My Money Scripts

Are We Facing a Super Subprime Crisis?

From Rick Kahler

The U. S. is facing a super subprime crisis that will make the current crisis seem like a cakewalk. That was the depressing news from David Walker, former Comptroller General of the United States and currently president and CEO of the Peter G. Peterson Foundation, when he spoke to financial advisors attending the national NAPFA convention in Washington, DC, in June.

It is well known that the current crisis was produced largely by consumers spending more than they made, funded by reckless borrowing. As a nation, however, we are doing the same thing. The problem, according to Walker, isn’t the doubling of our national debt from $5.8 trillion in 2008 to $11.2 trillion today. “The problem is the tens of trillions of unfunded obligations for Medicare and Social Security. These obligations grow faster than the economy or inflation.”

Walker, estimating all our obligations at over $62 trillion dollars, said, “America owes more than Americans are worth.”

He was somewhat optimistic about the response of average Americans to the crisis, especially increases in savings. He predicted this change in behavior would be sustained even when the economy turns around.

Despite the benefit of the recent fiscal policies in preventing the recent crisis from becoming a depression, Walker was not optimistic about the federal and most state governments. He warned, “We have an out of control fiscal and monetary policy. As a country, we are living beyond our means.”

Walker listed four factors that led to the current crisis and will lead to the coming super meltdown.

1. There is a disconnection between those who benefit from government fiscal policy and those who are affected by or pay for it.

2. There is a lack of transparency in communicating the risks being taken in our current fiscal policy.

3. We have created too much debt, not enough focus on cash flow, and too much reliance on credit rating agencies.

4. Government fails to act until there is a crisis. Instead of “leadership,” we get “lag-ership.”

One of the big problems is our national debt. During WWII, our national debt was 122% of GDP, but 100% of it was owed to Americans. Now, Walker said, 50% of our national debt is owed to foreign lenders.

The danger here is that other nations can pressure us into actions that are not in our best interest. This has already happened. Freddie Mac and Fannie Mae mortgages were not guaranteed by the government until this crisis. Then, Walker said, “Japan and China demanded” that the U. S. Government back their mortgages.

If we are to turn things around as a county, Walker says Americans must demand four things from their elected officials:

1. We must enact tough statutory budget controls.

2. We’ve got to reform Social Security.

3. We must reform Medicare and privatize medicine.

4. We must reform our tax system to raise revenue by becoming fairer and more business friendly.

Walker feels that of all of these, reforming Medicare will be the hardest. “Social Security reform is a layup. Medicare reform is a three-point shot made from under the opponent's basket.”

Once we come out of the current recession, the outlook is for our economic growth to be significantly less than in past decades. Walker predicted taxes are going up and the longer we wait to restructure government, the higher they will go. “My grandchildren will not have as good a life as I’ve had. That’s un-American.”

He concluded, “Americans, now more than ever, will have to work longer hours, learn how to budget, spend less, and save more for their future.”

Fooling Ourselves

From Rick Kahler

Do you work more than 40 hours a week? Do you have enough money for retirement? Do you wash your hands after you use a public bathroom?

Yes, these three questions do have something in common. They're all related to the difference between what we say we do and what we actually do.

Let's start with hand-washing. According to Steven D. Levitt and Stephen J. Dubner, authors of Freakonomics, 75% of men surveyed said they washed their hands after using the bathroom. However, researchers who camped out for hours in a number of men’s restrooms found only 10% of men actually washed their hands.

Our tendency to overestimate isn’t limited to just bathroom hygiene. In a Wall Street Journal article on May 29, 2009, Laura Vanderkam suggested that Americans have a bad habit of overestimating how many hours a week they work.

A number of studies and books have championed the notion that Americans are overworked, with the 60-hour work week being the new 40. The problem, according to Vanderkam, is that most of the information on these increasing work hours comes from asking people. Given our tendency to overestimate, this may not be the best way to obtain data.

