Friday, July 15, 2005

Rules of Dumb

I had a thought about financial "rules-of-thumb". Most don't work. Those that work at all, work in only some situations. What they should call them is financial "Rules-of-DUMB". I can think of a few right off the top of my head. Like:

1. Buy as much house as you can afford.

Now this one is just ridiculous although so many people follow it. Buying a "lot of house" will only serve to make you house rich and cash poor. And usually, what you can afford is determined by some mortgage broker. In my view, that's the last guy you should be listening to. That's like the sheep asking the wolf for advice on how not to get eaten. (No knock against mortgage brokers. I'm just pointing out a conflict of interest there.)

Most of us would be better off buying an easily affordable house. Not "mortgage broker" affordable, but The Millionaire Mind affordable. According to the book's author Thomas Stanley, an easily affordable house is one in which you can afford on HALF your present income for the next FIVE years without disrupting your lifestyle. If this can't be achieved, then consider that you have a house that is not easily affordable.

2. Diversify.

I'll paraphrase Warren Buffett by saying diversification is for the know-nothing investor. The know-something investor should concentrate. Our intent with diversification is to lower our volatility. But what we don't consider is we are also lowering our potential return. If we study our investments a little more and understand them, we'd be better served by concentrating on those investments that offer the highest probability of success. Concentrate to get rich then diversify to stay rich OR stay concentrated to get richer.

3. Save 6 months living expenses for emergencies in cash.

What emergencies are we talking about that would require 6 months worth of expenses? I mean seriously. This is just one of those rules that I think goes too far. If we are properly insured with health, life, disability, home/renter's, auto and the like, most emergencies are taken care of. Most of us, if we were to loose our jobs, will be able to collect unemployment. And if we were to find ourselves in that situation and unemployment doesn't cover our expenses, we certainly wouldn't need that much money in cash (money market fund, savings, under mattress, etc.)!

For most people, having more than say $5,000 in cash is a waste. The rest of your "emergency" funds should be diverted to higher earning liquid assets like stocks. But what if the stock market goes down you ask? Well all I can say is that the stock market is more likely to go UP! In fact, the market goes up about 75% of the time. So it's much more prudent to put your money (your emergency money too) in stocks, though the rule-of-dumb says otherwise.


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At 12:49 PM, Anonymous said...

mr taylor, your thoughts on saving a stash for up to 6 months expenses in cash was quite interesting. please share the source of your research as it relates to a market increase of 75%


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