From well over a decade of reading obsessively and investing broadly (and often badly), I’ve identified 10 financial principles that sum up my view of how you should run your personal finances.
I wish there were 9 or 11 instead: 10 sounds like a suspiciously round number, like something has been missed out or added in just for padding. But no – 10 it is.
Some will have you nodding immediately. Others will challenge your existing beliefs. Look out for those you instinctively disagree with: those are the ones with the greatest potential to improve your own thinking by making you consider a different point of view.
Principle #1: There are three levers you can pull to improve your finances
Those are Earning, Saving, and Investing. In other words:
- Make more money
- Keep more of what you make
- Invest what you’ve kept more wisely
Earning is the most powerful of these levers, because its upside is unlimited. By comparison, you can only increase savings by a limited amount (until you end up spending nothing) and investment returns by a limited amount too (even Warren Buffet “only” manages 17% per year on average).
Principle #2: Anything you own is either to “Protect” or “Expand” your wealth
Asset allocation – or “knowing what mix of stuff to invest in” – is something investment professionals debate endlessly.
We non-professionals can ignore most of it, and focus on the underlying reason why we might hold a certain asset. There are only two choices:
- To expand the amount of money you hope to have in future
- To preserve or protect the money you’ve already got (including maintaining its spending power in the face of inflation)
In other words, “getting richer” and “not getting poorer”.
We need to decide on the relative importance of each, then select assets that strike that balance.
Principle #3: Your future earning power is your biggest asset
The capacity to generate future income is the most valuable asset everyone starts life with. As your working life goes on, this future earning power decreases as it’s “used up”.
The lower your future earning power, the more you’ll want to focus on protecting rather than expanding. Why? Because you have less ability to “earn back” losses from investments that go wrong, and less time remaining until you need to live off your investments rather than your efforts.
Age is generally used as a proxy for earning power: the closer you are to retirement, the less risk you want to take on.
But that’s not the full story. A 30-year-old doctor has far greater future earning power than a 30-year-old cleaner, even though the cleaner might currently have higher net worth (because the doctor has medical school debt). A 50-year-old entrepreneur whose business has just taken off might have higher earning power than both of them.
Principle #4: Holding cash is both protective and expansionary
Cash gets a bad rap. Everyone points out that you barely earn any interest on it, and it loses earning power to inflation every year.
Call me Mr McDuck, but I love cash.
As a protective measure, cash is a great comfort blanket because its value is entirely predictable (assuming normal rates of inflation). If you have enough cash to see yourself through the worst realistic personal situation you can imagine, you can relax and take bigger risks (for higher reward) with the rest of your assets.
Believe it or not, cash can be expansionary too. Having cash on hand allows you to move quickly and take advantage of opportunistic deals that the cash-phobic can’t do.
However: You must know the purpose of any cash you’re holding, and not let it build up just because you’re too scared to invest it.
Principle #5: In financial markets, you have no edge. Nor do most other people.
What makes you think that you – presumably lacking in a lifetime’s experience, full-time dedication and teams of analysts with PhDs – can do any better?
That’s OK: you don’t have to beat the market. You can do perfectly well by just performing in line with the market. And that’s spectacularly easy to do: just own a bit of everything.
Actively investing in financial markets is fine if it’s a hobby or passion. The rest of us can give up trying, be happy in our averageness, and go off to do something more fun.
Principle #6: Where you have no edge, diversify. Where you do have an edge, focus in.
It’s fair to assume that human desires will remain infinite and we’ll continue to find better, more efficient ways of meeting them. Therefore, the values of the world’s companies will continue to go up over time. But as stated in Principle #5, you’re unlikely to have an edge in knowing which companies will perform relatively better and worse.
In situations like this where you don’t have an edge, it’s best to diversify: own a bit of everything, and do well on average. No special knowledge needed.
In other situations, you might actually have an edge. You might have relationships that allow you to find houses to refurbish at a better price than anyone else. You might own a business that has a unique advantage over its competitors.
Where you do have an edge, exploit it and focus in. Yes, you’re taking more risk, but it’s justified by your superior knowledge or ability. And besides, you’ve got your downside covered (Principle #4).
Principle #7: Everything is cyclical
Countless economists have cooked up models for running a country’s economy (and won Nobel prizes for them) that they claim will end the boom/bust cycle.
I don’t have a Nobel or any other prize beyond winning a £5 book token for a poem when I was nine, but I know they’ll all ultimately fail.
Markets are the aggregation of millions of individual human actions. Humans act as a herd, and whip each other into bouts of unjustified mania followed by woe-is-us pessimism. No fancy equations can overcome these tendencies.
Once you internalise this principle, you can be rightly suspicious when times have been either good or bad for too long. If you’d sold everything you owned on 22 March 2006 when Gordon Brown said in his Budget speech there would be “no return to boom and bust”, you would have avoided the enormous financial blow-up a couple of years later.
Principle #8: Timing the market well is better than not timing it at all. But timing it badly is even worse.
It’s rational to tilt the balance of your investments between “protection” and “expansion” depending on what’s happening in the markets. You don’t want to be expanding when assets are expensive and primed for a fall. You don’t want to miss opportunities by being cautious when there are bargains all around you.
There’s just one snag: most amateur investors get market timing completely wrong. They sell in panic when prices fall, and are too scared to buy until everyone around them is buying too and the next crash is on the cards.
That’s why it’s common investment advice to drip-feed a regular amount into investments, regardless of what’s going on. This advice protects you from your own bad decision-making…but removes the potential rewards of getting the timing right.
So when it comes to timing, you need to know yourself. Like Principle #6, do you have an edge? Do you have the ability to stay unemotional and form an accurate picture of the world around you, even when that means acting alone?
If you do, then by all means time the market. If you don’t, don’t.
Principle #9: Financial assets are the least valuable type
Intangible Assets, like copyrights and intellectual property, are great because you can just create them from nothing but your own imagination – no financial clout needed.
Real Assets, like property, are great because you can’t create them out of thin air. They have real-world utility and intrinsic value regardless of what’s happening in the financial markets.
Financial Assets, like shares and bonds, don’t have either of these advantages. You can only buy them by swapping them for another asset (commonly cash), and their values leap around depending on investors’ whims.
This is a radical oversimplification, of course, and I own plenty of financial assets. But if you read most personal finance advice you’d think they’re the only type – which cuts you off from some of the most valuable assets you can own.
Principle #10: Your finances are a reflection of your personal habits
Let’s finish with an unpopular one…
Your finances are the result of all the value you’ve created, all the discipline you’ve exhibited, all the investment decisions you’ve made.
Read the biography of any billionaire you can think of. I guarantee it’ll be a tale of hard work, persistence and brave (though not flawless) decision-making. And I bet they remained vigorous and active well into their 70s and 80s.
Read the biography of any successful CEO. You’ll find the majority of them wake up before 5am, and almost all have a daily exercise regime – again, often well into typical “retirement” years.
Yes, where you start out in life matters a lot. And sure, many CEOs and billionaires are excessively driven by their work to the detriment of other parts of their lives.
But at some point you need to take responsibility. Your actions and decisions are your own. That’s wonderful: it means improving your financial life is totally within your power.