3 important lessons from the financial crisis
It’s hard to know what to think these days. I find myself overwhelmed sorting through all the data and predictions. It’s time for reflection, so here are three of my lessons during this downturn:
1. Saving for emergencies: time to revive age old wisdom
Ancient societies understood the need to save for emergencies. Those that could save stored up food and supplies for unexpected hard times. The economy has changed, but the logic is relatively the same.
Nowadays we don’t save food but money. The modern version is creating an emergency or “rainy day” fund. This is a stash of money kept in a safe account to be accessed for real emergencies, like unemployment or an extended hospital stay. Smart people have always saved up, perhaps even as much as 3 to 6 months of living expenses.
Recently, emergency funds have been called old-fashioned because of greed and pessimism. First, it was the greed for higher returns. Many people felt safe money wasn’t earning enough. If stocks returned 10 percent historically, why should anyone sock money into a low interest savings account? Second, it was the pessimism that people wouldn’t follow the advice. When people are in debt, it can take a really long time to clear the debt and then save for emergencies. Advisers figured people faced with an unrealistic goal would do nothing, so it was best to modify the advice. In the end, even advisers printed in such reputable publications as the Wall Street Journal questioned the need for an emergency fund.
Despite these criticisms, the truth is that an emergency fund serves as crucial part of a balanced financial portfolio. The greed for higher returns is just that, greed. Higher returns in the stock market come with higher risk. Emergencies are unpredictable and sizable. How confidently can you predict real emergencies like unexpected medical costs? You can’t. Consider that over half of those filing bankruptcy in 2001 cited medical causes (pdf). I wonder how many people of these families would have benefited from a cushion of cash.
The pessimism is also misguided. Advisers are not in the business of judging what is realistic. They are in the business of telling people what is right. Correct advice is not a popularity contest.
It can be hard to save in rough economic times but it is not impossible. Consider an emergency fund as a first aid kit on your finances. In dire times, you need something to stop the bleeding. Read more about how to get started and how much to save.
Even if money is tight, you can prepare yourself for emergencies in non-monetary ways. For instance, if you live in an earthquake prone area, you can find all sorts of planning tips from the City of San Francisco’s site 72hours.org. Many of these tips involve nothing more than prudent planning and gathering common household supplies into a suitcase.
2. “I saw this coming” means “I am pretending to be smart but really I was lucky”
For reasons I do not fully understand, the doomsayers get a massive amount of attention during crises. It certainly makes for good drama listening to elaborate predictions of disaster. But there is no special reason to believe someone because they say they “saw it coming.”
The truth is there are millions of people making predictions about the stock market and economy all the time. No matter what happens, someone will have claimed they saw it coming! Correctly guessing a series of coin flips does not indicate any underlying skill.
In tough times, scam artists proliferate. I have been receiving an unusual amount of junk mail related to stock picks. One letter has this headline: “In the past 24 months-5 out of 6 of my stock picks have been Winners-Inside could be the next one!” Of course, what the author doesn’t mention is that inside could be the next Loser! The letter is ultimately a sales pitch for an expensive newsletter of dubious credibility. Be on guard for such scams.
What is missing from the letter is balance. If someone really wishes to claim skill at predicting things correctly, they should also provide a list of failed predictions for comparison. I have yet to find any pundit willing to produce such a list. Skill is a test of endurance, not about being lucky once in a while and claiming intelligence. We must not be fooled by randomness.
3. There has never been a better time to be frugal
The word frugal is widely misunderstood. Frugal does not mean being cheap or saving money. Frugal means avoiding waste and being efficient. Buying out of season clothes is being cheap. Using hand-me-downs is being frugal.
As you can see, frugal living is about more than saving money. It is about using scare resources in sensible ways. I would say Theodore Roosevelt summed up frugal living best: “Do what you can, with what you have, where you are.” Who wouldn’t agree with that?
