Wealth Creation Tip #3: Control your ego and you minimize your financial mistakes
Behavioral Economics seeks to identify the psychological drivers behind financial decisions. For example, in general, people are willing to pay more for a good when purchased with credit than they would if they were paying cash.
We will explore several ego-driven mistakes by first defining what they are and then providing an example.
I coined the first mistake “placing your ego in front of your wallet.” This is when your ego-driven response to something costs you money.
For example, we had a client that owned his building with another dentist. They shared common areas but each had their own practice. The client was re-financing his debt to improve his cash flow. The bank wanted our client to have the other dentist sign an acknowledgement that his dental equipment was collateral for the loan (called a Landlord’s Waiver). Our client did not want the other dentist to know that he had a loan against his practice and would not get it signed. His ego cost him $1,300 per month in cash flow savings. If he invested that savings monthly for 10 years and achieved a 10% return, he would have $266,000.
The second ego-driven mistake I commonly see is “consumerism,” or the need to buy things to make you look good. The irony of this one is that the people sitting on a couple of million dollars in liquid assets rarely look the part. Unfortunately, our society has anchored our idea of wealth to the consumption of luxury items. Here are two examples related to cars and homes.
A dentist that I know purchased the latest Mercedes SL 500. There was a waiting list for this model and he had to pay a premium to obtain the car. He also financed it. The payment was about $1,850 per month. Soon after buying it, he realized that he could not afford it. He has since returned the car and paid a huge prepayment penalty to do so. The lesson: If you cannot pay cash for your toys, you cannot afford them.
A Dentist plagued by consumerism tends to buy or build a large home. What concerns me is that dentists are building homes before they close the sale of their current home. In the current environment, you are more likely to be stuck with two mortgage payments.
Economics Lesson - Interest rates and home values
The value of a home can behave like a bond. When interest rates fall (rise), bond prices rise (fall). The same thing happens in the home market. In a rising rate environment, the value of homes should fall, assuming all other factors remain constant. The reason they should fall is that the number of people that can afford the home should shift downward because the cost of ownership is moving higher. If the cash outflow associated with a particular home is higher, fewer people can afford it.
If the buyer can afford a payment of $1,761 and rates rise by 2%, the value of what the buyer can afford has shrunk by 38% from $650,000 to $402,515.
For example, a dentist called us because he wanted to improve his cash flow. He claimed that he did not have any practice debt and wanted to pull cash out of his practice and his office building. The second home he was building had drained his cash reserves and was draining his cash flow. A UCC search discovered that he was lying to us about his practice debt. He had obtained loans against his practice shortly before coming to us for help. Since these loans were new and had prepayment penalties, he could not be helped. Desperation can make smart people do stupid things.
The lesson: You should sell your current home before you buy another one. If you cannot do this, maybe you should not buy a new home unless you have cash reserves equal to one year of mortgage payments.
Wealth Creation Tip #4: Make tax deferred investments a priority
Tax deferred investments can grow without the burden of paying tax on their gains, until a later date. You can do this with real estate and qualified retirement plans. Investing makes sense because inflation consumes the value of your money. To fight inflation you must get a return on your money greater than the inflation rate.
Compounding is a return on your return. The key to wealth creation is to invest as soon as you can so that time can work its magic.
The Lesson: Start investing early and allow compounding to work for you.
Wealth Creation Tip #5: Proper debt management
Proper debt management means knowing what kind of debt to incur for each situation, and knowing how to pay it off. Mastering this is critical to wealth creation.
Dentistry is capital intensive. You need capital to build, buy, expand, and maintain your practice. You must determine how to structure your debt to allow you to have the cash flow to fund your investments. I tackle proper debt structuring in a separate article.
Cash flow is far more important to wealth accumulation than being debt free. Wealthy dentists structure their debt so they can continue to make tax deferred investments. In general, it is better to fund your investments before you pay off your debt. This assumes your investments yield a higher return than the interest rate on your debt. If you have high rate debt (credit card debt), you should pay that off or restructure it before investing. See the presentation below.
The Lesson: Do not retire your debt and then begin to save. Get your money compounding as soon as you can.
My observations tie together to create a model for developing wealth as a dentist.
Review each Tip and compare them to where you are on your path to becoming financially successful. If you are weak in some areas, create a goal with a deadline that will motivate you toward changing your results. Always measure yourself from where you were to where you are now. Do not measure yourself against your ideal outcome; we never hit the ideal. What gets measured improves. Take an action today.
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