The 15 Principles of Personal Finance

Personal Finance is an American undergraduate textbook, and it covers a lot: cash management, stocks, bonds, funds, insurance, buying a house and a car, retirement planning, even wills. A pity I didn’t get to study this book in my undergraduate years more than a decade ago. Fortunately I’ve read it now, and there’s still time to teach my kids.

Because the book describes the American situation, much of its content is only useful at the level of principle; the specifics need to be adapted to China’s actual conditions. So I only flipped through it roughly. But the 15 principles of personal finance it distills run through the whole book and are strongly universal. Let me excerpt and list them here, with a short note on my own understanding.

1. The trade-off between risk and return: risk and return are generally positively correlated, so a financial advisor who pitches high returns with low risk can basically be defined as a fraud. But it isn’t that absolute — through superior knowledge and information asymmetry, low risk with relatively high return is possible; and conversely, a low-return product can also be high-risk, as with some online lending platforms.
2. The time value of money: you can’t understand investing without understanding compounding. In the Chinese way of lending money to friends, you borrow 10,000 yuan ten years ago and repay 10,000 ten years later — at a 7% annualized return that’s basically doubled.
3. Diversification helps reduce risk: as the saying goes, when the east is dark the west is bright. But pay attention to the correlation between asset classes.
4. Not all risk is the same: diversification cannot eliminate systemic risk. If the whole economy collapses, whatever stocks and bonds you bought are basically finished.
5. The source of competitive investment markets: through the bidding mechanism, markets are generally efficient, and beating the market is extremely hard. The line “the pig thinks so too” is exactly this principle. I often hear people say they hope to earn 50% to 100% annualized in the stock market; I can only wish them a happy gamble.
6. The effect of taxes on personal financial decisions: the casino operator is the one who makes money.
7. The importance of liquidity: high liquidity commands a premium, low liquidity a discount. Generally keep 3–6 months of living expenses; for T+0 or T+1 you can put money into money market funds, reverse repos, and the like.
8. Without a plan nothing gets done: I started doing an annual financial review and plan at the end of 2015, and the effect is obvious.
9. Knowledge is the best protection: don’t be the chives.
10. Protect yourself from major disasters and calamities: pure protection cover is the essence of insurance.
11. The time scale of investing: stocks should be held at least 5 years; Bitcoin I’ll hold at least 20.
12. The principal-agent problem — watch the sales pitch: I find reading the contract rather than the ad more reliable.
13. Pay yourself first: when money comes in, think first of saving, of investing, or of improving yourself.
14. Money isn’t everything: a correct platitude.
15. Get started! The earlier the better with investing; if you haven’t started before, start today.