Want a more prosperous, less stressful financial life? This is the best book I have read in the past five years and a perfect cornerstone for everything we say at FinancingLife.org.
Jonathan Clements was a personal-finance columnist at The Wall Street Journal for 20 years. He writes so well and thinks so clearly that even these topics of financial planning and saving become interesting to read. His little book is a gem for readers of every age. The emphasis is on getting a solid financial footing early in life, earning and saving for the whole of our lifetimes, and avoiding wrong turns in our search for happiness.
THERE ARE THOSE WHO THINK the goal is to beat the market and amass as much wealth as possible, that street smarts and hard work ensure investment success, and that the road to happiness is paved with more of everything— And then there are those who get it.Jonathan Clements
The book’s goal: to provide readers with a coherent way to think about their finances, so they worry less about money, make smarter financial choices and squeeze more happiness out of the dollars that they have. How to Think About Money, which was named 2017’s adult book of the year by the Institute for Financial Literacy, focuses on five key steps:
Step No. 1: Buy More Happiness. There is a connection between money and happiness, but the relationship is far messier than most people imagine. If we want to get the most out of our dollars, we need to think much harder about how we spend and which goals we pursue.
Step No. 2: Bet on a Long Life. Most of us will enjoy an amazingly long life that will often see us pursue more than one career and spend perhaps 20 or 30 years in retirement. That has big implications for how we handle our money.
Step No. 3: Rewire Your Brain. Thanks to the instincts we inherited from our hunter-gatherer ancestors, we are hardwired to fail both as savers and as investors. Result: It takes great self-discipline—or, in the absence of self-discipline, a certain amount of self-deception—to manage money successfully.
Step No. 4: Think (Really, Really) Big. We divvy up our financial life into a series of buckets, thinking of our insurance policies as separate from our bank accounts, and our stock-bond investment mix as unrelated to our debts. But to manage money prudently and make the right tradeoffs, we need to bring together all of these financial pieces—and the central organizing principle should be our paycheck, or lack thereof.
Step No. 5: To Win, Don’t Lose. To get ahead financially, we should think less about making our money grow and more about the dangers that could derail our financial future. This doesn’t mean we shouldn’t take risk by, say, investing heavily in the stock market or taking on a hefty mortgage to buy our first home. But even as we save and invest for the future, we should also aim to minimize potential subtractions from our wealth. Those subtractions might appear modest, like mutual fund expenses and stock trading costs, or they can be huge, such as selling shares at a market bottom or becoming disabled and yet not having disability insurance. Either way, there’s the potential for great financial damage.
The book advises how to think about work, debt, investments, and insurance at various stages of life, with lifelong preparation for the challenge of retirement.
“Chronologically, retirement might be our final financial goal, but we should always put it first. Amassing enough for a comfortable retirement is our life’s great financial task.” Given longer life expectancy, “we need to get ourselves on the right financial track as early in our adult life as possible, so we quickly achieve some measure of financial freedom.”
“When I talk to college students, I don’t tell them to follow their dreams. Instead, I tell them to focus on making and saving money… As our sense of financial security grows, earning money becomes less of a motivator… Many people reach the point where they have the financial leeway to pursue the goals they find intrinsically satisfying. But others never get there.”
“For those age 50 or older who have done a decent job of saving and investing, their most valuable asset will probably be their investment portfolio. But for anybody who is younger, the value of their human capital [income-earning ability] will likely dwarf any other asset they own… By thinking about our likely lifetime income and the constraints it imposes, we can get a better handle on the financial tradeoffs we need to make… We also need to be careful not to borrow too much. The size of our mortgage, and the amount of student debt we take on, should be guided by our likely earnings.”
“First, we should make it possible to save by keeping our fixed living costs as low as possible. We’re talking here about recurring expenses such as mortgage or rent, car payments, groceries, utilities and insurance premiums… My advice: Aim to keep your total fixed costs below 50 percent of pretax income.”
“Those who are self-employed, or who don’t have employer coverage, should seriously consider disability insurance, especially if they have little in savings and thus their financial life would quickly unravel if they couldn’t work… Keep in mind that the vast majority of disabilities are caused by illness, not accidents… Life insurance also makes sense for those who have families who depend on them financially, but who don’t have substantial savings.”
