Thursday, December 3, 2015

Pushing Water Up the Hill

First of all, I need to convince you that debt is generally a bad idea. Then I need to convince you that you can push water up hill.

The following is a highly embellished version of a thought experiment proposed in an interview by Nassim Taleb, an author who studies the impact of highly improbable events on economies and nations.

Consider twin brothers who have just graduated from school. One gets a job and begins to save 10% of his take home pay. He pays $1,000 cash for his uncle’s ten year old truck that was actually probably worth $3,000. He puts off buying a house until he can make that 20% down payment to avoid the dreaded PMI (Private Mortgage Insurance). The other brother gets the identical job. However, he buys a brand new pickup with a low down payment and a 72 month note that he can easily afford. He thinks he gets lucky when a local developer offers condos for sale with no money down to young folks with good credit ratings. After all, his mortgage payment will be less than the rent he is paying for a two bedroom apartment.

After three years their employer goes belly up. What happens next? One brother has $12,000 in the bank. He shrugs his shoulders, loads up the truck, and moves to Greenville, SC when he hears the words, “They’re hiring down here,” from one of his buddies, who made the move last year. The other brother can’t make the payments on his truck. It is repossessed. He can’t sell the condo because he is underwater. That is he owes more on the condo than it is worth.

Three months later the first brother found a job making widgets that are sold to the BMW factory in Greer, SC. He still has $6,000 in the bank and a beat up old truck on its last legs. The other brother is living in his parent’s basement with no job, no wheels, and a wrecked credit rating.

Savings are good because the impact of highly improbable events is often bad.

You can push water up hill. However, it requires wise decisions, energy, and discipline over long time periods. You will need some pipes, a pump, a source of electricity to run the pump, and some kind of reservoirs at different levels to store the water as it moves on its way up the hill.

For most of us, your job is the source of your money, the water you need to move up the hill of life. You start by moving a percentage of your income into a storage tank we will call an emergency fund. Once that tanks starts filling up, you can divert the flow of a portion of your savings to a 401(k) or some other tax favored retirement account. If your employer offers matching money, do this sooner rather than later. Later on, install a big tank for a down payment on a home. Once you have a mortgage, pay it down sooner rather than later, remembering how much sooner is a function of the interest rate you are paying. Finally, open a reservoir for your children’s education.

Here is how that worked during most of the years of my working life. First I had a checking account. I kept more than enough money in there to cover expenses for a couple of months. Later, I opened up a money market fund to cover emergencies and save for big ticket items like cars. My employer offered a 401(k) so I began by contributing some trifling percentage from day one. I don’t remember the actual number, but it was too low. When I had enough to make the then traditional 10% down payment, I became a home owner. Finally, I opened a taxable investment account at Schwab. Money went into that account but never came out of it for any reason until I retired.

Pushing water up the hill is a pretty simple task, but it isn’t easy. When dealing with money there is a bonus you don’t get with water. Once you have pushed enough money up the hill, you will find that the miracle of compound interest begins to fill your tanks without any further effort on your part. However, those tanks, your piping system, and valves still will need periodic inspection and repair.

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