Researchers at the Bureau of Labor Statistics conducted a study that required people to keep a time diary of various activities. They then compared their results with other popular surveys. What they found was interesting. People who said they worked 40 to 44 hours a week actually worked an average of 36 hours. People claiming to work 60 to 64 hours a week actually averaged 44. Those claiming to work 65 to 75 hours a week ended up working 55. Based on this information, you can probably just subtract 20% from the number of hours people say they work to get the actual number.

The fact that people overestimate is nothing new to the field of behavioral finance. Researchers have found in study after study that people are overconfident when it comes to their financial and investment acumen. I see this all the time. Of all the investors I've ever spoken with, most think they understand portfolio diversification. I can count on two hands those who actually did.

Another instance of overconfidence is how people view their retirement. Most people are unaware they have grossly underestimated the money they will need to maintain their current standard of living in retirement. They are confident that when they retire, “things will work out,” even though the average baby boomer has only $50,000 saved in a retirement account. What do they expect to do for income in retirement? Most, about 81%, say they will simply continue to work after age 65.

However, what people actually do after age 65 is quite different. A 2005 Department of Labor survey found that only 19% of people over age 65 who wanted to work were actually working. The other 81% either could not find employment or couldn’t work because of health reasons.

You don’t need a formal survey to figure out that people overestimate. Just find any child learning to play a musical instrument. Ask the kid to practice for a half-hour. Then clandestinely set a timer. When the child finishes, ask her how long she practiced. What she says and what the timer says are often two very different numbers.

Deceiving ourselves about hand-washing habits or practicing the flute probably doesn't matter very much. Deceiving ourselves about retirement savings, however, can have serious consequences. An important part of preparing for retirement may be learning to overcome our own overconfidence.

Weathering the "W"

From Rick Kahler

Is now the time to prepare for the possibility of a huge market downturn later this year? It may be.

A number of market prognosticators I've been reading think there is a good probability we will have a "W" shaped economic recovery. This theory suggests that the first dip in the "W" was the global stock market crash last fall, and the upward rise in the middle of the letter is the current market rise. The next phase will be another crash, equal to or deeper than what we saw in the fall, before we see a sustainable recovery.

I spoke about this possibility in the “Town Hall” I did for readers in April. If the 1929 – 1932 bear market is any indicator (and it’s the most comparable to the current crisis) we would now be in the middle of the bear market.

Bob Veres of Inside Information reported on a speech given last month by Roger Gibson, author of Asset Allocation. While he said it's not improbable that the next ten years will give us annualized double-digit returns, we may not have reached the bottom of the current bear market. Gibson's concern, which also parallels the thinking of investment advisor Lou Stanasolovich, is that the deepest recessions have seen P/E (price/earnings) ratios hit 7 to 9. So far, our lowest P/E ratio was about 11 and stands currently at 15.5. To reach a P/E ratio of 9, the market would need to fall 43%. That would put the Dow Jones Industrial average at about 4,900.

Before you jump out of your first story window, let's put this in perspective. First, almost no one saw the first crash coming. A bunch of people are seeing the second crash coming, which could be the best insurance that it won’t happen.

Of course, I do remember writing an article in 2004 about all the stories proclaiming we were in a real estate bubble which would prove to be as nasty as the dot.com bubble. I pooh-poohed that by saying no one saw the dot.com bubble coming, so all the predictions of a similar bubble in real estate were probably our best insurance there would be none.

Okay, maybe you should jump.

Before you do, though, there may be a better course of action to prepare for the possibility of another nasty down leg of this bear market. If you are retired and you’ve followed my advice and stayed in the market, this could be a good time to raise some cash. You may want to consider selling off enough assets to fund two to three years of withdrawals. This should get most portfolios through the worst of a downturn without having to liquidate at a market bottom to raise cash.

This is also time to make sure your portfolio is diversified in at least five asset classes. If your portfolio is mostly in U. S. stocks and bonds, you may want to consider moving at least half of it into additional asset classes like commodities, real estate investment trusts, absolute return strategies, treasury inflation protected securities, and international stocks and bonds. By my estimates, investors with a broad array of these asset classes lost up to 50% less in the recent downturn than those who held mostly U. S. stocks and bonds.

