Thursday, April 24, 2014

The Levels of Personal Financial Competence

Here I take a 1000-foot view and define levels 0 to 3 of personal financial competence. One of the big things I’ve learned about personal finance since I started writing this blog is the staggering number of people mired in the lower levels.

Level 0: Spend as you please and tomorrow will take care of itself

The main thing that characterizes people at this infantile level is declining net worth. They use credit to go out to eat, vacation, and buy cars. They justify their spending with nonsense like YOLO and “I’m worth it.”

I don’t include in this group retirees who are sensibly drawing down their life’s savings. Their net worth may be declining, but with a logical purpose. I also don’t include people who face serious medical problems that prevent them from making a living and require them to spend on health care. Foreseeable events like a car breakdown or needing dental care don’t get you off the hook for a level 0 label.

In my parents’ day, this level largely didn’t exist because there was limited access to personal credit. It’s not that people were smarter decades ago; they just didn’t have the same opportunities to borrow. When you go to the bank with each pay cheque, trade it for cash, and have to go hungry for a day if you don’t make the money last to the next pay cheque, reality hits you quickly. Young people today face a minefield of banks and other financial institutions sending the strong marketing message to spend as you please on credit.

Level 1: Steady state

People in steady state are managing to live within their means, but just barely. They’re not getting richer, but they’re not getting poorer either. Typically, people at this level have some debt, but they manage to make minimum payments, and they don’t build new debt any faster then they’re paying off old debt.

Everyone in level 0 will eventually be forced into level 1. You can’t spend other people’s money forever. The smart ones see the problem with living at level 0 themselves and cut their spending. The dumbest people in level 0 build up debts so large that no one will lend them any more money. Through no fault of their own, they get upgraded to level 1 and downgraded to a much lower lifestyle.

I don’t include in this level people who have enough savings to prepare them for retirement, and they choose to spend their incomes and their investment returns. Even though their net worth isn’t increasing, they qualify for a higher level.

Level 2: Saving for the long term

People in level 2 are building long-term savings. This doesn’t mean saving for a car or a vacation; it means saving for some far-off purpose such as retirement.

However, just contributing to an RRSP or TFSA isn’t good enough to make it to level 2. If you’re building debt just as fast as you’re saving, you’re not really saving at all. People who grow their lines of credit, car loans, or other debts at the same time as building long-term savings get sent back to level 0 or level 1.

The critical thing to make it to level 2 is to be building your net worth at a pace sufficient to be adequately prepared for retirement. Most people should target having a substantial nest egg by about age 60; career disruption after age 60 is very common. Maybe you won’t be able to do the same job you’ve always done, or even if you can, your employer may not agree.

Level 3: Investing savings sensibly

If you’ve made it through the minefield of overspending and are managing to increase your net worth over time, you have a shot at making level 3. As a very rough guide, I’d say that “investing savings sensibly” means investing in a way that has the expectation of beating inflation by 2% or more each year.

A lucky few have no need to seek investment returns. If you’ve got millions saved but live a modest life and see no need for anything but GICs at a few different banks, you can have your level 3 stamp right now. However, if you’re slaving away at work saving as much as you can, but saving it all in GICs, go back to level 2.

If you invest in balanced funds and pay a 2.5% MER, a little more in trading expenses, and the occasional deferred sales charge, you’re expected long-term return is less than 2% over inflation. Go back to level 2.

If you sold out of the market in 2009 and are still looking for signs that it’s safe to get all the way back in, your prospects aren’t good. Most market timers make their moves at the wrong times. Go back to level 2.

If your portfolio turnover exceeds 100% per year, odds are very strong that you’ll trail market averages badly. Go back to level 2.

If you pore over mutual fund descriptions of the type Gordon Pape used to publish each year to decide where to move your money, you’re likely a performance chaser who will lose out over time. Go back to level 2.

If you’ve been reading analyst reports and are sure that Blackberry is poised for a rebound, even though less than half of your previous picks didn’t work out, go back to level 2.

Personally, I’m hoping to beat inflation by at least 4% per year, on average, with index investing. It’s ironic that the average dollar invested with a plan to beat the index will end up doing worse than the index. Those who take the biggest chances to beat the index actually belong back in level 2.


It would be interesting to see the results of a poll asking people to self-assess their level. Because the average person can’t grow wealth faster than the economy grows, there is limited room in level 3. But I’d bet that a great many people think they’re at level 3.

For the most part I’ve aimed this blog at people who are in levels 2 and 3. Being a natural saver, I have no personal experience of living in level 0 or level 1. However, from reader feedback and watching friends and family, I’ve gained some insights.

