❝I liked things better when I didn't understand them.❞ -Calvin in Calvin and Hobbes by Bill Watterson
Nathan is talking with his friend Jason about how sore Nathan got while bowling for the first time in several years. He jokes that he never knew bowling was the kind of sport where someone could get sore! Nathan tells Jason that he's surprised his shoes still fit.
Jason then gets a confused look on his face. He said, "Wait, you can own your own bowling shoes?"
It seems silly to those of us who grew up bowling, but for those who aren't familiar, it's very obvious that we can't know something we don't even know exists.
The case of not knowing what we don't know runs deeper than arbitrary things like not knowing you can buy bowling shoes instead of wearing the same shoes everyone else wears. Sometimes it's dangerous.
Eric was going on a hike with his dog, Fido. This is something Eric has done many times. He plans on walking through the woods to see what there is to see. Afterall, Eric hasn't been to this trail before.
It's the middle of the day, but it's usually shady and cool in the woods. Unfortunately, about a quarter mile from the trailhead, the woods turns into a prairie. It gets hot! After exploring a little bit, Eric notices that Fido is slowing down. Eric didn't bring any water with; he didn't know they would be in the midday sun and heat! Now he's got a problem because they have to get back to camp, but Fido isn't doing well. He's dehydrated and overheating.
It didn't even occur to Eric to bring water with because it was going to be a relatively short, shady hike.
(note: Eric and Fido finally get back to the trailhead and Fido was fine after drinking and getting a cold shower!)
What's this have to do with money? Well, there are two sides to the personal finance coin, interior finance and exterior finance. Interior finance is about our relationship with money. Exterior finance is about the mechanics of money. While it’s true to say that all of the exterior financial knowledge in the world is useless without a solid foundation of interior finance, it’s also true to say that exterior finance is important. We need to know what to do.
Having perfect exterior financial knowledge is worthless if we are unable or unwilling to implement it. But it goes the other way, too. Perfect interior finance is worthless if we don’t know what to do with our money.
WE DON'T KNOW WHAT WE DON'T KNOW
Having access to good exterior financial advice and knowledge is immensely valuable because we have blind spots which, by definition, we don’t know about.
There are, obviously, things that we do know. You can think of the things that you know as being contained in this circle.
And for everything we know, there are countless things that we don’t know. If we added a circle to represent the things we don’t know, it would be more significant than the circle of things we know.
You’ll notice there is some overlap. You may wonder why there's some overlap between things we know and those we don’t know. The answer is that there are things that we know we don’t know. For example, I know that I don’t know how to fix a leaky pipe in my house, what subatomic particles are made out of, or what spacetime is.
There is a vastly larger space representing the area that lies outside of things that I know. These are the things I don’t know that I don’t know. I didn’t even know that there was anything that could be known. In the change process, this would be known as the precontemplation stage of change.
This means that there may be exterior tools and strategies that you didn’t even know existed.
Exterior finance is about knowing what to do with your money. It assumes you have a solid foundation of interior finance so that you have the willingness and ability to implement the exterior tactics. Without exterior knowledge, you may be leaving money on the table and harming yourself at worst.
When we think about the effectiveness of a particular strategy, we can think about the Pareto principle. The Pareto principle, or as I prefer to call it the 80/20 rule, says that you get most of the benefit with about 20% of the effort. That means the curve is steep upfront and doesn’t take much knowledge to get a better benefit.
Not correctly understanding exterior finance means you may be using an ineffective strategy or no strategy at all.
Understanding exterior finance gets you further up the 80/20 curve.
ELEMENTS OF EXTERIOR FINANCE
So let’s talk about what makes up exterior finance. Many people might think of investing or budgeting, but there is far more to it than that. Exterior finance comprises cash flow management, investment management, estate planning, insurance planning, and tax planning.
Cash flow is the core of exterior finance. If you don’t have your cash flow in order, the rest of the elements of exterior finance won’t matter. Cash flow is simply a fancy way to think about how money comes in and goes out. Money coming in – the most common being income – is sometimes called inflow. Money going out – most commonly your expenses – is called outflow.
If you’re inflow, including income, interest, dividends, rents, Social Security, and so on, is higher than your outflow, then it is said that you are running a surplus. You are bringing in more money than is leaving. Running a surplus means you have some options. You can increase your lifestyle if you choose. You can increase your savings to buy yourself options in the future. Or you can work less or find a job that doesn’t pay as much (but may be less stressful, for instance).
On the other hand, if your outflow, including expenses, taxes, giving, and savings, is higher than your inflow, then it is said that you’re running a deficit. Running a deficit means you’re in trouble. A deficit needs to be funded somehow, most commonly using debt or spending your savings.
Understanding your cash flow situation gives you a lot more flexibility.
Investment management is about making your money work for you. It’s about finding investments that give you the potential for higher returns and have an element of risk to them. Finding the balance between how much financial risk you’re willing to accept and how much expected return you want or need is one of the main focuses of investment management. This is where you hear terms like diversification, asset allocation, and risk tolerance.
