What is Money Management? Part 1

I’m comfortable writing about a topic that I’ve spent years thinking about and practicing. I feel informed and qualified to discuss: what is money management? At the same time, I have a different view than many who spend their careers working in the profession.

Money management determines future financial security, for better or worse, so it is one of my passions. On the one hand, I feel like I’m stating the obvious: money management is simple, no one cares more about your money than you, and what I write about worked well for me. And, although I hold a divergent view, I know I am in good company.

On the other hand, I don’t have the experience and resources of a professional money manager supported by a multi-billion dollar industry that employs thousands of people to help them manage your money.

So, in this case, I’ll raise my voice and ask the questions someone should ask. It’s an important topic, so there are probably others who want to understand it better too. My views follow, supported with numbers, my own experience, and others who share my divergent thinking.

Please consider this the beginning of a discussion, and I look forward to your thoughts and feedback.

Let’s jump in and see if we can find an answer to take to the bank.

What is Money Management?

Quicken, a personal finance management software tool, and Investopedia, a website on investing and finance, provide similar definitions.

Quicken writes, “Money management refers to how you handle all aspects of your finances, from making a budget for where each paycheck goes to setting long-term goals to picking investments that will help you to reach those goals.”

And, Investopedia says: “Money management is the process of budgeting, saving, investing, spending or otherwise overseeing the capital usage of an individual or group.”

Money management is making the most of what you earn, borrow, save, and invest. Remember your parents discussing a budget, the bills, and balancing the checkbook at home where it belongs? That is money management, and they were money managers.

So how did it get so complicated?

Over the past forty years, the U.S. financial sector grew three times as fast as the overall U.S. economy and made up $1.7 trillion of the Gross Domestic Product (GDP).

Over that time, financial institutions hired more employees to staff increasingly complex, esoteric, and time-consuming areas. They must generate financial service fees, commissions, and interest to support their economic engine’s size, growth, and complexity.

Is this complexity needed? If it helps the investors, they serve to increase their share of the economic returns, then there is value-added, and somebody may justify it. However, if the investor did get the same share of returns, or less as you will soon see, that’s a problem.

During the industrial era, “featherbedding” was the practice of hiring more workers than needed to perform jobs without an offsetting increase in production or quality. The financial sector’s version of featherbedding today is to staff up with white-collar workers and complexity to justify increased fees.

Traditionally good money management was the way the individual could grow their wealth on steroids. They took charge of their financial destiny, chose a path to financial security with the right approach, and stuck with it.

Money Management Steps

It is essential to consider how you think about, feel about, and use money. Understanding your relationship with money builds a foundation for starting and discovering unknown bad habits that may hurt you.

An early step is to determine where you are and then decide where you want to go. Next is to make a plan that sets the direction and decide on daily behaviors and actions to reach those goals.

The actions are deliberate decisions you make in advance to guide you without a lot of further thought. Limiting yourself to one Starbucks coffee a day or taking lunch to work are examples of deliberate actions that become habits to save money.

Paying off a student loan, a mortgage on a home, or purchasing a car can takes years and a financial path mapped out helps get you there. Starting a business or preparing for retirement can take even longer to accomplish.

The further you are from the goals, the more critical it is to have a plan. In financial matters, planning is essential.

What is money management? It is following a plan made up of any number of necessary steps. Here is one example of the many versions you can use to go about it.

Six Steps to Money Management

1. Start with a Proactive Mindset
2. Determine Your Current Financial Situation
3. Setting Your Financial Goals
4. Identifying and Evaluating Alternatives
5. Implementing Your Personal Financial Plan
6. Reviews and Revisions

It all boils down to figuring out where you are, where you want to go, and how to get there through a personal financial plan. The exact path varies depending on your starting point and the vision of where you decide you want to end up.

Do I Need a Money Manager?

Do we really need a professional money manager to help us with the household budget, buy a home, pay down student debt, or save and invest? I don’t think so.

A holistic view of finances is needed to understand what is going on, so informed decisions get made. A frugal lifestyle, spend money carefully will help, but it is not money management. It is just one part of understanding personal finance. You cannot save your way to prosperity!

A good income from a successful career is another positive. However, it is not unusual for money managers to find highly successful people who are embarrassed because they don’t understand their finances. Money managers highlight this fact, guess what, to promote the need for money managers. And, no one is going to care more about your money or future financial security than you.

Money management and personal finances are not complicated. They require a holistic view, a look at both the forest and the trees. It’s all right there, waiting to be done, just like that closet or garage you haven’t gotten around to cleaning but know you should.

Whatever you do Start Soon

It would be best if you start, but before you delegate this critical responsibility to a money manager, consider the full impact of that decision. There are alternatives with enormous financial lifetime benefits of doing it at home, where I believe it belongs.

Indeed you can balance a checkbook, pay bills on time, and set aside for savings. And you need a “living plan,” one that changes with you as you learn and your situation changes.

A SMART Personal Financial Plan is just that, smart and personal. It remains open to the individual options life will present to you over time. And, there are plenty of apps to help you in real-time.

 

For example, interest rates on savings accounts are meager today. So, hiring a money manager to find higher return alternatives may initially seem like a good idea.

That is until you calculate the total cost that will likely shock you. But, don’t despair, there is a better way.

