Here is a test. Suppose you had $100 in a savings account that paid an interest rate of 2% a year. If you leave the money in the account, how much would you have accumulated after five years: more than $102, exactly $102, or less than $102?
This test might seem a little simple for readers of The Economist. But a survey found that only half of Americans aged over 50 gave the correct answer. If so many people are mathematically challenged, it is hardly surprising that they struggle to deal with the small print of mortgage and insurance contracts.
The solution seems obvious: provide more financial education. The British government just added financial literacy to the national school curriculum, to general acclaim. But is it possible to teach people to be more financially savvy? A survey by the Federal Reserve Bank of Cleveland reported that: “Unfortunately, we do not find conclusive evidence that, in general, financial education programmes do lead to greater financial knowledge and ultimately to better financial behaviour.”
That quotation, from an article in this week’s Economist, gives me an excuse to mention the best personal finance book I’ve ever read: Andrew Tobias’s The Only Investment Guide You’ll Ever Need. Self-aggrandizing title aside, the book is genuinely fabulous because it is hard-headed, practical, and best of all right.
Here are the takeaways from Tobias’s book:
1. There are no get-rich-quick schemes. Your goal should not be to become rich, but to become financially secure.
2. Forget about the stock market and other fancy investments. Instead, earn more than you spend. Then reduce your spending even more. It is easier to save a dollar than to make one.
3. If you must invest, put your money in low-cost, broad-based index funds, every month, for the rest of your working life, regardless of market conditions. (This is known as dollar cost averaging.) You are not smart enough to make money on fancier investments — and this includes ordinary blue-chip stocks.
And that’s basically it. (The book actually goes into some more advice on specific stock-picking tips, but I found that inconsistent with its earlier message so just ignored it.)
The one thing that I don’t believe the book really covers is the corrosive effect of comparing yourself with others. Who hasn’t felt a little bit envious of a friend who happened to purchase a ton of Apple stock on the cheap, or the co-worker who somehow manages to flip her house every few years at enormous profits? But the truth is that these are all distractions. There are always people who get lucky. Your goal shouldn’t be to chase that luck — a path that usually leads to disaster — but rather to control what you can and be conservative with growth options.
What does all this have to do with the opening quotation? What Tobias’s book does a good job explaining, especially in the opening chapters, is that personal finance isn’t some kind of mysterious alchemy. Sure, there are always new ways of making (and losing) money. But the basic principles that guide your decisions should be simple, practical, and most of all immune to fads. Save more. Spend less. And don’t sink your money into risks you don’t understand.
(Also, understand that 2% interest compounded over 5 years will get you a little more than $10 on top of your $100 investment.)