What many of us typically think of as the nuts and bolts of personal finance–how to budget, how to avoid and manage debt, how important it is to diversify the money you invest–is essential to anyone who wants to gain a solid financial footing. But to be able to fully embrace a rewarding and secure financial life, more fluency is required. The value of a job, of a retirement plan and of carrying insurance sufficient to your needs are good examples. Millennials need to be as literate about personal finance as they are about craft beer, indie bands and apps.
Decisions made today can make a sizeable difference 50 years from now. Understanding the consequences should be a key aim of financial literacy. Here are three meta-concepts for Millennials to chew on. Think about sharing them with your family.
1. Your most valuable asset is yourself.
For the majority of people during their working years, their human capital–their ability to earn money–is their largest single financial asset. The obvious question is: How will each invest his or her own human capital? For all of us, a long-term investment horizon makes all the difference, but Millennials are better positioned to capitalize on this in order to successfully shape their futures and to contribute to the greater good of their communities.
2. Our brains are booby-trapped to make irrational decisions about money and investing.
Let’s assume your kid has a job and realizes that his or her 401(k) with a match is a great deal. How will he or she manage the money? All of us are prey to cognitive biases and irrational thinking. In many cases, we’re even hard-wired to make all sorts of errors in judgment. This applies to financial professionals as well, which is why rigorous discipline is so important in investing.
Judgment processes about money are highly subjective, yet many patterns that defy logic seem to be shared. Investors engage in herd behavior, chasing market performance in buying high and selling low. And counterproductively, many investors tend to run for the exits during periods of high volatility like we’ve been experiencing lately, removing themselves from opportunities to benefit when the markets rise.
Research shows, for example, that most people perceive losses about 2.5 times more negatively than they view gains positively. Imagine there’s an equal chance of Standard & Poor’s 500-stock index returning or losing 15% in the next year. Millennials who feel the potential loss much more strongly than the happiness they’d experience from a successful outcome are less likely to see investing in U.S. stocks as attractive. And that’s despite U.S. equities’ historic track record and younger adults’ longer time horizon to weather market vagaries.
In his entertaining book on the subject of neuroeconomics, Your Money & Your Brain, Jason Zweig abstracts a great deal of research. Here are several of his findings:
— A monetary loss or gain is not just a financial or psychological outcome, but also a biological change that has profound physical effects on the brain and body.
— The neural activity of someone whose investments are making money is indistinguishable from that of someone who is high on cocaine or morphine.
— Financial losses are processed in the same areas of the brain that respond to mortal danger.
— Expecting both good and bad events is often more intense than experiencing them; anticipating a gain, and actually receiving it, are expressed in entirely different ways in the brain.
There’s a large body of work in financial decision-making by psychologists and economists, loosely called behavioral finance, that’s worth exploring. Nobel Prize-winner Daniel Kahneman’s work Thinking Fast and Slow is a great place to start. Knowing more about how and when our judgment can go awry can be of great value in helping us make rational decisions about spending, saving, and investing money.
3. It’s helpful to think of your finances in terms of managing risks as well as reaching for goals.
Risk management is important throughout life and is frequently not given its due–particularly for those in their “invincible” 20s and 30s. During those years, kicking the getting-serious-about-my-finances can down the road can seem like a reasonably safe bet. Younger adults often put off saving for the future–not least those who are saddled with daunting college loans.
Yet in the constellation of personal financial risks, longevity risk–the risk of running out of money before the end of life–is huge. For the average person, for example, this poses a much greater risk than market risk. Every Millennial should have a plan for addressing it. As a nation, we are living longer and longer. For the last decade and more, with growing alarm, I’ve been tracking statistics on what future U.S. retirees are setting aside. These statistics reflect a shrinking number of people who can safely anticipate a financially secure retirement.
Another financial risk that often gets short shrift from Millennials is the loss of employment income, which can be addressed by disability and life insurance. This of course is especially important for those supporting a family. Ultimately, Millennials must look inward to carefully addressing their own risks and liabilities.
This is true financial wisdom: We need to face the financial choices the times demand of us, understand the factors that cause us to make less-than-optimal judgments and make our choices explicit–and take responsibility for them.