Financial Decisions
Life's Money Rules:
1. Know The Difference Between Needs and Wants.
Our actual needs are pretty limited: food, shelter, clothing, companionship. Just about everything else is a "want," and our wants are essentially endless. Because our resources are limited , we have to make choices about which wants to fulfill. Also, the way we fulfill our needs involves a lot of choice. Shelter, for example, can be a bed at a mission for the homeless or a $125 million mansion. Our food choices offer a similar range, from beans and tap water consumed at home to steak and Dom Perignon at an exclusive restaurant.
2. Scarcity Makes Your Choices for You.
It's lovely to believe in a world of endless abundance, but the reality is that at any given point in time our resources have limits. Whether it's oil in the ground, our time here on Earth or the cash in our pockets, there's only so much available to be spent. People who ignore this reality are the ones who run out of paycheck before they run out of month, or who extend their unsustainable spending by relying on credit cards, home equity loans and other reckless borrowing.
3. The Pointlessness of the Hedonic Treadmill.
The hedonic treadmill means that we quickly adjust to improved circumstances. A raise at work or a new possession may make us happy for a little while, but we soon take our situation for granted. Our expectations continue to rise: if only I could get another raise, or a better car, or a bigger house. Should those expectations be satisfied, again we'd adjust and quickly want more.
4. Every Money Decision has a Cost of its Own.
" Opportunity cost," very simply, means what we give up to get something else. In every choice, there's an opportunity cost. If you decide to go to college, for example, you're giving up the income you could have earned by working full-time during those years plus whatever you could have purchased with the money used to attend school. You also may take on loans to pay for school, which will have to be paid back with future income that could have gone for other purposes.
5. The Supply and Demand Rule.
For the most part, prices are set by the interaction between supply and demand. If demand for something suddenly shoots up and the available supply of that something doesn't change, then prices will increase. If demand drops or supply increases, though, prices typically fall.
6. Throw No Good Money after Bad
"Sunk costs" are expenses that have already been incurred and can't be recovered to any appreciable extent. "Sunk cost fallacy" means an irrational belief that a further investment of time, money or effort will somehow resurrect the value that's already disappeared.
7. The Role Risk Plays
Every human endeavor carries some risk, and investments are no exception. What differs is the amount and type of risk and how you're compensated for taking it.
8. The Time Value of Money
This boils down to a relatively simple proposition: that the dollar I get today is worth more than a dollar I'm promised sometime in the future.
There are several reasons for this. One is the "bird in the hand" reality: the dollar I get today is real, but the dollar I'm promised in the future likely will be worth less (because of inflation), or I might not get it at all (you might renege on your promise to give it to me, or die, or cease operations if you're an employer or business). Also, the dollar I get today can be invested to create more dollars in the future.
9. The Wonder of Compound Interest
This is a concept best illustrated by taking one penny and doubling its value every day for one month. At the end of 31 days, you will have $10,737,418.24. At the beginning, the amounts are nominal, but by the end we're talking big bucks. No one's going to double your money every day. But this concept explains how people who save relatively small amounts over the years can build rather substantial nest eggs. After a few decades, their actual contributions represent only a small part of their burgeoning wealth -- it's mostly their returns that are earning returns. But this also illustrates how debts can quickly balloon out of control.