It might be different today – however when I went through high school – we were never taught much about finance.

For example, the subjects I elected were Maths I and II, Physics, Chemistry, English and Economics.

Economics was perhaps as close as it got…

But when it came to understand leverage or borrowing to finance a car or a house… these things were not taught.

For most people, the principles of saving; the danger of excess debt; and the impact of inflation etc were taught at the dinner table – not in the classroom.

All of these things I taught myself not long after completing my post-graduate degree in engineering.

Put simply, I needed to!

As a young graduate earning six figures – I felt it important that I learnt how to make money work for me. But also – to begin to understand the risks.

Now by way of example, some of you might be surprised at the questions I get today from readers. They include (but are certainly not limited to):

  • how do I start with a broker?
  • what should I look for if investing in a stock or a business?
  • how much is too much leverage?
  • is it better to rent or buy? And why?
  • tell me how government bonds work? Why would I own them?
  • how do I measure cash flow? or
  • what’s the primary function of a central bank?

Basic stuff right? Well not for all folks.

None of these are complex subjects – however very few of us are taught these things before the age of 20.

And I think that’s a real shame…

You see, given how much things like debt can influence the quality of one’s life, it’s very important we understand as much as we can about finance.

Which is a nice segue to tonight’s missive. As you will find out, financial illiteracy can very expensive if you don’t have it. And it can ruin your life…

PBS Documentary

Last night I watched a disturbing video from US channel PBS: 

They talked to something called “financial fragility” – an expression which made a lot of sense.

For example, I have often use the expression “financial flexibility” — which is another way of saying never take on too much debt or leverage.

In this context – “fragility” is the other end of the spectrum!

Their 12-minute video talks to the plight of many middle-class Americans.

My first thought was how it could equally apply to many middle-class Australians over the coming 5 years or less (more on why shortly with some compelling numbers)

But first, let’s set the scene with some (scary) stats:

  • The average US middle-class family has financial reserves to last ~3 weeks
  • When asked if they could raise $2,000 in 30 days – 40% said “no”
  • Most middle-class US citizens have not seen any wage growth (when adjusted for inflation) since the 1970s.

Whilst I was not surprised with the lack of wage growth in nearly five decades (it’s well documented and was a pillar of Trump’s election campaign) – I was surprised at the first two numbers.

It’s hard to imagine being that “fragile” when it comes to cash flow.

Now to take things a bit further – take a look at this chart (which is from September 2014):

As we can see, whilst real incomes have continued to fall, the cost of services such as education, health, child care and rent have all skyrocketed.

So What’s Going On?

In short, it’s a long list. But we will try and unpack some of it.

(ps: for those who are going to raise the failings of trickle-down economics – we can talk to that another time).

First up, this is very much a subject of inflation.

But it’s not inflation as most people know it…

For example, below is the commonly cited “CPI” number which is produced by government officials:

According to the Fed Reserve, CPI in the US sits around 1.64%.

And at most, it hit 5% in 2008 and 1992.

But I have a slightly different take. You see this is a blended number…

I like to split inflation into two distinct categories:

  1. goods (and services) which are exported (eg produced in China or equivalent); and
  2. goods (and services) which cannot be exported (eg rent, child care, education, utilities, insurance, health, energy costs etc).

What you will generally find is anything which can exported will be!

If nothing else, for the simple reason it is cheaper to do so.

For example, tell me someone who doesn’t like having a flat-screen TV for less than $1,500 and a t-shirt for under $20.

Clothing, electronics, furniture, TV, equipment etc — all of these things have gone down considerably the past decade or more.

But all most of this falls into the discretionary category.

In other words, having 2 (or more) TV’s in your home or 10x T-Shirts might be nice… you can survive fine without them.

But what about the stuff which can only be produced on home soil?

Eg: your rent, your schooling, your medical bills, your insurance and so on.

Well that’s a very different story.

