FACULTY Q&A

The subject of finance tends to suggest large-scale operations – stock markets, banks, etc.

Nejat Seyhun, professor of finance at the University of Michigan’s Ross School of Business, has spent years thinking about how lessons from his field can also be applied to individual financial problems, such as deciding go to college, buy a house and get into debt.

Seyhun has collected his thoughts and research-based advice into a new book, “Personal Finance for Everyday Challenges,” which fills a niche between self-help works and finance textbooks. He shares some of his ideas.

Most of us probably don’t apply financial concepts in our daily lives. What can an average person gain by learning to do this?

From time to time we make big decisions, and those big decisions affect us for the rest of our lives. At what age do we get married? Who do we marry? Or the decision to go to college. It is a huge decision, which costs hundreds of thousands of dollars, but we do not apply financial ideas to it.

The same goes for other big decisions—we buy a house, we buy a car, we buy a vacation spot—but we don’t apply financial concepts. Buying a holiday home creates a source of rigidity, since we have to spend our holidays there every year. It is important to think about financial flexibility.

My son is a young man fresh out of college. He has just signed an employment contract, which commits him to a non-competition clause for three years. You can bring your financial point of view to this: what is the cost of this signature?

Or you can consider things like credit card debt, how much we save, where we save. Do we use tax-efficient vehicles? Basic financial literacy can also help with retirement savings decisions.

I am not saying that finance will necessarily give us all the answers. Even though college doesn’t make financial sense for me, I can still choose to pursue my passion, but at least I’ll do it in an informed way. Just about any big idea, any big decision we make, could benefit from a very basic level of financial literacy.

A critical concept in finance is the idea of ​​risk. Why is it so important in personal financial decisions?

Finance tells us at a very basic level that we need to think about risk, understand what risk is, and think about how we might manage it. It’s basically saying that you can’t just look at the most likely outcome and make decisions based on that. You have to look at the tail risk – which is unlikely but still possible – and you have to think about the cost of those tail risks.

Some very sophisticated and successful people have ignored the fundamental lessons of finance about risk. Some people put all their money into a single stock, such as when employers give employees a discount on company stock and people stock up on it. Very basic concepts will tell us that this is probably not a good idea. Think about what happened with Enron: people lost their savings and their jobs at the same time.

Everything is subject to risk, and finance gives us a framework to manage it in a reasonable way. He doesn’t have all the answers. It depends on our perception of risk and our individual risk tolerance. But finance gives us at least this framework.

One of your key points is that “the essential path to financial security is to defer unnecessary spending”. It makes a lot of sense, but sometimes we have trouble with it. What makes it such a powerful idea?

It’s a very simple idea that I see most people in America ignore and regret later in life. We have a Turkish proverb: “Stretch your legs according to the length of your blanket. If your blanket is small, it will still warm you if you tuck your feet into it.

This simple lesson we ignore. We always try to impress people with our wealth and power, spending money, showing off our possessions, our big house and our big diamond ring and our brand new car. But this comes at the expense of our future comfort and peace of mind.

Many people end up with good jobs, earning six-figure incomes, not being able to make ends meet because they spend too much money. We live in a society of plenty, but unfortunately when we lose our jobs, when an accident happens and our health deteriorates and we have no insurance, it can bankrupt anyone. which of us.

We don’t need to buy a new car, we don’t need to go to the cafe every day and have a $5 cup of coffee. These things add up. If we don’t look at those things, then we have a marriage and spend $30,000 or more – if you instead leave that money for 40 years, you can retire with that money. Unfortunately, we don’t think about those trade-offs. The idea that we must delay gratification is lost.

You present convincing arguments for investing in the stock market, in particular in diversified funds. Yet, some people may be hesitant to do so due to the day-to-day volatility they see in the market. Why shouldn’t we care?

Before investing, we have to say to ourselves: “Okay, what is my problem? What is my risk tolerance? No one can tell us, except ourselves. We have to say, “Listen, if I lose half the money, how am I going to feel about it?”

There’s actually a name for it, “freak out.” If you panic with a 50% drop, that money doesn’t belong in the stock market. This is the first lesson that I tell my students, “Look in the mirror and answer the question, ‘What will scare you?’ Only then can you start investing in the stock market. You are investing for the long term.

What other key lesson do you hope people take away?

There is a very basic lesson in finance: prices reflect information. When I look at a price, I have to learn from it. I shouldn’t assume that the million or billion people whose interactions led to this award are idiots.

Once I figured out that pricing is informative, it leads to a lot of lessons. I’m not going to fall for scams, first of all. We all get these offers and bargains. A very basic lesson in finance is, “If it sounds too good to be true, it’s too good to be true.” Forget that. Don’t even be tempted.

Another lesson is that there are reasons for the prices we see. Why is this house selling at a discount? There must be something wrong. In an efficient market, this price tells you something. So we have to learn from the price.

Written by Bob Needham, Ross School of Business