How to Save Money and Make Smart Financial Decisions

Interview with Terrance Odean

Professor Terrance Odean of the University of California at Berkeley discusses how to make smart financial decisions. Why is living on credit not a good idea, and can money really bring you happiness?

Douglas Goldstein: Professor Terry Odean is from the University of California, Berkeley. He is a specialist in behavioral finance. He’s going to be teaching an online course called “Making Smart Financial Decisions.”

Douglas Goldstein: What are some of the biggest risks that people have that maybe we can make them a little smarter about?

Terrance Odean: In my course I cover a few topics. We look at saving and spending, at credit and debt, insurance, investments and issues around retirement. Saving, probably is the biggest problem people have today. They are not saving enough and since in the U.S. we have had a big switch from traditional pensions, where if you were lucky enough to have a pension when you got to retirement you would get income for life to what are called the defined contribution pensions such as 401(k) plans where the responsibility for saving enough and then for making good investments falls with the worker. So that’s a tough problem for people and it’s one of the reasons that people aren’t saving enough.

Douglas Goldstein: You said saving was a tough problem and spending was the next issue. So where’s the problem there? How are the two connected?

Terrance Odean: I would say they are related. If you are not saving enough you are probably spending too much and there are a lot of reasons for that. Among them, it’s just easier to spend too much today than it was when I was growing up. My parents didn’t have credit cards. So they couldn’t spend on money that they didn’t have. It would have been very difficult for them to do so. There are a lot of things that were different in the ‘50s than now, but basically it’s easier to spend money now. As I say, it’s harder to know how much you need to save because my dad was a high school teacher and my mom was a high school teacher. They basically knew that if they worked at their jobs for 35-40 years, they would have enough in retirement, so they didn’t have to ask themselves the question “Are we spending too much?” Spending was very simple. You do not spend more than you get each month because there’s no way to do so. When the money is gone, it’s gone. Today, people have credit cards and it makes it very easy to get in trouble and easy to spend too much.

Douglas Goldstein: We said saving, spending, and credit. What are the issues with credit?

Terrance Odean: The big thing with credit and credit cards are that you have to pay off your credit card at the end of every month. If you can’t maintain the discipline to pay off your credit card in full at the end of every month, you’d be better off not using a credit card.

Douglas Goldstein: And here’s another issue: insurance. What are the areas that people have problems with?

Terrance Odean: So the big thing with insurance is first of all, figure out what you need and what you don’t need – for example life insurance. If someone is financially dependent on you, someone you love such as your child or spouse, or sometimes your aging parent who’s financially dependent on you, you need life insurance. If nobody is financially dependent upon you, you don’t need life insurance. Second, if you buy life insurance, you should buy term life insurance. I go into that in more detail in my course as to why. The other thing is if you have homeowner’s insurance or automobile insurance, regularly get new quotes, like every three years. Go out and get quotes from three or four different companies for exactly the same terms on a policy. It’s surprising, but the prices that companies charge sometimes vary quite a bit. It took me a few hours to do this; it took more than 15 minutes. I spent a few hours doing this. Three or four months ago I saved myself $700, $800 a year. So you know, I can’t guarantee everyone is going to save that much. I perhaps waited too long between intervals of shopping but it’s worth doing. So the big thing with insurance is figure out what you need, figure out what you don’t need, shop around, and if you want to get, for example, your auto insurance premiums down – to pay less, consider taking a bigger deductable. You know a bigger deductible on your collision and your comprehensive insurance. Choose a deductible that won’t be a disaster for you. You don’t want it so high that it’s going to set you back but if it’s inconvenient, that’s okay. It will save you money in the long run.

Why Do People Have Problems with Saving?

Douglas Goldstein: Let’s dig into some of this a little more and see some of the complaints that people have about this and frankly I’m wondering if these are some of the questions you are going to have to address in the class. Number one is, it’s hard to save. You talk about saving but it’s just not easy. People – they are not making as much as they would like and there are real expenses that they have. What do you recommend to someone who says “Yeah you are telling me to save but what do I do?”

Terrance Odean: Okay, that’s a very good question and I’m quite clear in my class that although I am encouraging people to save, I realize it can be very difficult. There are a couple of steps that you can take to make it a little easier. The first is automate your savings. So if you are working at a company with a 401(k) plan, have money put straight into your 401(k) account each month. Try to raise how much you are putting in. If you don’t have a 401(k) plan, you have in the U.S. for example an IRA, individual retirement account. Automate that so that when your pay check comes in, money gets put in that account automatically. Don’t wait to the end of the month and say “Well I’ll put whatever is left over at the end of the month into saving.” Another idea – it’s a great idea, not mine – it came from my friends Richard Thaler and Shlomo Benartzi. It is called a “Save More Tomorrow”. Now I know that sounds like a procrastinator’s dream, but the idea is this. Commit now to raising your savings rate sometime in the future. Oftentimes, that might be when you get a raise. So you might say… okay. I really can’t squeeze anything more out of my pay check right now. But next time I get a raise, maybe I’ll commit to put in half of that money into the savings and the time after that when I get a raise, I’ll put half of that money into savings. Half of each raise until I get to whatever my target level is of saving. And I think that’s a pretty good way to automate raising your savings and to make it palatable. I’m not claiming easy, but to make it a little easier.