Amazingly, many famous advisers have turned people away from frugal living. They say things like garage sales or cooking your food are poor uses of time. They are mistaken, and it is their advice that has contributed to America being one of the most wasteful countries. And our wastefulness is getting us nowhere fast. As Jared Diamond, professor at UCLA, wrote in the New York Times:
Much American consumption is wasteful and contributes little or nothing to quality of life. For example, per capita oil consumption in Western Europe is about half of ours, yet Western Europe’s standard of living is higher by any reasonable criterion, including life expectancy, health, infant mortality, access to medical care, financial security after retirement, vacation time, quality of public schools and support for the arts. Ask yourself whether Americans’ wasteful use of gasoline contributes positively to any of those measures. (source)
An economic downturn is always a good time for reflection. It is when things are scarce that we feel guilty about wasteful habits and find ways to improve. I shudder about all of the bottled water that I drank in an office a few years ago, probably 4 or 5 bottles a day. It would not have taken much effort to fill a pitcher and drink tap water.
It is not always the most fun thing to do, but I urge you too to examine your habits and see where you can be less wasteful. Recently I’ve reused old socks for rags, reused a store-bought salsa container for my homemade salsa, and gone back to old habits like printing on both sides of paper (or better yet, printing less and only when I really need to). You will likely save money as you become less wasteful. But even if you don’t, good habits are their own reward.
In any case, these are my thoughts during this crisis. I’m sure there are other important lessons and tips you’ve discovered and I want to hear them, so please share. What have you learned about personal finance during the downturn? What can people do to improve their situation?
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11 Responses to “3 important lessons from the financial crisis”
“How confidently can you predict real emergencies like unexpected medical costs? You can’t.”
I’d say you can and people do. This is the basis behind any sort of risk assessment. All other factors being equal, you can take the number of any specific type of medical affliction and calculate the odds that, during your life time (or any specific finite period) you’ll suffer from it. Multiple those odds by the cost to fix it, divided by the time period and you get how many monetary installments you need to make to prepare for it (depending on what unit of measure you used for the time period).
If you wanted to get really technical you could include relevant factors, such as smoking increasing your chances of lung cancer (or living in Los Angeles).
Essentially what you’d be doing is becoming your own insurance company since this is exactly what insurance companies do. Based upon a set of finite factors, they charge you money so that should a anticipated event occur they have the money to cover you. There are pros and cons:
Con: When an event occurs, the insurance company has the money up front. When you are saving for an event you will only have the full amount at the end of the time period you factored for. (That is, if you factor the chance of getting a disease throughout your whole life, and calculate accordingly, you’ll only have the money to cover the entire procedure upon your estimated death, when it won’t matter).
Pro: When an event occurs, the rate you’re charging yourself won’t go up. Despite the fact that you are specifically paying an insurance company to cover some specific event, when it happens, your rates will always go up.
To compensate for the con you could always calculate based upon a shorted time period (which would mean stocking away more money per month/year) so you have the full amount quicker. Or you could have a base “emergency” stash that is used to cover the difference between what you have and what it will cost.
As far as doomsayers getting more attention, I think that’s part of our biological make-up. Indeed it seems to present a survival advantage that we are sensitive to potential disasters, no matter how unlikely. Preparing for a disaster that never comes incurs a minimal cost while failing to prepare for a disaster that does come incurs the maximal cost: ones life.
Why people put trust in confidence schemes during such times when they would otherwise be sensible enough to avoid them is a more complicated issue. However, studies show that when people are put in situations where they feel they are not in control (such as the current economic “situation”) they are more prone to superstitious beliefs. What are such cons other than modern versions of snake oil salesmen providing panaceas for all your ailments? (Source: http://www.newser.com/story/39159/lack-of-control-breeds-superstition.html)
By Scott on Nov 20, 2008
Thank you for your elaborate discussion of risk assessment. We can discuss theory a bit more, but I think it would be hard to accurately self-insure.
I face the sad reality of close friends and family going through health problems recently–diabetes, heart disease, and various forms of cancer. Hospital costs are very difficult to estimate, and no one expects it will happen to them. It comes like a train wreck. There are lots of unexpected and un-insurable costs–caregivers, physical therapy, travel costs, and if you’re a man who’s worried about the effects of radiation, then the cost sperm banking becomes relevant too. These are things I hope no one has to go through, but yes, they can happen.
This is why I think it is best to save up big since good estimates can go bad quickly…
Fear can certainly be gripping, so you’re right that’s why we pay so much attention to the downside. Interesting story on the superstitious beliefs.
I wonder if that means the downturn will make more people believe in miracles
http://mindyourdecisions.com/blog/2008/10/14/can-a-rational-person-believe-in-miracles/
By Presh Talwalkar on Nov 21, 2008
Hard to self-insure, I bet. After all why else would we voluntarily buy into what is essentially a racket with the insurance companies (maybe the topic of another Mind Your Decisions? Why DO we put up with insurance companies?)
