Wednesday, July 20, 2011

The Many Roads To Broke.

Unlike Rome, not all roads lead to broke, but a lot do.

Personally, being broke doesn’t seem appealing. That’s why it seems strange that so many people aspire to it as discussed in a previous posting entitled “The Only Truth About Finance.” However, there’s more than just ignoring the fact that “If you always spend all the money you get on consumption, you will always be broke.” Logicians have a fancy word for it, but in simple terms, the reverse isn’t true. Even if you don’t always spend all the money you get, you can end up broke. One way was mentioned as a corollary: Just spend all you have one time and you get to broke.

There are, however, numerous other paths. Bad investments are one, thus the extensive discussion of investing in previous postings. The path most relevant currently is borrowing. Mismanaging credit can offset prudent attention to the only truth in finance. When one thinks about borrowing, it is essential to remember this quote from “Whose Future Is It:” “The borrower is betting his or her future. The lender is just betting someone else’s money.” So, let’s look at betting one’s future. In the posting entitled, “On Investing Part 14 (contd.): Some old fashion beliefs had a sophisticated basis,” it was addressed as it relates to the most common form of real estate investment, but there is more nonsense said about borrowing than just about any topic.

We’ll come back to the myths; for now let’s focus on broke as it relates to borrowing. Borrowing by itself can lead to broke. That’s very true of consumption loans. But, even with consumer loans, borrowing alone doesn’t make the broke permanent. There’s certainly greater risk with consumer loan than loans used to finance investments. So, consumer loans will be the topic of the next posting.

What’s particularly risky about borrowing is that previous experience where borrowing worked out, isn’t good guidance as to whether it will work out the next time. Each success influences the borrower’s perception of the cost and risk. Thus, success reduces, or biases, the assessment that led to success. That’s true without reference to repetitiveness (i.e., how often loans are taken out). It’s true without reference to scale (i.e., how much is borrowed or how much leverage results from the loan). Those can be viewed as results of the bias; they are symptoms, not the cause.

In fact, on a mass scale, previous success actually gives off the wrong signal. If the logic above is as correct as behavioral research indicates, then mass success creates a leverage bubble. The risk associated with each individual’s borrowing is increased because everyone is successfully borrowing. That’s true even without the demonstration effect (i.e., everyone is doing it, so it must be OK) on each individual’s assessment. Further, those results don’t even take into account the analogous lender responses.

Borrowing can take one beyond just ignoring the only truth in finance and actually, in a sense, stand it on its head. It is the only way to actually spend more than what you make. So, it isn’t too surprising that borrowing is a major road to broke. It is worth remembering the three Ds of estate sales (death, divorce and debt).

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