Personal finance is littered with gotchas. Acquainting yourself with tried and tested financial laws and rules provides some immunity to the worst of these gotchas.
Rules of thumb such as the Rule of 72 and the Dunning Kruger Effect have saved many investors from a sticky financial end. My collection of favourite rules can steer people away from risky decisions and towards more sensible ones:
Dunning Kruger Effect
The idea behind this rule is that people are sometimes too dumb to know they're dumb. Incompetent people can sometimes have grandiose delusions of their own abilities. Dunning and Kruger did a test that found that people who scored in the 12th percentile in a logical reasoning test guessed that they'd scored in the 62nd percentile. People who are quite intelligent in other parts of their lives sometimes grossly overestimate their prowess at investing. Kruger and Dunning found that the more people knew, the more modest they became in their perception of themselves. There is a great quote from former United States President Thomas Jefferson who once said: "He who knows best knows how little he knows."
The Rule of 72
This is a very simple rule of thumb that tells you how long it will take to double your money in a particular investment. All you need to do is take the number 72 and divide it by the rate of return of an investment. If that's 4 per cent, for example, it will take 18 years to double your money. At 5 per cent, it's 14.4 years. That shows the power of a small percentage increase. But you need to do your calculations using the post-tax rate of return. Otherwise you might be fooling yourself.
Regression to the mean
This law is all about the bubbles that appear in investment markets. Prices often go irrationally high (or low) in investment markets, but eventually over time they revert to a mean, according to this rule. On a chart showing the rise of the property market or sharemarket in New Zealand or elsewhere prices jump up and down in the short term, but over time track up in a fairly steady way. They cling to a "trend line" in the words of Wharton Business School professor Jeremy Siegel. Eventually prices come back into alignment of the trend line, taking ill-prepared investors' "profits" with it. That alignment could happen by prices going sideways as inflation goes up, or it could be a sudden drop in prices. The former is more common with the property market and the latter tends to happen more in the sharemarket, which can be volatile in the short run.
Law of unintended consequences
I call this the cane toad law. Cane toads were introduced to Australia to curb sugar cane beetles. The unintended consequence of the introduction of 102 toads in 1935 was an ecological disaster that is slowly jumping its way across Northern Australia. One example of how the law of unintended consequences can affect our finances is that medical advancements mean that people are living longer. The unintended consequence of that is that they are outliving their retirement savings. Anyone investing on the basis of tax efficiency should be wary of this one. The Government can change the rules overnight. Sometimes well-intentioned Government tinkering with the economy can have far-reaching financial consequences for individuals. On a more personal level "card tarts" who shop around for introductory rates on credit cards could unintentionally blight their credit record and make it harder to get a mortgage later on.
According to this law the bad drives out the good. A modern example of Gresham's law is the second-hand motor vehicle market. People with good reliable cars don't tend to sell them. So the market price is based around the assumption that second-hand vehicles are lemons. Even when one of those good cars goes on to the market it can only sell if priced as a lemon. Economist George Akerlof wrote a paper in 1970 based on this concept, called: "The Market for Lemons: Quality Uncertainty and the Market Mechanism". I suspect that apartments and also homes from the leaky era are bought using Gresham's Law.
If something can go wrong it will go wrong. This is a bit negative. But in the world of personal finance you could, for example, lose your job, have an accident or illness and become disabled, or your tenant could set up a cottage P-lab and contaminate your entire property. It happens. That's why everyone should have plans to deal with the worst case scenario. No investment is completely bullet proof and nor is any investor. Investors need, in the words of American personal finance writer Dave Ramsey, a "Murphy's repellent". What that repellent is depends on your personal situation. If you're dependent on wages or salary for your living expenses then it might be income protection insurance. If you're a landlord it could be comprehensive landlord insurance cover, including P-lab cover, abandonment, malicious damage and other tenancy-related risks, which many "landlord" policies don't actually offer.
Someone who invests in shares or funds needs to have proper diversification. That doesn't mean several investments that invest in more or less the same underlying products.
There are other "rules of thumb" that are oft repeated in the world of personal finance and can protect us against the silly decisions we make because we're bestowed with fallible human brains. Some of my favourites are:
Do the maths
Don't assume that an investment is going to be profitable. A classic one with this is buying an investment property without factoring in costs such as maintenance, rates, insurance, conveyancing and other costs.
Diversify your investments
How many people have you heard of that lost everything because one investment fell over? Plenty in the case of finance companies.
If you don't understand an investment, don't buy it. This is where the Dunning Kruger Effect comes in. One of the worst examples of people being burned by buying investments they didn't understand was the Blue Chip Finance "joint venture" deals. Many of the elderly investors thought that they were lending money to Blue Chip, for which they would be paid an annual cash payment of around $9000. They had instead taken out a mortgage to buy an apartment that was never built. When Blue Chip collapsed they were left paying the mortgages that they didn't even know existed.
Bull markets begin in bad times. People see others doing well from a market and want to invest, by which time the horse has bolted. These are the people who at the height of the GFC would have thought it was a bad time to invest. Yet that was the bottom of the market and where the current stock market bull runs began.
Buy a house as young as you can. The sooner you can get on the property ladder - no matter how modest the first home is - the sooner you'll start building up capital. A small number of very clever young people stay at home with their parents and buy a rental property, getting the tenants to pay off the mortgage.
Cut your losses
Expert investors cut their losses before they get too bad - selling off shares or other investments that have failed them. According to Investopedia some of the reasons we can't sell the duds are: we delude ourselves that stocks always bounce back, investors don't like admitting they've made a mistake, we neglect our portfolios, or that we believe that there is always hope.
If it's too good to be true, don't do it
Every year Kiwis get sucked into all sorts of scams and poor investments based on amazing returns cited by a flash salesman or scammers. Be particularly wary of anyone who cold calls you. If investments were that good there would be investors lining up to buy whatever it was. There would be no need for anyone to make cold calls looking for business.
Consumer debt is dumb debt
If you have any debt other than mortgage or business debt then you're throwing money away needlessly, on goods that, quite honestly, aren't essentials.
Consumer debt includes any extensions to the mortgage to buy a car, kitchen or other depreciable items.