The COVID-19 crisis has not only caused a major health crisis across the world. It has and will further produce lots of financial havoc notably in personal finances, as jobs are lost and a substantial recession hits the overall economy. So how to manage your personal finances – alongside all additional challenges, such as homeschooling your kids? I recently came across an Afford Anything Podcast with Dan Ariely which contains a number of great tips.
Already in a previous article, I have pointed towards three major areas of our personal finances which are heavily impacted by the COVID-19 crisis: 1. Income, 2. Spending behavior, 3. Investments. I wrote the article several months ago but the themes mentioned then are still valid today. Not only does the COVID-19 crisis still linger on but have the economic consequences of lockdowns and adjustments in the economy only started to unfold. I therefore want to revisit these three areas of personal finance and add some useful tips I could learn from Dan Ariely listening to the podcast.
You don’t know Dan Ariely? He is an Isareli-American psychologist who is leading in the domain of behavioral economics. He is a best-selling author of books like Predictably Irrational* (which I highly recommend) as well as some great TED talks. But let’s now get back to Dan Ariely’s personal finance tips.
The employment income of many families will by now have been impacted by the pandemic. Not only can unemployment hit depending on the sector you are working in – at the same time, unemployment benefits will vary widely by jurisdiction, if they exist at all. Also short-term work or just reduced bonuses/commissions, etc. can substantially reduce employment income. For such circumstances, Dan Ariely offers an evergreen of personal finance tips, the emergency fund! Also refer to my own article on the emergency fund.
I like particularly like two aspects which Dan Ariely stresses regarding the emergency fund. First, he emphasizes that keeping some money in cash is a means of building resilience (at the expense of efficiency) which also provides peace of mind. Second, he correctly points out that the size of the emergency fund should depend on the riskiness of the income streams. Consequently, a free-lancer with volatile income should have a larger emergency fund than a civil servant. Dan Ariely still adds that there is a psychological component to this too, i.e., it also must feel right how much you put into your emergency fund, irrespective about rules of thumb such as of having three months’ worth of living expenses.
At the same time, I miss an answer on what to do if you are already in the middle of a crisis but don’t have an emergency fund. Tough luck you might just say. I would beg to differ; I believe that the pandemic can also be a moment to build an emergency fund for the first time! Why? The various restrictions imposed due to lockdowns are conducive to the establishment of an emergency fund. Simply put, various opportunities for discretionary spending are not available, e.g., the weekend trips, fashion shopping or eating out / partying are all not possible due to the pandemic. If you disagree, I would love to hear from you and discuss your specific situation offline!
I would preface this section by stressing that awareness about out spending behavior is insufficient, probably for many of us and in society at large. Limited transparency and awareness on what we spend and how much we spend on it is a fundamental problem to truly get control over our personal finances. Dan Ariely rightly observes this when he coined the phrase “the checking account is the trash can of personal finance”. As we will see, recycling and sorting our trash is the first step to orderly personal finances…
Clearly, the COVID-19 pandemic has substantially changed our spending behavior. Given the various restrictions to avoid the spreading of the virus, we have completely overthrown historic spending patterns, think restaurants, bars, travel, … So, adding to this the lack of awareness about our spending I mentioned before, there is clearly a case to create the transparency now! Dan Ariely has several tips at hand to accomplish this.
First, he encourages to “decompose” the cashflows in and out of the checking account into various buckets for different types of expenditures, so we don’t mess up our finances based on emotional, short sighted decisions. This could mean setting up separate accounts for living expenses, car expenses, fun expenses (e.g., eating out, cinema, etc.) and vacation expenses. Compartmentalizing expenditures in these buckets allows make trade-offs visible within the respective buckets. For example, if the fun expense account is depleted for the month, there should be no further nights out or at least a conscious decision at the expense of another account. Finally, as it’s great to see your own recommendations confirmed by a major behavioral economist 😉, let me draw your attention to my article on a smart account model (in German).
Second, a purist approach to avoiding spending temptations does not work in Dan Ariely’s opinion. Also, rigorous yet tedious approaches to tracking expenses might not be successful in the long term, just as calory counting does not really work over a longer period of time. He rather recommends simple rules to guide us when managing our expenses, e.g., only go out for dinner once a week. This simplicity of rules is at the core of many systems which really work to achieve behavioral change such as Alcoholics Anonymous or various religions – so there seems to be something to it!
Third, Dan Ariely has an important perspective on digital technology! Spending has become very easy and arguably even more opaque with advanced payment technologies, such as Apple Pay or other solutions. There are almost no remaining emotional thresholds to “open your wallet and spend”. While this is not conducive to the spend transparency I have been arguing for, technology can certainly help. Many online banking or spend management solutions allow to categorize your expenses such that your spending is visualized. This is a fantastic start to the transparency we are looking for – and it also takes away the pain of manually tracking your expenses in a household account book.
2020 was a rollercoaster ride on the stock market, e.g., if you look at the S&P 500 between March and August, but also towards year end 2020. Here is a chart, courtesy of Yahoo Finance
Several observations on the 2020 market development:
- By March 15, the index had dropped by a whopping 31.8% from the previous high
- By August 9, the index had fully recovered to it’s previous high, in fact making a neat V-shape recovery
- By year end, the index had closed with a fascinating +11.2% in a year which was dominated by one of the largest crises in recent history!
From my point of view, 2020 with the movements of the market described above, is a case in point for long-term investing! Consistently, Dan Ariely gives several very helpful tips including what I would call a decent tranquillizer: First, don’t look at your investments regularly! Avoid having your emotions influence your investment decisions short time. This could have certainly happened in 2020! Second, put money in the market and forget about it – terrible mistakes happen if you move in and out of the stock market. This could have visibly happened in 2020, if you sold out in March (at the beginning of the COVID-19 crisis) and stuck to cash for the rest of the year. You would have missed the fantastic recovery and the 11.2% return for the year.
I hope that you found the tips provided by Dan Ariely just as helpful as I did. If you are interested in the full Afford Anything podcast, here is the link to it again. I am looking forward to hearing from you via a comment or via e-mail on firstname.lastname@example.org – thank you!