Wednesday, November 30, 2016

Hierarchy of Financial Needs

Most readers would probably have come across Maslow's famous hierarchy of needs: a pretty neat explanation of how humans should view our existence in terms of our needs. Abraham Maslow, an Amercan psychologist, created this hierarchy as he was trying to understand human nature. 

The hierarchy of needs is usually produced in a pyramid like the one shown below. The theory goes like this: humans have needs and we need to fulfill our basic needs before we can advance to the next level. For example, the most basic needs like food, water, shelter have to be fulfilled before we can think about health, starting a family, owning a property etc. As we move up the hierarchy, we need friendship and connections, develop self esteem and finally achieve what we are supposed to achieve - self actualization. In short, reaching our potential in life.

Maslow's hierarchy of needs

As civilization progressed, most developed countries today, including Singapore, have moved up the pyramid and a lot of individuals do have opportunities to achieve self actualization. Maslow postulated that only 1% of humans would actually succeed. Well, that's probably not far from the truth given that a few hundred million people still live in poverty, in war torn territories, fearing for their lives, wondering if they could eat the next meal. Let's pray for them. However, in developed countries, the population of people who can self-actualize would be much higher, including most readers here.

In the world of personal finance, we can modify the pyramid to map our financial needs following more or less the same rules as the original Maslow pyramid. In this new hierarchy of financial needs, we also need to fulfill the lower levels before we advance upwards. The lowest level corresponds to the very basic and important needs. In life, obviously we need food and water before we talk about other needs. In finance, it's the same reasoning, we should fulfill fundamental needs first. However there would be minor differences as we delve further. 

At the most fundamental level, we first need to build our foundation before anything else. This foundation incorporates, most importantly, stable income which is salary, or for entrepreneurs, cashflow from their core business. Once we have achieved that, we should own our homes or for some countries, make sure that the salary takes care of the rent (unfortunately Singapore might fall into this culture some day as it gets too expensive to own our homes). And as the old adage goes, we also need savings for the rainy days. As a rule of thumb, we should have cash savings of around 12 months of expenses to cater for emergency needs. Since this website started out talking about investment, we often neglect these bread and butter issues. Investment actually comes after we have our foundations built! The following pyramid gives a sense of how the financial needs are ranked.

Hierarchy of Financial Needs

The second level is security, or protection. This is where we make sure we are protected by buying insurance and strive to have more incremental savings (beyond 12 months of expenses) if we can. We also then try to supplement our cashflow by investing these savings, thereby receiving dividends if we buy stocks, or bond coupons if we have bonds. Needless to say, one of the best security is having a second property that gives good rental income. The goal here is that the dividends, coupons, rent received from stocks, bonds, property here would cover expenses some day. It is worth mentioning that salary, by and large, will always be the main source of income. Rich Dad Poor Dad did the world a major dis-service by introducing the concept of passive income. It's a lie. Passive income cannot replace salary or an entrepreneur's main source of cashflow. Even if we reach aforementioned scenario where our dividends, coupons and rent can cover all our expenses, we should still work if we are employable. Of course, we then have the freedom to choose jobs that we find meaningful and hence can truly enjoy.

Insurance is a topic that deserves more scrutiny, but perhaps in another post. The whole industry is made complicated by agents as most of them mis-inform and mis-guide their customers. While it is important to have insurance, it's more important to buy the right ones with the right amount of money! A rule of thumb could be using 5-10% of the overall income to buy the correct insurance (usually term insurance) for good protection. Insurance is ultimately a cost paid to gain protection from adverse events and agents like to use emotional blackmailing to make people pay more than they should. We need to exercise common sense and rationality extremely well when dealing with insurance agents.

At the growth level, the focus for this website, we are actually talking about investing like the great investors - Warren Buffett, David Einhorn, Ray Dalio etc. We think hard and try to pick stocks well - stocks that compound growth and becomes multi-baggers over time. Or we take advantage of rare arbitrage opportunities to compound wealth. Hopefully we beat the markets when we measure ourselves across decades and make really good money. By right, this level should only be attempted when we have fulfilled the lower levels. But we do need stable income from dividends and bonds (at the security level). So, in a sense, there are overlaps. We need a few good stocks to supplement our income at the security level, yet the same capital would help catapult our growth. It's also worth noting that the growth level takes on higher risks to achieve higher returns. 

The highest level, arbitrary termed wealth maximization is about maximizing returns, which means we engage in the highest risks investments which can pay out big amounts, usually by utilizing a small percentage of our net worth (say maybe only 3-5% of our total net worth). For instance, buying long dated options or bio-tech stocks or for high net worth individuals investing in venture capital and the likes. This is a stage where we are prepared to lose the whole amount, but since it's limited to a small percentage of the portfolio, it doesn't really change things. But we have the opportunity to hit the jackpot i.e. like finding the next Facebook or Alibaba. Again, as with Maslow's needs, perhaps only 1% of the global population would reach this stage. 

Over the years, many experts had also reviewed Maslow's original hierarchy and it was proposed that changes should be made to reflect how the world had evolved since Maslow's days. So the new hierarchy looks something like this:

Haha! Yes more fundamental than anything else, today we need WiFi! It comes before the need to eat, sleep and having a shelter. Okay, just kidding. The new hierarchy actually adds to the highest level which is termed self-transcendence or simply transcendence. Later in his life, Maslow and others believed that perhaps self-actualization was not the ultimate goal in life. It was to self-actualize and use that ability to help others. In Maslow's own words:

Self Transcendence - seeks to further a cause beyond the self and to experience a communion beyond the boundaries of the self through peak experience

In our hierarchy of financial needs, perhaps there is a similar transcendence. What is our purpose of accumulating so much wealth when most of our financial needs would probably be finite? Most billionaires have come to this conclusion. They would never finish spending their billions and it might not be such a good idea to simply give it to their sons and daughters, as it kills their motivation to work hard. Hence people like Warren Buffett and Bill Gates actually pledged to give away more than 80% of their wealth to further progress the human race. This is very noble and perhaps an inspiration for us as well. No matter where we are at the hierarchy, we can always transcend and give away whatever we can afford to those who need it more.

Financial Transcendence - giving away what we can afford to help others

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