances take it for granted that our readers may have read many of the same books that we’ve read. The question is what books have we all read? I think there are a few books that belong in everyone’s library. Many these books I imagine are also owned by other bloggers.

The Millionaire Next Door, Thomas J. Stanley and William D. Danko

I believe every single personal finance blogger has read the Millionaire Next Door. I would say most bloggers are disciples of this book. It’s a good book, and well worth reading, but probably could be summarized by two statements. “Spend less than you earn. Don’t compete with the Joneses.” Those are certainly two principles I agree with. Personally my biggest gripe about the book is that it’s both overly simplistic, and academically sloppy. The latter I wouldn’t have a problem with except the writers present as if it were an academic study. It’s not. The book is anecdotal rather than data driven despite citing plenty of simple statistics. The book is simplistic because it approaches the process of wealth creation from a one size fits all approach. While there’s no question in my mind the first step to sustained prosperity is spending less than you earn, that simple statement has two complicated parts, earning more and spending less. The Millionaire Next Door will not teach you how to earn more, and really the only lesson it gives on spending less is, buy a used car and a small house. Still this book is a must read. Read it and you’ll understand most personal finance bloggers, as we all like to fashion ourselves the would be “Millionaire Next Door.”

A Random Walk Down Wall Street, Burton Malkiel

This is probably most definitive book about the act of investing rather than how to invest. As the title suggests it tends to believe that equity performance cannot be predicted, hence the random walk. While the theme of the book is to basically invest in index books, there are few books that match it in explaing the general nature of stocks.

The Intelligent Investor, Benjamin Graham

Benjamin Graham was Warren Buffett’s mentor and this is his definitive book on value investing. It’s must read for any aspiring value investor. That said, it’s dated on many topics, and both a lengthy and muddled read. There are also many people who believe that Benjamin Graham to be far too conservative in his investment approach. Warren Buffett is widely accepted as having improved on Graham. However, you can’t talk about value investing without talking about Benjamin Graham and the Intelligent Investor.

Rich Dad, Poor Dad, Robert Kiyosaki

This last book I suggest not because I think it’s a particularly well written or informed book, and hesitate to even recommend it any fashion. However it’s an influential book, and one illustrates an alternative line of thinking.  The book can be illuminating for individuals who have never really thought about money.  I’m not sure who the best benefits by reading this book. Regardless, there’s no question the influence this book has had. For many people this book has changed how they think about money.  Reading provides insight into how other people think even if ideally you take no hard money lessons from the book.   The book given that it’s authored by an “expert” who is on the seminar circuit is all about pitching a path to riches rather than concrete steps to take.

Since my posts are not part of any specific outline, I thought this week I would move slightly towards the other tent in Economics, Macroeconomics, after convering basic supply and demand curves last week. We’ll talk about topic that is endlessly debated, but one in which most Economists (both left and right leaning) tend to agree more than disagree, Trade. Trade is generally framed as international trade, but at it’s essence international trade is no different than trading between two individuals. Just as the companies in Massachusetts import and export good to California, the U.S. trades with countries like India and China.

Adam Smith who set the ground for modern Economics with his book, The Wealth of Nations, not only recognized the value of trade, but was the first to quantitively to understand that value. He introduced the idea of absolute advantage as the reason for trade. For example let’s say we have two countries, Canada and the U.S. with 100 units of labor it can devote to producing Hockey Pucks, and or Beer. Canada produces Hockey Pucks at a rate 10 for each unit of labor, and Beer at rate of 5 can for each unit of labor. Without trade, Canada might choose to produce 500 hockey pucks, and 250 cans of beer. The U.S., on the other hand, can produce 10 cans of beer for each unit of labor and 5 hockey pucks for each unit of labor. The U.S. then might choose to produce 500 cans of beer and 250 hockey pucks. Canada has the absolute advantage in the production of hockey pucks, and the U.S. in beer because each country needs less labor than the other to make the product it’s absolutely advantaged in.

If we introduce trade, each country is able to take advantage of it’s absolute advantage in production of hockey pucks in the case Canada, and Beer for the U.S. Each country specializes and trades with the other to get the product it decides not to make.

As a result the total production of both hockey pucks and cans of beer is maximized for 1000 of each. If we assume that trade partners only engage in trade if it benefits them, we can assume that both the U.S. and Canada benefit with both more beer and hockey pucks. For simplicity’s sake let’s just assume that beer and hockey pucks are both worth $1 and trade effectively 1:1, the U.S. and Canada can both have 500 hockey pucks, and 500 cans of beer. Without trade neither of the countries had the ability to produce both products at that level.

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Economics gets a reputation as the “dismal science” as coined first by Victorian Historian Thomas Carlye. I for one don’t believe it’s dismal nor really a science. It’s a social science which basically means it’s an examination of human behavior through a scientific lens. While I think it’s easy to know what economics is, it’s actually somewhat harder to define. Technically, Economics is the study of the production, distribution and consumption of goods and services. It’s an awfully big category. I didn’t know anything about Economics before the first course I took my freshman year. Even though I ended up majoring in the subject, my first course, Introduction toMicroeconomics , hardly inspired me. However, there’s no question that today, studying Economics has ultimately shaped how I view the world. Economics because it often assumes perfect competition,symmetric knowledge, and perfectly rational participants is far from infallible, but none the less provides a great framework to understand business, and policy decisions.  Everyone would do well to have a basic understanding of Economics.

I want to devote some time in the next couple weeks getting back to Economic basics. While I don’t think my blog is particularly full of Economic jargon (though I do think it’s full of financial jargon), I realize I do take it for granted that my readers have some basic background in economics (at least some of the terms and concepts).   Economics usually breaks down into Microeconomics, and Macroeconomics. Microeconomics deals with the behavior of individual entity such as a person or a corporation. Macroeconomics centers around broad measures of the economy such as total employment, and trade. So company’s decision to import products from China is a microeconomic decision while the impact on the trade balance is a macroeconomic effect.

Everyone starts with Microeconomics, and one the first concepts taught is supply and demand curves, where quantity consumed or supplied is determined by price.

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