Insurance, at its core, is about managing catastrophic financial risk. Insurance comes into play when there are events that are probably not going to happen, but if they do they are devastating. Because the consequences are dire, insurance allows us to pay a premium every year (or quarter or month) to an insurance company that will take that financial risk from us. The idea is that it is better to pay a smaller, known amount than run the risk of having to pay a devastating large, unknown amount.
Some examples include:
The risk of dying too young with your family missing out on the income you would’ve produced (life insurance)
The risk of something happening to you that prevents you from earning income (disability insurance)
The risk of living too long and running out of savings (annuities, or longevity insurance)
The risk of your house being destroyed by a fire or other natural disaster (homeowners insurance)
The risk of being sued because of something that happened while driving your car (car insurance, specifically liability insurance)
The risk of something happening to you that would require expensive hospital bills (health insurance)
Estate planning is planning for what happens when you pass away. The most popular estate planning document is a will, which specifies, among other things, what happens to your assets and who takes care of your children.
There’s more to estate planning than just a will. Some assets transfer to beneficiaries regardless of what you will says. This will be things like retirement plans and life insurance policies. Other documents include various trusts which transfer your assets to a separate entity known as a trust, durable power of attorney, which designates somebody to make legal and financial decisions for you if you’re unable to, healthcare directives or living wills which specify your preferences for end-of-life care, and a healthcare power of attorney which specifies a person to make medical decisions for you if you’re unable to.
Tax planning is about managing your tax bill. The most common type of tax that most people associate with the word “tax” is income tax. There is income tax at the federal level and at the state level for most states. In addition to income tax, there is also sales tax on things that you buy, capital gains tax on any gains from investment, property tax on any property you own, gift tax on substantial gifts you make, and many other more nuanced taxes. Tax planning is about being smart about how and when you pay taxes.
RULES OF THUMB
Author Tim Maurer has said that personal finance is more personal than it is finance. That means that there is no one-size-fits-all advice when it comes to exterior finance. Having said that, there are some rules of thumb that can apply, at least as a starting point.
A rule of thumb regarding the use of debt separates debt into two buckets – “good debt” and “bad debt.” To understand the difference between good and bad debt, we need to talk about the difference between appreciating assets and depreciating assets. An asset is anything that you own. An appreciating asset, then, is an asset that is likely to go up in the future (at least in the long run, in the short run, that may not be the case). Examples of this include your house and the value of your education.
A depreciating asset, on the other hand, is an asset that is likely to drop in value. This is most things. The rule of thumb is that using debt for appreciating assets is okay but should be avoided for depreciating assets.
College has become expensive over the last decade and shows no sign of stopping. It’s difficult to know how much one should take out to go to college. As stated above, a college education is an appreciating asset and thus falls under the “good debt” category, but that doesn’t mean we should take out too much debt.
The rule of thumb is to keep your student loans down to your expected first-year salary. This rule of thumb takes into account what type of career you want. For example, this rule of thumb would allow leaving school with $80,000 if you plan on being an engineer but not if you plan on working for a nonprofit or becoming a teacher.
How much should you save? One rule of thumb says that you should aim to save 15% of your salary. Of course, this doesn’t necessarily mean that you should spend more as your salary increases, but rather it represents a floor.
How much money should you have in stocks vs. bonds and cash? One rule of thumb is to subtract your age from 100, which is the percentage to put into stocks. For example, if you are 30 years old, this rule states you would put 70% of your investments in stocks (100 – 30). However, if you are 60, you would put 40% of your investments in stocks (100 – 60). As with all rules of thumb, it’s not perfect, but it does a good job of recognizing that, generally speaking, you don’t want as much of your portfolio exposed to market risk toward retirement when you are most likely to have to withdraw the money (and risk selling at a loss).
Exterior finance is the nuts and bolts of money. On one hand, exterior finance is worthless if you’re unable or unwilling to implement it. On the other hand, having a solid foundation of interior finance is worthless if you don’t have enough exterior financial knowledge. Striking a balance is the key, and knowing more about various exterior financial topics can help you on your journey toward financial health.
You get one life; live intentionally.
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References and Influences
Ariely, Dan & Jeff Kreisler: Dollars and Sense
Bernstein, William: The Four Pillars of Investing
Clements, Jonathan: How to Think About Money
Ellis, Charles: Winning the Loser’s Game
Gibson, Roger & Christopher Sidoni: Asset Allocation
Newcomb, Sarah: Loaded
Quinn, Jane Bryant: Smart and Simple Financial Strategies for Busy People
Sethi, Ramit: I Will Teach You To Be Rich
Zweig, Jason: Your Money and Your Brain
Note: Above is a list of references that I intentionally looked at while writing this post. It is not meant to be a definitive list of everything that influenced by thinking and writing. It's very likely that I left something out. If you notice something that you think I left out, please let me know; I will be happy to update the list.