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In a world where we’re told that “everything’s relative,” there are some truths we cannot ignore. We can fool ourselves into thinking we’re able to ignore them, but we can never ignore them for very long. There’s a lot of financial and economic ignorance going around, so I thought I’d highlight a few financial and economic truths we won’t be ignoring, no matter how much we think our sophistication and brilliance supersedes these truths.
To get something, you have to give up something else. Making decisions requires trading off one goal against another. You trade your hours for dollars at your job, then trade those dollars for goods and services, such as food, fuel, housing, or dry cleaning.
The downward spiral of using debt to fund the consumption of items that instantly depreciate in value is a personal financial disaster. High interest charges and fees are designed to keep the money flowing to the lender and to keep the borrower in slavery.
Your home may be “appraised” at $250,000 but if no one will pay more than $225,000 — it’s only worth $225,000. You may think you’re worth $75,000 to an employer, but if no one is willing to pay you more than $65,000 …
The dollar I receive today is worth more than a dollar I’m promised sometime in the future. The dollar I get today is real, but the dollar I’m promised in the future will be worth less because of inflation, or I might not get it at all. After all, companies fold, people declare bankruptcy, or a lawsuit may wipe out my ability to collect. Also, the dollar I get today can be invested to create more dollars in the future.
A thinking person takes action only if the marginal benefit of the action exceeds the marginal cost. If a graduate degree is worth only another $2,000 per year at your job, but costs $35,000, it doesn’t take a rocket scientist to see that you’re going in the hole.
To think that a $1,000 investment (at 8 percent interest and compounded quarterly) when a child is born can be worth over $172,000 with NO other deposits when that child turns 65 really IS amazing. Put the power of compound interest to work FOR you rather than against you.
Whatever gets rewarded, gets done because behavior changes when costs or benefits change. Companies frequently ignore this truth and find that their incentive programs only cause people to perform in a way that will produce the incentive but still not produce the desired behavior.
Imagine if all 50 states refused to trade with each other without tariffs, import/export quotas, or other barriers. The ability for all 50 states to trade with each other was one of the reasons the US became such an economic powerhouse. Free trade allows each person or nation to specialize in the activities he or she does best. By trading with others, people and nations can buy a greater variety of goods or services. Besides, nations who are trading partners have strong incentives to avoid wars with each other.
Households and firms that interact in market economies act as if they are guided by an “invisible hand” that leads the market to allocate resources efficiently. Begin central planning by government bureaucrats and you get the opposite effect: inefficient allocation of resources, shortages, and surpluses. No one understands how best to spend money than the people directly affected by it.
“In a free market, firms would be smaller and less hierarchical, more local and more numerous (and many would probably be employee-owned); prices would be lower and wages higher; and corporate power would be in shambles.” –Robert Long, The CATO Institute
Countries with productive workers creating a large quantity of desirable goods or services per unit of time enjoy a higher standard of living than nations with lower productivity. As a nation’s productivity grows, so does its average income. Individuals who can consistently produce desired results will always be in demand.
The beauty of truths, laws, and principles isn’t that they’re restrictive, it’s that once you understand how they work, you can use them to your advantage.
photo credit: randomduck
Note: this post was included in The Carnival of Personal Finance: Cyber Monday Edition at Mighty Bargain Hunter.
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It drives me nuts when my dad tells me what he thinks he could get for his house if it was on the market. His figure is a lot higher than I think anyone would pay.
And my father-in-law collects antiques and likes to think he has a valuable stash of goods. Maybe he does. But, unless someone is willing to pay a particular price, it’s just taking up space in his house.
admin (22 comments.) 's reply:
November 25th, 2008
Could you elaborate and give an example for #7 - People Respond to Incentives? I think I understand what you’re saying here but not really sure. Thanks.
admin (22 comments.) 's reply:
November 25th, 2008
Sure. If you offer a bonus to people for hitting certain sales targets on a progressive scale, people will give try to hit those higher and higher targets.
At one firm I used to work, we had three monthly targets: regular, high, and super. We received a bonus on the regular target of 8 percent, the high target of 11 percent and the super target of 15 percent. It caused the employees to really work to hit those targets when the end of the month came along.
In other words, put the carrot out there and people will work to get it!
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