Preet Banerjee’s excellent book, Stop Over-Thinking Your Money, is mostly about moving people from levels 0 and 1 to level 2. He says that if you can start saving and avoid the worst investing mistakes, you get an A in personal finance. You can expect me to keep writing about moving from an A to an A+.


  1. Any good books you recommend on moving from level 2 to 3? The Moneysense couch potato guide to investing comes to mind but I am curious if there are more

    1. @Greg: The main things that get you from level 2 to level 3 are an adequate allocation to sticks, sufficient diversification, low costs, and low turnover. Here are some books I found helpful:

      Stocks for the Long Run

      Winning the Loser's Game

      Playing the Winner's Game

      MoneySense Guide to the Perfect Portfolio

      The Quest for Alpha

      The Investor's Manifesto

  2. Can you expand on this comment... "I'm hoping to beat inflation by at least 4%... with index investing... the average dollar invested will end up doing worse than the index... those who take the biggest chances to beat the index actually belong back in level 2." How do you avoid doing worse than the index, as you say, preferably 4%? What do you consider is taking a 'big chance'?

    1. @Karen: Historically, stocks have beaten inflation by more than 4%. I'm hoping that they continue to do almost as well.

      All forms of active investing create costs: commissions, spreads, taxes, opportunity costs of being out of the market, etc. There will be some winners, but the average across all dollars trying to beat the market has to be below-market returns. This isn't a prediction; it's a simple mathematical certainty. Just as there is no way to divide up a 15-ounce pie into 5 pieces that average more than 3 ounces each, you can't divvy up market returns (and pay costs) and have the average dollar come out ahead.

      Those who take the biggest chances in active investing are those who take the uncompensated risk of concentrated investments. A good example would be an older guy on one of my softball teams. He had millions in Nortel stock built through company savings plans and just held on. The team broke up before Nortel crashed, so I don't know what happened to him, but he was certainly taking a huge risk. Another type of big risk is making huge market-timing trades.

      The easiest way to avoid doing worse than the index is to simply buy the index in the cheapest way possible and just hold on.

  3. Brilliant post, Michael! It's interesting that moving from level 0 to level 1 can actually leave you with a worse quality of life. I feel like I was there once after I finished school and had to dig my way out of consumer debt. I definitely spent more than I earned before then and it was a big reality check to live on much less. The good news is that I was able to turn that situation around rather quickly and start growing my net worth. I find most people just need that "a-ha" moment to realize that they can't keep overspending and ignoring their finances.

    1. @Robb: Thanks. It's true that life is better in the present in level 0 than it is in level 1, apart from the worry. However, the view of a person's future looks better when they're in level 1 than when they're in level 0.

      I'm glad you found your a-ha moment. People reach these moments in different ways.

  4. Having gone from level 0 to level 3, it feels a whole lot better at level 3. Took me a lot of years to get there, much longer than it should have, but I am glad I finally made it.

  5. @Tara: Glad you made it. There's a nice view from level 3.

  6. Interesting, wondering how you got the idea for this post? I like it. Particularly your level 3 "rejection" criteria. I think you were too generous to the people who have hid their money under a mattress since 2009 though.They should drop back 2 levels :)

    Good book choices as well - I have 3 of them. Reading "Pension Confidential" at the moment, which I have found fascinating as well.

    1. @Paul: The idea for this post came from thinking about the differences between what I write about and what Gail Vaz-Oxlade writes about. I'm a fan of her work, but we have very different audiences.

      Pension Confidential looks interesting. Unfortunately, my library doesn't have a copy. We'll see if I'm motivated enough to buy a copy.

  7. I'm an aspiring Level 3. I'm 44 and its only been in the last five years or so that I really started paying attention to the particulars of spending, saving and investing. I say that with a certain amount of embarrassment and regret, but suspect I'm not entirely atypical when you look at how much consumer debt the average Canadian has, etc.

    Have rid myself of all debt and regularly save about one third of my take home pay. The nest egg builds. But I'm still likely too conservative as about about two thirds of my modest portfolio is still high interest cash and GICs. The other third is TD e funds. I am very fortunate, though, in that I will receive a defined benefit pension.

    For me, the key transition is from level 1 to 2. Investing is important, no question, but becoming a saver instead of a spender is no small feat for many (if not most) people. And a feat made all the harder by the constant bombardment of advertising encouraging us all to borrow and incur debt.

    1. @Juan: Congratulations on making it to level 2. You have an impressive level of savings. Take your time learning about investing and understanding the level of risk you can handle. That defined-benefit pension will definitely help.