Big-picture finance concepts can help inform personal money concerns, according to U-M business expert
The subject of finance tends to suggest large-scale operations—stock markets, banks and the like.
Nejat Seyhun, a professor of finance at the University of Michigan Ross School of Business, has spent years thinking about how the lessons of his field can also apply to individual financial issues, such as deciding on college, buying a home and taking on debt.
Seyhun has collected his research-based thoughts and advice into a new book, “Personal Finance for Everyday Challenges,” which fills a niche between self-help works and finance textbooks. He shares some of his insights.
Most of us probably don’t apply finance concepts in our everyday lives. What can an average person gain from learning to do this?
Every once in a while, we make big decisions, and those big decisions affect us for the rest of our lives. At what age do we get married? Who do we marry? Or the decision to go to college. This is a huge decision, costing hundreds of thousands of dollars, yet we don’t apply financial ideas to it.
The same goes for other big decisions—we buy a house, we buy a car, we buy a vacation place—but we don’t apply financial concepts. Buying a vacation home creates a source of inflexibility, since we have to vacation there every year. It’s important to think about financial flexibility.
My son is a young guy fresh out of college. He just signed an employment contract, which committed him to a no-compete clause for three years. You can bring your financial perspective to that: What is the cost of that signature?
Or you can consider things like credit card debt, how much we save, where we save. Do we make use of tax-advantaged vehicles? A basic financial literacy can help with retirement savings decisions, too.
I’m not saying finance will necessarily give us all the answers. Even if college does not make financial sense for me, I may still choose to pursue my passion, but at least I will do it in an informed way. Just about any big idea, any big decision that we make, could benefit from a very basic level of financial literacy.
One critical concept in finance is the idea of risk. Why is this so important in personal money decisions?
Finance tells us at a very basic level that we have to think about risk, understand what risk is, and consider how we might deal with it. It essentially says that you can’t just look at the most likely outcome and make decisions on that basis. You have to look at the tail risk—that which is unlikely but still possible—and you have to think about how costly those tails are.
Some very sophisticated, successful people have ignored the fundamental finance lessons on risk. Some people put all their money in one stock, such as when employers give employees a discount on company stock and people load up on it. Very basic concepts will tell us that’s probably not a good idea. Think about what happened with Enron: People lost their life savings and their jobs at the same time.
Everything is subject to risk, and finance gives us a framework to deal with it in a reasonable way. It doesn’t have all the answers. It depends on how we feel about risk, and what our individual risk tolerance is. But finance at least gives us that framework.
One of your key points is that “the essential path to financial security is to postpone unnecessary spending.” That makes a lot of sense, but we sometimes have trouble with it. What makes this such a powerful idea?
That’s a really simple idea that I see most people in America ignore and then regret later in their lives. We have a Turkish saying: “Stretch your legs according to the length of your blanket.” If your blanket is small, it’ll still warm you up, if you tuck your feet in.
That simple lesson we ignore. We are always trying to impress people with our wealth and our power, by spending money, by showing off our possessions, our big house and our big diamond ring and our brand-new car. But that comes at the expense of our future comfort and peace of mind.
A lot of people find themselves with good jobs, making six-figure incomes, not being able to make ends meet because they spend too much money. We live in a society of affluence, but unfortunately, when we lose our jobs, when some accident occurs and our health deteriorates and we don’t have insurance, it can bankrupt any one of us.
We don’t have to buy a new car, we don’t have to go to a cafe every day and have a $5 cup of coffee. Those things add up. If we don’t watch those things, then we have a wedding and spend $30,000 or more—if you instead leave that money for 40 years, you can retire on that money. Unfortunately, we don’t think of these trade-offs. The idea that we need to delay gratification is lost.
You make a persuasive case for investing in the stock market, in particular in diversified funds. Yet some people may hesitate to do so because of the volatility that they see from day to day in the market. Why should we not worry about that?
Before we invest, we have to say: “All right, what is my pain point? What is my risk tolerance?” Nobody can tell us that, except ourselves. We have to say: “Look, if I lose half the money, how am I going to feel about this?”
There’s actually a name for that, “freaking out.” If you’re gonna freak out with a 50% fall, that money doesn’t belong in the stock market. This is the first lesson I tell my students: “Look at yourself in the mirror and answer the question, ‘What will freak you out?'” Only then you can begin to invest in the stock market. You’re investing for the long term.
What’s another key lesson you hope people will take away?
There’s a very basic lesson in finance: Prices reflect information. When I look at a price, I should learn from it. I shouldn’t assume that the million or billion people whose interactions led to that price are idiots.
Once I understand that prices are informative, that leads to many lessons. I’m not going to fall for scams, first of all. We all get these offers and great deals. A very basic lesson in finance is, “If it sounds too good to be true, it is too good to be true.” Forget about it. Don’t get even tempted.
Another lesson is there are reasons for the prices that we see. Why is this house selling at a discount? There must be something wrong with it. In an efficient market, that price is telling you something. So we need to learn from the price.
Written by Bob Needham, Ross School of Business