Last week, I attended a seminar on personal finance management and investment strategies for IT professionals. It was a private event, and my colleagues recommended the speaker, so I decided to carve some time into my schedule and invest it in my financial education. Sadly, after the seminar ended, I was a bit disappointed. “Why?” you might wonder. The answer: “It did not pass my basic validation check, which I had adopted in my life.”
Before even listening to any advice, I prefer to clarify the following points:
Has the person who suggested something used that in their life?
What was the result of implementing these suggestions? Can you measure it in numbers?
What were the environmental conditions of this person during that time?
If you cannot get answers to all these questions or verify the information provided, I would seriously question such advice.
Know who you trust
Financial scam
Would you rather entrust your life or the life of your child to a no-name doctor or a surgeon with a proven record of successful surgeries if you had a choice? Would you follow advice on fitness and personal health from a weak or obese person or a muscular athlete? I suppose, for many, the answers to both questions are obvious.
On the contrary, when it comes to finances, people often forget about performing at least a basic background check of such “advisors.” Unfortunately, the world is full of “financial gurus” who tell you to invest in some highly profitable assets just now because it might be too late to do it tomorrow, books on achieving “financial freedom” written by authors who never actually were financially free and questionable financial institutions that promise you high returns but obscure the ways they earn a profit.
If a person teaches you something they have never done by themselves, what are the chances you are doing something that will yield the promised results? Any time I see or hear something like “…assume you invest $100k with a 5% return rate, in 10 years you will get… blah-blah-blah…” instead of real experience, I usually become suspicious about the expertness of such a guy or gal.
So, check first whether this person actually makes money the way he or she tells you or by selling you some financial bullshit. Or, if a person who calls herself a “financial advisor” hasn’t achieved noticeable results in managing her finances, why do you even listen to them?
Math, economy and history
Or do your homework
If the advisor has implemented some investment strategy before, you had better check the numbers because your understanding of success (or profitability) might differ from yours. After doing simple math, you might be unpleasantly surprised that the promised 10% return will be cut in half because of commissions, taxes and inflation (surprise!), and the sum you put in your pocket will be significantly less than you expected.
For example, is it a good investment if somebody offers you to open a bank deposit with a 15% or even 20% interest rate? Well, it depends on many factors. Let me illustrate this with numbers. Here, I will use figures for Ukraine, my home country, but you can apply the same principles to your location.
First of all, if you look only at the interest rate of 15%, it seems pretty impressive compared to Vanguard’s 2018 Index Chart. On the other hand, such a deposit interest rate is not something unusual for Ukrainian hryvnia, the local currency in Ukraine:
Source: tradingeconomics.com
So, what is the trick? Let’s continue our exploration. If you are familiar with the basics of the economy, you might know that there is such a thing as inflation. Simply put, your money becomes less valuable with time, and you can buy fewer goods with them. Historically, over the last 10 years, the inflation rate in Ukraine remained relatively high – hryvnia depreciated by roughly 10% annually:
Source: tradingeconomics.com
Wait, you might ask. But what about that spike in inflation from 2014 to 2016? To understand it, we have to look at the local economy in general. If you check the balance of trade for Ukraine, you will see that over a long period, more goods were imported (consumed) than exported (produced) by the Ukrainian economy. That means that most goods in Ukraine were bought in international markets and paid for in foreign currencies, such as the US dollar and Euro. Consequently, the local prices for these goods in hryvnias were bound to their prices in dollars or euros.
Also, if you spend more than you earn (import vs. export), you will eventually have to pay your debts. The payments might be delayed but must be paid sooner or later. To repay those debts, the government might decide to devalue the local currency to international ones, so the locally produced goods will cost less for international customers, and the imported ones will be more expensive for locals to buy. For you as an individual, it means that you (suddenly) are paid less for your work as related to the value of a local currency, plus you have to pay more for the same goods you bought yesterday for fewer coins. It’s not a pleasant experience, but that’s how it is.
Turning back to Ukrainian hryvnia, it looks like this on the following chart:
Source: tradingeconomics.com
Over the same 10-year period, the exchange rate of UAH to USD went from 8:1 to 25:1. In other words, now one Ukrainian hryvnia is worth three times less than it was 10 years ago.
Now, if you do the math, you will see that over a long span, this investment is not as appealing as it might have seemed from the start. Inflation might easily cut your earnings from 15 to 5 percent. If you continue this investment strategy, the next local currency devaluation can wipe out your savings.
Of course, my example here is a bit simplified, but the general idea is that to master finances, you should also learn math, economics, and history. If you cannot understand where the money comes from and why it comes, you will never be able to evaluate whether your investment will be good or bad.
Getting rich and financial freedom
Conventional wisdom
If the strategy was indeed successful in some economic environment, it does not automatically make it the best choice in any situation. Please don’t focus on the strategy itself without considering the background in which it was implemented.
For example, you might have already heard about compound interest and how to become financially free by applying it. A typical example of passive income is putting your money in a bank account and multiplying it by doing nothing. Sounds appealing, right? Yes, if you open a cash deposit with $10,000 at a 5% interest rate for 50 years, in the end, you will have approximately $120,000 (of course, the real value of that figure will vary depending on taxes and inflation).
What is usually omitted in this financial logic is the two-fold nature of time. On the one hand, the more time you invest, the more money you might have in the end. On the other hand, do you genuinely believe that you will benefit from that money when you are 70 or 80 years old or, even worse, already dead? Seriously?
Of course, in the case of Warren Buffet, compound interest might make sense. A 5% return from 10 million dollars brings you $500,000 annually. As you might notice, the scale is entirely different. You don’t have to wait 30, 40 or 50 years to enjoy your “retirement.”
Aaah… Now, some questions might arise at the back of your head…
John Sonmez from Bulldog Mindset has already filmed a very explanatory video about the concept of the wealth triangle and how it works:
Regardless of strategy and asset types, every investment has three components: initial capital, interest rate and time. At least two of these components must be relatively big to yield a noticeable return.
So, every time you hear an argument like “You should definitely do this because everyone invests in X…” or “All rich people use this investment strategy…”, run the numbers, and don’t rely blindly on some conventional “wisdom.” Before making any important investment decision, it wouldn’t hurt to model your idea or, if possible, create its proof of concept. There is a huge difference between somebody who invests N thousand dollars in stocks and Warren Buffett, who spends N billion dollars on the stock market. In the first case, you buy some shares to earn dividends or resell them later for a higher price; in the second, you acquire the whole business itself and bend the rules of the market economy to work in your interest.
To conclude this long read, if you asked me for advice on managing your finances and investments, I would quote the best financial advice I have ever heard: “If you have $10k, you had better invest it in your financial education first.”
P.S. If you are looking where to start your learning of finances and money management, I can recommend the following books by MJ Demarco:
These are not some “conventional” classics on funds, stocks and other investments, but rather an uncensored truth about common beliefs about money and wealth.
