IDEAS ARE TOOLS that can help us see the world with greater clarity. Indeed, I find myself returning to certain financial notions again and again, because they’re so fundamental to understanding the world of finance and how we can make our lives better.
Arguably, these ideas should be divided into two parts. How so? Seven of the 15 notions help us to understand the financial world better. For instance, our human capital is our financial life’s core organizing principle. Risk vs. reward is the fundamental tradeoff every investor needs to wrestle with. Opportunity cost describes a different sort of tradeoff, compelling us to consider not only what we’re getting for our money, but also what we’re giving up.
Meanwhile, skewness helps explain why the investment game is so hard to win—and why indexing makes so much sense. Risk pooling is the key reason to buy insurance. Being an owner, especially by purchasing stocks and becoming a part owner of corporations, is crucial to good investment returns—and those returns can go from good to great, thanks to long-term compounding.
What about the other eight ideas? I readily admit there’s an element of advocacy to them. As we manage our money, we should be humble, we should favor simplicity, and we should control what we can—and find a way to live with what we can’t. We need to rein in our instincts, so we don’t shortchange our future self. We also need to be aware of the pitfalls presented by signaling and by the hedonic treadmill, and instead strive mightily to figure out what constitutes enough.
Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Balancing Act, A Penny Saved and Tax Rate Debate. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.