Monday, August 07, 2006

Making Good Choices: Understanding the choice/wealth cycle

It seems pretty basic, but I'm surprised at how few people really think about it. In fact when I was in college, these ideas were not real to me at all. My grandfather tried to teach me the concept, but I never really grasped it. He said, "life is about managing risks." But I don't think that quite captures it. (Sorry, Papa.) Rather it isn't really just risk, its choices. Choices and wealth are directly and constantly related.

Some fake examples relating choices to wealth

1. Parents choose to spend large amounts of money on their kid's education. As a result, the kid, Jeff, takes better classes and lands a better job and makes more money than would have been made otherwise. [Good Choice = more wealth]

2. While the Jeff is at college, he decided to skip out of some key activities and therefore had less exposure to important ideas from his classes. This lost knowledge kept him behind a co-worker (Jane) and he did not get a promotion and raise as fast as his co-worker. [Bad choice = less wealth]

3. Since Jeff did not get a promotion, during a recent trip to the store, there was less money available to buy a new television set for the new apartment and he had to settle for something inferior. [Less wealth = fewer choices]

4. After just a few months with the television, a bonus 2000 dollar comes in for Jeff. Even though his new television still works great, Jeff really wanted the nicer one to begin with. So, Jeff decides to buy a new television of the more expensive model that he wanted to begin with. [Bad choice = less wealth]

5. Since Jane took the same bonus and invested it in her retirement account and let it sit for 30 years at 10% average annual interest and has 35000 extra in her account at retirement and is able to take 5 more vacations than Jeff. [more wealth = more choices later]

All of these examples are easy to understand and follow and the concept is simple. Each choice you make has an impact on your wealth. And the more wealth you have, the more choices you get to make. As you can also see, some choices are more expensive or 'risky' than others.

Each choice has a cost and a risk associated with it. I like to think that I really understand this cycle now and I am making better choices with my money than I was, even 2 years ago. All of this is not about risk. Note, there's nothing wrong with buying things you like or want. But curbing those impulses, especially the need for "the latest and greatest" might significantly improve available cashflow for investments.

But what about the little things?

There's very little risk in buying or not buying my morning coffee. Instead, its a choice: a choice to go without a small luxury now, with the understanding that I will enjoy either better or just more luxuries later. The risk of course is that if you invest the money, it could be lost, or you could die before you get to use it. Neither of those really bother me that much. If I die, it will go to people I love. I'm ok with that. And if I choose my investments carefully, I will likely not lose much if any of it and there's a much bigger chance that I will gain significant wealth.

More choices is Better

So, for me, more choices is usually better. I live a pretty good life now. But by putting off certain expenses for a few years now, I hope to give myself decades of excellent living later - in a relaxed, enjoyable environment without pressure, when I know that my body will be tired and may not have the energy that it has today.

This is a concept that I've always liked and I think it might make more sense as I evaluate my past and future choices in later posts. Especially as the retirement age grows and grows. I can't speak for everyone, but I don't think that I will want to work 40 or 50 hours a week once I am 65. And the thought of having to do that in order to pay my medical expenses makes me very comfortable about making small choices to sacrifice now.

Most choices have an economic impact

I've bought in to this concept: choices have consequences. And these consequences are often related to your wealth and therefore the next choices that you can make in life. It's a cycle. It is a simple concept, but once you acknowledge it, it becomes easier to consider the impacts before the next choice. I like the idea, but like anything, practicing it is the tough part.

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