In this case, inflation is racing ahead – well in excess of 7% per annum (in most cases) and that hurts. And particularly those who are operating on the margin… eg the middle and lower class.

Stick with me here… as this story is starting to unpack… as it all falls in the financial acumen melting pot.

Health Care…

Let’s start with the hottest topic in the US today.. health care (or the lack of in their case!)

The US Centre for American Progress tells us (from their Sept 2014) report:

  • The real (inflation adjusted) cost of healthcare for middle-class families had risen by 21% between 2000 and 2012, versus an 8% decline in real median household income.
  • Insurance and health care is an important factor regarding the middle-class squeeze because increases in these prices can put an added strain on middle income families.
  • In 2000, workers paid an average of $153 per month for health insurance coverage for their families, however, by 2005 these numbers had increased to $226 per month

Obviously things are now at breaking point… as we see with repeal and replace Obamacare.

Health care in the US is crippling the average American… as prices rise well above the 1.6% level of CPI

Given the choice of another flat-screen TV or your health – which one are you going to choose?

Education…

Here the story is similar (from the same report):

  • For middle-class families, education costs have risen by 62% between 2000 and 2012.
  • Because of increases in college education costs, many middle-class Americans are missing out on a college education because of high prices, or caused them to leave college with massive amounts of debt, not allowing the middle class to enjoy the full benefits of a college education (which leads to higher average income).

Here’s something else – did you know that there is currently over $1.4 Trillion outstanding in the US just in student debt!

I am sure these “kids” are hoping rates don’t rise too much in the near future. I digress.

Okay – one more – rent! 

Housing and Rent…

Now if you thought health and education were squeezing the middle class… housing is not far behind:

  • As at Sept 2014 cost of rent for middle-class families had risen by 7% between 2000 and 2012. Home-ownership is often seen as an arrival to the middle class, but recent trends are making it more difficult to continue to own a home or purchase a home.
  • Housing prices fell dramatically following their 2006 bubble peak and remain well below this level. Many middle-class homeowners were particularly hard-hit by the crisis, as their homes were highly leveraged (e.g., purchased with a low down payment).
  • The use of leverage magnifies gains (or losses in this case).
  • They owe the full balance of the mortgage yet the value of the home has declined, reducing their net worth significantly

This very much at the centre of our PBS’ subject’s story… where he is not able to even raise $100K to badly service repairs to his decaying house.

What hurt him?

First up taking too much leverage opposite his house prior to the correction. And perhaps second, crippled by debt opposite the kids (expensive) school fees.

To cite a quote from the video: “raising kids is expensive”

Yes it is… and getting more expensive (eg insurance, health, etc etc).

The point is inflation is misleading.

If the good or service cannot be exported – there’s a good chance the cost of that service is going to outpace your income. Which leads folks to a financial hole.

And when they are making poor decisions on things like mortgage debt… things start to spiral… and quickly.

Financial Illiteracy…

All of these things are squeezing the middle-class – but they are important to understand.

They all go into the “financial melting pot”.

Money in and money out (perhaps more going out than coming in).

But it doesn’t stop people making reckless decisions..

For example, what hit me most was the lack of financial literacy. The fellow being interviewed was quite transparent about this (to his credit).

From mine, I think this was best evidenced in the US in the lead up to the housing bust of 2008.

For example, not unlike what we see with Australia today, US household debt went crazy as they speculated on housing (enabled by both their central bank and retail banks) If you wanted to borrow 5, 6 or 7x your income… it was not a problem.

And they did… 

The ratio of household debt to GDP rose from 47% GDP in 1980 and peaked at 96% GDP in 2009

When this figure hits around 100%… things start to wobble.

At that point, the income struggles to service the debt. And when you add the other pressures I outlined above (education, health, insurance etc) – eventually things snap.

Again, it’s not hard. Money in and money out.

Now let’s compare the private debt situation of the US with that of Australia today… are we at the US peak of 96%?