A Thought Experiment

Let’s do a thought experiment to illustrate this. Imagine three twenty-two-year-olds that earn the U.S. median income of about $60,000 per year and save 10% of their income, or $500 per month, until they are sixty-seven years old.

Over the forty-five years, they share similar lifestyles and incur the same cost of living. They invest their savings in the stock market to increase their return. The stock market’s historic return averages ten percent per year, and they assume that rate.

One person decides to use a professional money manager, the second chooses to become an active individual investor, and the third is a passive investor. I’ll explain these below.

The Money Manager Approach

One finds a money manager that appears well qualified with certifications in financial planning, investment management, and a Master’s in Business Administration. Employed by a major financial institution, with hundreds of billions of dollars in assets, their money managers can access the financial institution’s vast resources.

You agree to pay what seems to be a reasonable fee of one percent per year calculated on your assets in exchange for their expertise.

After gathering all the information and doing analysis, they develop a personal financial plan that shows your current financial situation and simulates a path to your secure retirement goal at age 67.

You agree to savings, investments, and expenses in the plan and make lifestyle choices. They explain that the asset allocations used will maximize the risk-adjusted returns, all derived from the efficient market hypothesis.

It shows you’ll end up with $5.2 million at retirement after the $500 per month generates returns that compound at 10 percent per year for 45 years. These results supported by simulations, regression analysis, proprietary algorithms, and illustrated on color charts, graphs, and tables.

You leave with the plan and the satisfaction of a secure financial future. After all, you can achieve financial security, even retire early if you choose, and enjoy the life you want. You are happy with the money manager’s decision and appreciate a job well done!

The Money Manager’s Actual Results

Let’s flash forward forty-five years and see what you can expect based on the average money manager’s actual historical performance.

You played by the rules, followed the plan, with no negative lifetime surprises. However, after forty-five years, your account shows you’ve accumulated $713,000, not the $5.2 million shown on the original plan. How could that happen?

The Real Cost of Money Management

There are two components to the cost of a money management service. The reported cost; in this example, the agreed to one percent fee. And the hidden cost that never gets explained is hard to see until it’s probably too late.

I know $713,000 is hard to believe, so let me explain what happens.

The Money Manager Cost $1.5 Million of Your Retirement.

We assumed the money captures its historical average market return of 10% per year. The advisor is charging 1%, so you realize a net 9% instead of the market’s 10%. That “only one percent” reduces the outcome after forty-five years of compounding from the expected $5.2 million to $3.7 million.

The seemingly small 1% cost $1.5 million over your investment period for the advisor’s average performance. And there is more.

Actively Managed Mutual Funds’ Underperformance May Cost another $3.0 Million.

The stock market index funds should match the stock market’s performance at a low cost. They typically cost less than 0.3%. These funds are straightforward to buy and hold.

Over the years in this thought experiment, they would yield a net 9.7% return. So why would you pay a money manager 1% for the simplicity of owning a diversified low-cost index fund when you could do this on your own for 0.3%?

It is a good question, and your money manager is acutely aware of how good it is too.

Many advisors recommend actively managed mutual funds or funds from their financial institution instead of the low-cost exchange traded funds. They rationalize it will help diversify investments to mitigate risks. And, in theory, an active fund manager’s expertise should outperform the market and more than offset the 1% advisor fee.

That rarely occurs “…with 89% of the large-cap funds underperforming the S&P 500 over the past decade…,” as reported by SPIVA.

The Underperformance is Significant

The amount of underperformance is significant, as outlined in Forbes magazine. Where the estimated cost and the resultant underperformance of funds are as follows:

• Disclosed cost (paid to the mutual fund managers) is 1.19%,
• Hidden costs (trading expense, paid for research, etc.) are 1.44%,
• Tax inefficiency adds another 1.10%,
• Poor behavior (fund managers chasing performance, window dressing, etc.) is 2.49%.
• The estimated total cost adds up to 6.2%

Subtracting the 6.2% fund’s disclosed and hidden cost from the plan that assumed a 10% stock market return reduces the outcome by another $3 million. The disappointing result is $713,000 after four and a half decades of effort.

In reality, outside the thought experiment, you would see the results falling behind the plan and make changes. Still, many precious years of compounding are lost. And, the answer will never improve unless you find an * above-average* money manager. That’s easier said than done.

In “What is Money Management?” Part 2, we’ll examine the active individual investor and the passive investor approach. And illustrate a way to achieve a much better outcome that might surprise you.

What is Money Management Summary

1. Money management is making the most of what you earn, borrow, save, and invest.
2. A holistic view is needed, one that looks at earnings, borrowing, saving, investments, and places your well-being and interests first.
3. Saving habits, high income, a successful career certainly help accumulate wealth but are not enough.
4. However, you can not save your way to prosperity. A frugal lifestyle can help, but it is not money management.
5. Outstanding money managers do exist. But the “average” money manager arrangement shares your wealth with others. Is it worth that cost?
6. No one cares more about your money, your future, or your financial security than you.
7. Consider both disclosed and hidden costs, and look at all alternatives, including doing it yourself.
8. Start at home, use common sense and financial literacy to ensure you get a fair share of economic prosperity.

In the next post, You the Passive Money Manager, Part 2 of this series, I’ll show the average outcome for the active individual investor, the passive investor, and advice from two of the business’s best investors: Warren Buffett and Jack Bogle. Be prepared for a much easier and more rewarding outcome!

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Thank you for reading!