“It’s not your salary that makes you rich; it’s your spending habits.” – Charles A. Jaffe .
Aristotle is said to have once said, “We are what we repeatedly do. Excellence is therefore not an act but a habit.” If you believe this quote still rings true today as it did back in his time, it makes sense that if we are having financial problems, they probably stem from our financial habits.
How do we then build better financial habits? The answer may lie in economics.
Understanding economics and personal finance does not mean you will not make mistakes or face financial disasters. The best way to make managing your money seem like a natural extension of the rest of your life is to make it habitual, a regular part of routine. Understanding some of the following concepts will help us cultivate good financial habits.
Choice
Our needs are limited to the actual basics of food, shelter, and clothing. Just about everything else is a “want,” and our wants are almost always endless. Our resources are limited and we have to make choices about which wants to fulfill. The way we fulfill our needs also involves a lot of choices. Many people believe they have to spend money in certain ways or in certain amounts to fulfill a need, when in reality their spending is a choice. Taking responsibility for our choices empowers us to make more sound decisions of spending habits.
Scarcity
We are mostly mistaken by the belief that we live in a world of endless abundance, but the reality is that at any given point in time, resources are finite; whether it is oil in the ground, our time here on earth or the cash in our pockets, there is only so much available to be spent. Ignoring this reality may lead to running into debt trying to sustain a lavish lifestyle that we may not afford. The refusal to make the difficult choices needed to manage money responsibly means reduced number of choices in the future. The money spent on interest to pay back the loans cannot be invested in other long term goals, like retirement.
The best way to deal with this problem in personal finance is to create a budget based on clear goals, and stick to it.
[Read More: Budgeting Strategies That Work]
Opportunity Cost
Opportunity cost simply means what we give up to get something else. In every choice, there is an opportunity cost. Understanding that your choices will always have an opportunity cost and examining what those costs are should help you make better financial decisions.
The principle of opportunity cost is closely related to sacrificing current consumption to save and invest for the future. Every shilling spent today could have been saved and invested to generate more income for spending in the future. The key issue here is to separate needs from wants and through the budgeting process, focus on reducing spending on non-essential items so as to save and invest the surplus funds generated. This is the best foundation of sustainable wealth creation.
Time Value of Money
This boils down to a relatively simple proposition that a shilling in hand today is worth more than one promised in the future. This changes when a rate of return (or interest rate) is introduced. A rate of return means that the money you have today can be invested to create more in the future. When it comes to debt, lenders want to be compensated for two risks, one is purchasing power risk, which is the erosion of the money they lend due to the effects of inflation, and second is default risk, which is the possibility that the borrower will be unable to repay the loan. The higher the perceived rate of future inflation and the more lenders doubt your promise to pay the money back, the more interest they will charge on the loan to compensate for the risk.
In the same context, the time value of money is much appreciated when it comes to compounding of interest in interest-earning investments. Saving relatively small amounts consistently can build a rather substantial nest egg with the aid of compounding of interest over time.
Conclusion
When you understand the direct implications of your choices and actions on your financial decisions, you learn how to make the foundation of your current financial position to build a successful future.
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