“Historically, over long holding periods, U.S. stocks have earned 7 percentage points a year more than inflation. Factor in 3 percent inflation and we’re looking at a nominal return of 10 percent a year…. Arguably, the U.S. stock market’s wonderful historical performance also can’t be repeated, because it reflects a one-time gain from rising valuations.” In 1915 companies were trading at 11 times earnings; by 2015 that multiple was up to 24. “Given today’s heady valuations, returns are likely to be significantly lower… I suspect long-run returns will be around 6 percent a year, while inflation runs at 2 percent.”
“What if stocks subsequently tumble 15 percent? If we focus just on the price decline, we might be unnerved. To stave off panic, we should instead think about the market’s earnings and dividend yield. As prices fall, every $100 invested not only buys us more in dividends, but also more in earnings. If the market’s price-earnings ratio had been 20 and stock prices fall by 15 percent, the P/E would drop to 17. If we divide 100 by 17, we find the earnings yield is now 6 percent, rather than 5. Like a bond investor who can now buy at higher yields, we should be more enthusiastic about stocks, not less, because every $100 invested is buying us $6 in corporate earnings, rather than $5.”
Clements recognizes low-cost index funds as the winning investment strategy. “Suppose that, for 40 years, we stashed money on a regular basis in a broad stock market index fund. Vanguard Group founder John C. Bogle calculates that we would accumulate 65 percent more wealth than an investor who owns an actively managed stock fund, with its higher trading costs, higher management fees and larger cash holdings… Moreover, the cost of active management isn’t nearly as modest as it appears. Yes, we might pay 2 percent of assets per year, which doesn’t seem like a huge sum when it’s framed that way. But in a world where stocks could return just 6 percent a year, we are surrendering a staggering 33 percent of our potential gain to investment costs.”
“Even if we have the tenacity to stick with a sensible investment strategy in the face of market turmoil, our investment gains won’t amount to much in dollar terms unless we have a decent sum invested in the market—and that takes good savings habits.”
“When we retire and start drawing down our nest egg, we will spend most of our savings on U.S. goods and services, so it seems wise to keep the bulk of our portfolio in dollar-denominated investments. Thus, while the U.S. accounts for roughly half of global stock and bond market value, I keep more than 60 percent of my stock portfolio in U.S. stocks and almost 100 percent of my bond market money in U.S. bonds.”
Clements notes that recovering from losses can take a long time, using the 2000-2002 dot-com crash as a case and point. “The Nasdaq Composite Index—widely viewed as a yardstick for tech stock performance—fell a jaw-dropping 78 percent. It wasn’t until 2015 that the Nasdaq Composite returned to its March 2000 peak (and, as of early 2016, it was once again below that level).”
Are you taking more risk than necessary? “If we have amassed enough money to lead the life we want, we have won the game. Why would we keep playing—and risk throwing away the financial security we have achieved? We might be comfortable keeping 70 percent of our portfolio in stocks. But if we have amassed sufficient savings that we don’t need great investment returns, it might make sense to throttle back our stock exposure to 40 or 50 percent [so there will be] less chance that we will die broke.”
“Once we retire and our paycheck disappears… our human capital ‘bond’ no longer pays us regular income, so it’s hard to be sanguine about plunging financial markets. A stock market crash could have a devastating impact on our ability to pay the bills. That’s why, as we approach retirement, we should shift perhaps half of our portfolio out of stocks and into bonds.” The precise allocation depends on what other income streams we have, such as Social Security, a pension, or an annuity we may have purchased.
“The shift toward bonds has two benefits. First, bonds typically kick off more income than stocks, so we will have more investment income to replace the lost income from our human capital. Second, and more important, we will have a buffer against stock market turmoil. Once retired, to generate enough spending money, we will likely need to sell a sliver of our portfolio’s holdings every so often… If we get hit with a vicious stock-market decline… we can always generate spending money by selling from the bond side of the portfolio.”
“The goal isn’t to get rich. Rather, the goal is to have enough money to lead the life we want. We shouldn’t put that at risk by incurring excessive investment costs, straying too far from a global indexing strategy and failing to buy insurance against major financial risks.”
Jonathan Clements is a gifted writer. I recommend this book for everybody.