Put from a very simplistic point of view it is possible to a degree but I doubt many people go through the time and effort to estimate exactly how much they need to save for what types of emergencies and, admittedly, I was thinking from more of a business perspective since that is what I’m familiar with.
As far as miracles, I think that dovetails into my link about being out of control and superstitious behavior.
By Scott on Nov 21, 2008
I think section #3 is very interesting – frugal living. My parents and grandparents lived through the depression of the 1930’s. They learned to live a frugal life during that time and they continued doing so in their later years even when the economy improved. I tell my brother that the silver lining for our current financial crisis is people will learn how to live a frugal life. However he is more cynical and tells me they’ll just go back to their wasteful ways after the economy picks back up again. I disagree.
By Mark W. on Nov 22, 2008
To Scott: yes, I too wonder about insurance companies, particularly for health. It is such a strange system but I would guess better than nothing.
To Mark W: I also have hope that society will change towards frugal living. There are some signs of change already. I now see a lot of people using all they have because resources are relatively more limited. I see more carpooling, saving of restaurant leftovers, and efforts that also save the environment (like reusing bags for groceries).
By Presh Talwalkar on Nov 24, 2008
>> For example, per capita oil consumption in Western Europe is about half of ours, yet Western Europe’s standard of living is higher by any reasonable criterion
I have a couple of theories on this:
1) the U.S. has taken upon itself to be global policeman. This is an expensive (hobby), and likely contributes to lower standard for American taxpayers.
2) the U.S. has very high social mobility, which is good for GDP, but bad for social fabric. So many valuable services that are cheap or free elsewhere, are very expensive here. That may be something like professional counseling (due to lack of friends & family), or day-care (due to lack of family). This sort of thing also reduces real standard of living.
By Paul on Nov 24, 2008
I believe the reason the US doesn’t have universal health care is because as ‘Paul’ states, America needs to spend huge amounts of money on its Armed Forces.
Perhaps America should downsize it’s Army, Air Force and Navy, as it can no longer afford to wage war around the world. Divert that money into healthcare and look after its own tax payers.
America’s influence in the world is decreasing anyway, so why throw money at external problems.
By Bryan on Nov 24, 2008
On point #2, “I saw it coming,” means, “I am pretending to be smart and was lucky.”
http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom
By Glenn on Nov 26, 2008
Good speculations Paul on why Americans are “wasteful.” In other countries families do seem to live closer together which reduces the need for expensive services.
As for the armed services, as Bryan elaborates on, I think this is an interesting issue but not necessarily mutually exclusive. We could reform healthcare independently. But yes, I wonder about how countries can spend money on wars without taking care of its own people. Of course domestic aid is hard to implement–I took a course on welfare policy and many studies suggest higher social supports decrease the incentive to work. It is the billion dollar question how to structure welfare correctly.
Great one Glenn–this is exactly the kind of article that has become so “in style” right now.
By Presh Talwalkar on Nov 26, 2008
>> Of course domestic aid is hard to implement–I took a course on welfare policy and many studies suggest higher social supports decrease the incentive to work.
Its likely both welfare and warfare can be nicely framed in game theory. For example, I suspect welfare largely benefits women and children. But what results is Government becomes surrogate husband. This decreases the a woman’s motivation to tolerate a real husband / monogomy (women aren’t naturally monogomous if given a choice). Consquently, single mom’s proliferate. Men recognized they are no longer needed as husbands, so they drift, idle, and/or gang-bang. This creates a negative feedback loop of social decline, that increases need for more & more (government) welfare.
The case can also be made for warfare. The Europeans have a bad track record of living peacefully with each other. Western history books are stuffed full of petty but brutal European Wars. Also, Russian hopes and dreams for centuries involved securing warm water ports for its navy, so if left unchecked, they would have easily pushed south, and occupied much of what is today the oil rich middle east. I haven’t read the followoing book, but the title tells me alot about global geo-politic: Zbigniew Brzezinski, The Grand Chessboard.
By Paul on Nov 26, 2008
Interesting theory on how welfare and warfare relate. I can see how they are self-perpetuating processes.
By Presh Talwalkar on Dec 2, 2008