Source: Tradingeconomics.com

We are now over 120% to GDP — just in terms of private household debt. Again, most of this is opposite housing.

But here’s the real kicker… when measured as a function of disposable income… it looks like this:

Source: OECD

And we wonder why spending is falling in Australia?!

Go figure.

Translation: financial illiteracy.

For me, this is the (Aussie) elephant in the room. Very few are talking about. No-one wants to admit it.

But it’s there… staring at us right in the face.

Importance of Financial Education

So why are we so leveraged?

And what’s driven us to these insane levels?

How did we get into such a bloody mess?

Ultra-low rates? Keeping up with the Jones’? The “fear of missing out”? “If I don’t get in the market today – when will I ever get in etc?”

Well maybe all of these things!

My view is many Australians have little (to no) solid understanding when it comes to finance (and the risks). They simply don’t know what to do with money.

Yes, they know what “money” is and why the need it. It’s hard to buy a beer and pay rent without it.

What I am talking about here are basic financial acumen. For example:

  • what it means to take on excessive leverage (eg 4x your income);
  • understanding the nature of interest rates (and their cycles);
  • the role of central banks and monetary policy;
  • how inflation impacts the dollars in your pocket; and
  • a bunch of other similar related concepts that I talk to regularly

You see, when I write this blog, I try and do it with three broad hats:

  1. help educate non-financial readers about these (and other) basic principles;
  2. help people make informed financial decisions (eg consequences of leverage and risk); and finally
  3. help people if they are considering asset speculation (eg trading / investing in stocks and/or borrowing money to buy property)

Yes, occasionally I am guilty of a mad ideological rant about why we need free(er) markets and far less intervention from governments (low rates is a great example).

But it’s only because I am passionate about our future and I know the unforeseen consequences. Our friend is a great example.

However the broader theme of this blog is education.

How can I work hard to improve what you are doing and your understanding of markets?

So let me ask you this:

Do you think the average Australian is “well informed” when they might be borrowing 5x (or more) their annual gross income to buy a property?

I don’t.

I think they are more likely a victim of what I outlined above. Eg ultra-low rates; keeping up with the Jones’; or most likely the “fear of missing out” crowd.

But more than this, most folks don’t know any better. If you ask them, the bank said it was okay.

Offer someone free money on a platter – they will generally take it.

Putting it All Together…

I think it would be very interesting if the Australian Bureau of Statistics (or similar entity) asked if the families could muster $2,000 in the next 30 days as part of its next survey.

I wonder what the results would yield?

Or how long they could go without a pay cheque based on their existing cash reserves?

I would hope the answer is closer to 12 months as opposed to 3 weeks. But given what I see – I would not be surprised if it was less than a month before they felt the pinch.

So how do we make Australian’s more financially literate? Or do we simply turn out like the bloke on the PBS documentary?

Victims of low rates and speculation?

Before I close, it was pleasing to see that last month this (small) blog reached around 24,000 people.

Whilst it’s not many – it tells me there are some folks who know just a little more about what’s happening in financial markets.

For example, it might be property.

Or it might be stocks, currencies, bonds or interest rates… but it’s all education.

But I know blogs like mine are not common.

They take a ton of work. Not many people are willing to volunteer their time (and knowledge) for at least 1 hour every day to try and explain what is ‘another language’ to many people.

This is my sixth year writing – culminating in nearly 3,000 posts and almost 20,000 charts.

Hopefully you are more financially aware as a result. And who knows, maybe you have passed this onto someone who has also benefited (for which I say thanks). Let me know.

My point is don’t end up becoming financially illiterate… it’s too damn expensive.

Especially in today’s day and age where irresponsible central banks (and governments) are not helping your cause.

… trade the tape

When investing in shares, you can lose you some or all of your money. The potential gains on my blog are based on investing in Australian and US markets and don’t include taxes, brokerage commissions, or other fees. It’s important you seek independent financial advice regarding your particular situation. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you’ve invested. If in doubt – always seek independent financial advice.

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