Thursday, January 29, 2009

Financial Lessons from the Wealthy

We often hear that the rich keep getting richer, and that’s a common refrain in America. I usually enter this fray by noting that the educated keep getting richer, and that the best economic solution seems to be further education.

This is particularly true of financial education. I’ve been managing money since 1983, and I’ve noticed some important gaps in the typical family’s financial knowledge. Simply put, wealthy people behave differently, and we can learn some important lessons from them.

The stock market isn’t a casino. Many middle-class people think it is. It’s true, buying a single stock is risky. Buying many stocks, though, is prudent.

Millionaires own stocks, but they aren’t frequent traders. When Dr. Tom Stanley and Dr. Phil Danko wrote The Millionaire Next Door (Longstreet Press, 1996), they discovered that fewer than one percent of interviewed millionaires traded stocks on a daily basis. Another one percent traded on a weekly basis. In fact, more than 40 percent hadn’t traded a single stock in the year prior to interview. Clearly, millionaires are investors, not gamblers.

The heart of wealth management is the idea of thoughtful diversification. This scientific basis for portfolio theory won a 1990 Nobel Prize in Economics (several, actually). In essence, risk is reduced and performance enhanced by owning a wide variety of investments. There’s a lot more to it, but that’s the basic concept.

Many so-called safe options collapse to genuine evaluation. Low interest rates, inflation, and taxes eat much of the gain from bank deposits or government bonds. Comfort comes at a very high price, and a bit of education about stocks and diversification can put a mind at ease.

Not all debt is bad. “Neither a borrower or lender be,” Ben Franklin advised. It’s become a sort of holy middle-class mantra. Despite Ben’s advice, there are different kinds of debt, and not all debt is bad. Borrowing for consumer goods such as furniture is almost always bad. Borrowing to buy a nice house in a nice neighborhood is almost always good, so long as the terms of the loan are reasonable. We all know by now that sub-prime mortgages, interest only loans and 50-year mortgages are bad debts.

Many quality advisors recommend against paying off a mortgage early, and there is solid evidence supporting this approach. Nevertheless, many middle class folks want to pay off their residence as quickly as possible.

They think they’re doing the right thing, but money for paying down a mortgage comes from somewhere, and it’s no longer available to invest. That can be counterproductive. Our wealthy friends understand the difference between good and bad debt and aren’t always in a big hurry to pay off their mortgage.

Do-it-yourself isn’t the best choice. Wealthy people know where they excel. Many own a business that relates to their strongest skill.

They also know their weaknesses. They probably don’t try to save money by fixing their own cars because they know a mechanic can do it better, and in the end, they’ll save money by hiring an expert the first time around, rather than to repair mistakes.

When it comes time for a new roof on their home, they pay someone to do it for them, so that they won’t spend their time cleaning up leaks.

And you’d better believe when it comes time for surgery, these are not folks picking up instructions off of the Internet to replace their own knees.

The point is, hiring professionals is often the best path. Consider this the next time you’re looking over your retirement fund or other investments.

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