This is new, although I’ve written similar things before:
Aristotle believed that our goal should be eudaimonia which is frequently translated as “happiness” but what he meant was much closer to well-being or human flourishing. Before Financial Architects existed I briefly thought of naming it Eudemonic Wealth Management (eudemonic means “conducive to” eudaimonia) – fortunately wiser people than I suggested not naming the firm something virtually no one knew or could spell!
Anyway, how did Aristotle believe eudaimonia was to be achieved? He believed that right actions were usually a golden mean or a middle way; that virtue lay midway between two vices. (For more, see this for example.)
You are probably wondering what all of this has to do with financial planning. I believe the virtue of wealth (having enough) is between the two vices of profligacy (over-spending) and miserliness (over-saving). I also want to note that having “enough” is not entirely income related: there are lots of high-income broke (i.e. don’t have enough) people as well as low-income not-broke (i.e. have enough) people. My definition of “enough” is whether someone is likely to have to dramatically curtail their lifestyle (whatever it is) in the future.
Merely by nature of our business, we and our clients have much higher savings rates and wealth levels than the vast majority of society. Those less-well-off people generally think that they should have more money, but they also would, in most cases, spend the money if they had it. You can’t both have the money and spend it though! They want to be millionaires (or more) not to have a million dollars, but so they can spend a million dollars on the things they think millionaires have and do. But then, ipso facto, they would no longer be millionaires, they would be poor again!
In addition, that desire to be wealthy is usually only a wish, not a real desire. Let me use an example from another area of life. Many Americans (myself included), could stand to lose a few pounds. We want to be thinner, but in sort of an abstract way – we don’t really want to eat less or exercise more (or we would). In much the same way, many Americans want to be wealthier – but they don’t want to spend less or work harder.
Before I go on, I want to put a little disclaimer here. From my perspective most people (not most of our clients, most people in the U.S.) are spendthrifts. From their perspective I am a miser (and you probably are too). If the goal is to maximize happiness, we could very well all be right. “They” maximize happiness by living for today and “we” maximize happiness by knowing the future is relatively secure. The following comments are descriptive not normative. In other words, I’m stating what is necessary to build wealth; I’m not saying that building wealth is, or should be, the goal for everyone. There is no way for anyone to make that claim either way for other people. When I was younger, I would think “those people should…” where now, older and (perhaps) wiser, I more often think, “those people are making choices I wouldn’t make, but it must work for them…”
That said, I’ve given a lot of thought over the years to what causes some folks to build wealth while others don’t. I think there are two elements: time horizon and locus of control. I’ll elaborate on those further below.
Consider a few things that most of us would consider mistakes in most cases (or at least pretty sub-optimal):
- Carrying credit card debt at 18%
- Not contributing to a retirement plan (not even for the match)
- Working a “dead-end” job (and not trying to change the situation)
- Overspending on luxury goods
I would submit that all of those are great financial decisions – if the universe ends on Tuesday. They are only bad decisions if it doesn’t.
Once I saw this, it explained a lot of decisions that people make that seemed obviously foolish to me. They aren’t foolish necessarily; the folks making them just have a very short time horizon. You can equate this to discount rate too. A short-term horizon is the same as a high discount rate. If someone has a 30% discount rate, then 18% credit card debt is a screaming deal. If someone has a 3% discount rate, then paying down on a mortgage at 4% is attractive.
Now, obviously, there are life situations where people are hindered from doing what they “should” do, but ceteris paribus short-term thinkers will do the things on that list and long-term thinkers won’t.
On the flip side a person could have a time horizon/discount rate that is arguably too long – these folks are misers who will never spend any of their money because they “might need it later.” In the United States today people with this inclination are pretty rare. The people who aren’t saving enough for the future seem to vastly outnumber those who are saving too much. (Again, from my perspective of what’s “enough” and “too much.”)
Locus of Control
A person with an internal locus of control believes they can affect what happens. A person with an external locus of control doesn’t think they can. The “sweet spot” is in the middle with a locus of control that is correctly calibrated. If you think saving is pointless because even if you save something will happen and you will lose all your money anyway, then you have an external locus of control and you are unlikely to save. On the other hand, if you think you are planning for retirement, not by saving in a diversified portfolio, but by simply buying a penny stock or lottery tickets because you believe you can (against all evidence) pick winning stocks or lottery numbers, then you have a locus of control that is too high.
Let me try to explain this another way. A high school student does poorly on a test:
- External locus of control response: “That teacher always hated me.”
- Excessive internal locus of control response: “Despite my failing grades I don’t need to study to succeed. I’ve got this.”
- Appropriate internal locus of control response: “I need to study harder next time.”
Appropriate internal locus of control folks “own it” and do the necessary work while external locus of control folks “blame” their situation on others. As adults, the three students above grow up and take the following approaches to retirement:
- External locus of control attitude: “The world is rigged against me and I’ll never get ahead so there’s no point in saving.”
- Excessive internal locus of control attitude: “I don’t need to save much (or at all); I’ll just be sure to buy investments that will have at least 100% annual returns.”
- Appropriate internal locus of control attitude: “I’ll save prodigiously and invest in a prudent and diversified portfolio so I can retire comfortably someday.”
Now, I should note that there are people who have an external locus of control and it is appropriate. If you live in a repressive or authoritarian country or are in the middle of a natural disaster or war, you frequently can’t get ahead by your own work. In some cultures and families, if you are the one who “does well” you are expected to support others who haven’t done as well (even if it is self-inflicted). If every time you scrape together a few dollars of savings other people feel entitled to it, then it’s hard to get ahead. Your success isn’t in your hands if there are excessive demands from your loved ones.
But assuming 1) you live in a country with a relatively free and stable economy, 2) you are capable of working, and 3) you don’t have family and friends who will feel entitled to any wealth you accumulate (or you can say “no”), then financial success is just a matter of having a long time-horizon and internal locus of control. With those traits, building wealth is almost inevitable; without them, it’s almost impossible.