If you raise a little cash and diversify, the worst outcome is that you give up a point or two of return over the next two years. And if the worst happens, you may have bought yourself some peace of mind and the staying power to be "in the game" when the actual recovery comes.

Chrysler, Crack, and Capitalism

From Rick Kahler

The principles of capitalism are everywhere. Just ask Steven D. Levitt and Stephen J. Dubner, authors of Freakonomics. Not long ago I attended a talk where these two authors shared their eclectic brand of economic research.

One area they discussed was the structure of drug cartels and the "salaries" paid to their members. The typical cartel employs around 5,000 people. At the top is the "board of directors," who each typically make about $500,000 a year. Next are "regional governors" at about $350,000. Under them are the local leaders with exclusive territories. They typically earn 20% of gross revenues, meaning they net perhaps $75,000 to $100,000. Finally, there are the foot soldiers, who typically are teenagers selling crack for around $5 an hour.

This structure isn't all that different from other business organizations. The entry-level drug dealers are finding jobs in the dominant local industry, much as young people in Rapid City might find jobs in tourism. Of course, there is the fact that the drug industry is illegal. Also, the death rate of gang members is 7%, which is seven times the percentage of our soldiers killed in Iraq. “And why do they do this for $5 an hour?” asked Levitt. “They are simply willing to take a risk to improve their income and their lives.”

In contrast, Levitt turned to a recent Rasmussen poll on capitalism which found that only 53% of Americans believe capitalism is the best economic model. “If you don’t like capitalism, you need to find a different economic model,” he suggested to the audience. According to Levitt, that alternative isn’t communism or even socialism, models which have failed in Russia, China, and Eastern Europe. Neither have proven to improve people’s lives and produce wealth.

Nevertheless, the current attitude of most Americans seems to be, “Let’s give socialism a try.” Shortly before his death in 2006, Milton Friedman predicted that, even though socialism is a discredited economic model, people would be seduced by its collectivist ideas again. And what's going on right now? The US Government has essentially nationalized Chrysler and General Motors. The President has just appointed a "czar" with broad authority to set and oversee pay levels for top executives at seven of the country's largest companies.

During the presidential election, John McCain’s campaign was criticized for saying much of the financial crisis was psychological. Levitt suggested McCain actually got it right. “Bad economies can become self-perpetuating. It all depends on where a person is getting their data.” For example, someone reading The New York Times last fall, with its repeated references to "if" we would recover, would have concluded the end was near. The Wall Street Journal and BusinessWeek painted a completely different, more pragmatic picture of the crash by discussing “when” we would recover.

Levitt compared the current economic crisis to someone who gets sick. Their research shows that at the onset of an illness most people do nothing, not going to the doctor until they are feeling really sick. Typically, this is also the peak of the illness, so the patient is likely to improve regardless of what the doctor does. The doctor gets the credit, even though the patient was going to get better anyway.

In similar fashion, he added, the American people are going to needlessly waste two to four trillion dollars to make themselves feel better. This socialistic "cure" may get the credit for our economic recovery. Its only real impact, however, will be to create a burden of debt that will reduce American’s standard of living for decades.

Changing Our Money Culture

From Rick Kahler

Last week's column discussed the belief of social anthropologist Dr. Jennifer James that the United States is currently in a society-wide "moral void" when it comes to the economy. By moral void, she doesn't mean a lack of morality, but rather a time of panic and inability to make logical and common-sense decisions.

During periods of fear and stress, such as the current economic crisis, the part of the brain that uses logic and facts to make decisions is overwhelmed by the more primitive part of the brain that operates emotionally. The result is individual and collective financial decisions made out of fear and panic.

What we call "society" or "culture," of course, is actually the accumulation of a great many people's individual beliefs. Changing our cultural beliefs about money and the economy, then, starts with changing our individual beliefs.

1. One of the first steps in this process is to become aware of the effect fear has on the brain. We can teach ourselves not to make decisions when we're aware of being overtaken or "flooded" by strong emotion. When you're overwhelmed by bad financial news, for example, there is a strong urge to do something quickly to relieve the fear and panic the news creates. When you recognize this need to take action for the emotional brain response that it is, you can train yourself not to respond to it immediately. Instead, you can give yourself time to get past the fear before you do anything.

