Monday, October 5, 2009

Squeezing The Margins

My father has been a business consultant for decades, my mother is a certified financial planner, and my brother has run several small companies. So as you'd expect, my family talks a lot about money-- both now and when I grew up. Much of the discussion is about how to make the most money.

For example, if you have a savings account that earns 3% a year and have a credit card balance that costs you 10%, you have no reason to keep anything in savings until that credit card is paid off. Not paying off the credit card costs you 10%, bringing the net return on savings to 3% - 10% = -7%, or a 7% loss. The 3% return isn't the full story on investment. You also lose 10% in "opportunity cost", since saving the money means you forgo the opportunity of paying down debt.

On the other hand, if you have some subsidized government school loan with a 4% interest rate and you are earning 5% on average from savings, you will make more money by paying the loan off as slowly as possible, putting all additional money into in savings. When you put $100 into savings rather than paying this loan, you owe 4% more in loan interest ($4) but earn 5% more in savings interest ($5). This is a net gain of 1% ($1).

I've heard all kinds of other, more complicated ideas to leverage money for potentially greater returns. All the ideas come down to this basic concept though:

Maximize the spread between your expected investment interest rate and your debt interest rate.

If you could get a loan with a 7% rate that funds a business with an expected return of 8%, then that's 1% better than not doing anything at all. In theory.

The problem is that more complicated investment strategies have a greater chance of going wrong. There's simply more potential source of failure. In the real world there is no such thing as a guaranteed 8% return on investment. More typically what happens is that there's a pretty high chance that there will be between say, 6% and 10%. And there's a very low chance you'll get a 0% return or even less. So maybe you'll get lucky and get a free 3%. But another possibility is that the investment will give 6%. The business would consider this a success, but it cost you 7% to make this investment, so you're down 1% for your effort. And there's always the chance of a catastrophic failure, meaning you lose most or all of your investment.

Lately I've been rethinking this strategy of squeezing the margins. The increased risk is certainly part of it. Mathematically you will maximize your money if you go from a guaranteed $1,000 to anywhere between $900 and $1,400 most of the time and occasionally $0. But maybe maximizing your money isn't the end goal of life. The potential life impact of losing between $100 and $1000 is probably a whole lot worse than the best case scenario of gaining $400.

Additionally though, more complicated investments just take more time to manage and stay on top of. The purpose of money, at least in my life, is to give me more time and reduce my stress. Working hard for an extra 1% isn't worth it if I can't turn that money back into the time I spent to get it. Squeezing the margins isn't the key to financial security, though it does maximize your odds of getting lucky and striking it rich. Here's the strategy I use:

Reduce, Reuse, Recycle

This is the recycling motto. Most people don't know this, but these steps are ordered by importance. In other words, the most important thing you can do is reduce the amount of things you obtain that need to be recycled. The second most important thing is to reuse the things you have. And if can neither do without them nor reuse them, then as the last option you should recycle them. Sadly most people these days focus on "recycle" and ignore the other two.

This mindset applies just as well to finances though, and with the same priority scheme:
  • Reduce: Don't buy things you don't need
  • Reuse: Don't have money in so many places you can't keep track of all of it
  • Recycle: Put your money in the place it gives the highest return
That third rule is the same one as "squeezing the margins". Squeezing gets you into trouble when it violates the second rule-- once it takes a lot of effort to manage your investments, you are setting yourself up for a fall. But most importantly, the secret of wealth is not buying things you don't need.

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