Douglas Goldstein: You talk about not spending more than you have and one of the interesting things about credit is it allows you to actually live a better life today than you would otherwise be able to do. A lot of people say – and I see the argument, interest rates are relatively low, or not even that. They’ll just say, “I want to own this today. I can diversify the purchase over time by borrowing the money and what the heck, the government is doing it too. I’m just learning from my congressman about paying tomorrow for enjoying things today.” Why wouldn’t someone do that?

Terrance Odean: I’d say if you own the printing presses for money, circumstances are different than if you are putting money on a credit card. Interest rates on a credit card are not low. It’s a very, very expensive way. If you actually have savings, think about this for a moment. Suppose you do have savings in the bank or in an account and you have some of your money invested in bonds, relatively safe. Where can you get 16% a year? Nowhere. But where can you pay 16% a year? You credit card company will be happy to charge you that. It’s a very expensive way. I talk about a book in one of my videos and I obviously didn’t write the book called Happy Money and the book goes through ways to spend your money that will make you happier. One of the points they make is they say you are giving this argument and say “I really want to take a vacation. Oh I want to take a vacation and I think I’ll just put it on the card and pay for it over the next year.” Generally, you will be happier if you delay the vacation, you can enjoy planning it, enjoying thinking about what a great time you’ll have then you go and have a great time and there’s no nagging feeling of “Gee, this is a good expense” but when you get home, you can think back on the memories of your great vacation without also thinking “Yeah, but I still owe thousands of dollars on the card.” So I think if you can delay your gratification, you’ll probably be happier and you certainly will end up wealthier.

Why Is It Not a Good Idea to Default on a Credit Card?

Douglas Goldstein: Some people say “Listen, I’m going to run up the bills and I’ve seen other people default on their credit cards, I’ll just do it too.” Why do you recommend against that?

Terrance Odean: There are a lot of reasons to recommend against that. Not the least of which is it’s a very difficult strategy certainly in the U.S. these days to run up your credit card debt and then declare bankruptcy. The bankruptcy laws were changed a few years back and if your income is above the median income in your state, you probably won’t be allowed to declare chapter 7 bankruptcy which would be where your consumer debt was fully discharged. Instead, you are going to end up with a repayment plan and you will sooner or later have to repay that debt. So that is the practical argument. Of course, there is also an ethical argument which we could leave for another show. But, I think some people would feel that that was unethical approach. Personally, I think it would be a very stressful way to live. I don’t think that would make me happier but of course each person can answer that for himself. But I guess the more pressing answer is, it doesn’t work very well.

Douglas Goldstein: You came right across the board and said you should not buy whole life insurance; you should buy term insurance. I think the logic that people usually say is the point of insurance is to insure you against something that you cannot afford. But the insurance companies would certainly have a word to say with you about that one, not the least of which is saying some people aren’t able to save. Also there are not tax benefits with saving through an insurance policy. If one dies when the market is down, his investing errors are not going to lose anymore. Why are those problems?

Terrance Odean: The analysis that I’ve seen suggests that on average, you can get better investment returns and the same life insurance coverage if you separate your insurance and investing into term life insurance and then, you know, invest in mutual funds or other products. There may be people who have unusual circumstances who would benefit from one of these more complex products. They do tend to be very expensive so the fees that would be in charged tend to be quite high. You can get mutual funds that charge much, much lower fees.

One of the themes in my class when I teach my undergrads about personal finance is that complexity is the enemy of the consumer. So financial services industries like complex products, and one of the reasons they like complex products is because it makes it difficult for consumers to compare the prices on different products because they’ve got a bunch of different products. Each has different bells and different whistles and you get attracted to a feature and you have no clue as to whether you are paying way too much for that feature. One thing I like about the term life insurance is how simple it is. I get term life insurance, I get a level policy maybe for 10 years, maybe for 20 years, whatever meets my needs. You know how much you are going to get paid, you know what you’re going to pay in premiums and you know the circumstances under which you are going to get paid. It’s really simple, so you just say to yourself I want a million-dollar policy or a $500,000 policy or whatever it is. I need it for 10 years or I need it for 20 years. I want to know what it’s going to cost me. You can compare that. All that’s left now – as long as you are dealing with companies that are financially sound, what’s left is what’s the premium. Very easy. These other policies – very complicated – much harder to know whether you gain the better or the worse deal.

Douglas Goldstein: How can people learn about you, learn about your work and learn about this course?

Terrance Odean: Probably the easiest way is to go to my website www.odean.org. At the top, I have a link to the signup sheet for the course. The course is free. It’s free to the public. It starts on April 15. There’s also a link to my YouTube channel where people can watch a sample of videos from the course. Alternatively, one can go to the edX website. The course is hosted on edX and search for "making smart financial decisions."