2. During a time of fear, it helps a great deal to bring your brain back into equilibrium before you act. It often helps to allow yourself a time of quiet reflection, deep breathing, and focusing on something other than the fearful money scripts shouting that you "Have to do something right now!"

3. Become aware that the fear urging you to act is based on your money scripts, the deep beliefs about money anchored primarily in the unconscious, emotional part of your brain. Most of us have perhaps 50 to a couple hundred money scripts operating constantly. They are partial truths, but we assume them to be absolutely true. The more we are aware of those scripts, the less power they have.

4. Learn to question and reframe your money scripts. Once you identify a money script, you can begin to revise it by considering alternatives—imagining situations where it might be true, false, or partially true. Research shows that people who function best around money have flexible rather than rigid belief systems about money.

5. Align yourself with others who appear to be what you want to become. Conversations with others who are just as fearful as you are only reinforce and build everyone's fear. Instead, seek out friends and financial advisors who can help ease your fears and help you become more comfortable with new ways of thinking.

6. Build a solid base of knowledge. When you understand the basics of money management and investing, especially the concept of thinking for the long term, you are less likely to be overcome by fear during challenging financial times.

Culture, according to Dr. James, is "The stories you tell yourself about how things ought to be, usually at a very young age."

An important component of financial health is accepting financial reality and working with the way things are instead of the way we wish they were or think they ought to be. When we change our individual stories about money, we change what we teach our children and how we act financially. This can be the start of creating a more realistic and healthier culture around money.

Culture, Cash, and Common Sense

From Rick Kahler

Culture is "The stories you tell yourself about how things ought to be, usually at a very young age." This definition came from social anthropologist Dr. Jennifer James as she spoke to several hundred financial planners at the Financial Planning Association’s annual Retreat in Palm Springs, CA.

James's definition of culture is similar to the idea of "money scripts," the beliefs about money and how it works that a person typically develops during childhood. We assimilate our money scripts from a number of sources, including our parents, caretakers, siblings, teachers, and our society’s culture.

One example of a cultural money script, which James said is primarily found in the United States, is "anyone can be a millionaire." Whether this is a realistic belief or not, she pointed out that "culture is more powerful than common sense."

One of the big challenges in today’s world, according to James, is the rapid cultural changes we are witnessing. This is especially notable since "culture is the last thing that we change and it’s the hardest thing to change."

I would agree that changing our deep-seated cultural beliefs about money is remarkably difficult. Why are the stories we tell ourselves about how money and finance ought to work so much more powerful than financial reality? Why are they so hard to change?

We have to look no further than our current financial crisis to understand how difficult it is to change our money beliefs. Is it common sense to spend more than one’s income? Of course not, yet for the past decade we’ve gone on a spending binge fueled by borrowing on credit cards and home equity loans. As of the summer of 2008, our national savings rate was a minus .5%. Spending down our savings for consumption was not sustainable. It made no financial sense. However, the power of our money culture that allowed such behavior was far more powerful than common sense.

Neuro-economics is teaching us that such seemingly illogical behavior makes perfect sense when we understand how the brain works. Our cultural beliefs are anchored primarily in our lower brain and our common sense in our upper brain. Brain imaging finds that when we step out of our cultural norms, the lower part of the brain that registers pain goes into overdrive. Sensing danger, a chemical dump allows our lower brain to take over all thought processes and go into survival mode by shutting down any input from the upper brain. Common sense and logic literally disappear.

James underscored the brain research with the metaphor of a "cultural tapestry." "If someone starts tearing up your tapestry and you can’t see what’s being rewoven, you feel like you’re in a moral void. When that happens, we burn witches at stakes."

She believes when societies are in moral voids, as the Unites States is currently, they move backward in time. She thinks what we are seeing economically and politically is an attempt to return to feudalism, rather than democracy. While I don’t necessarily agree with her economic conclusions, I found the analogy intriguing.

I see the same society-wide dynamic she described operating in individuals. When someone’s money tapestry is being torn up through job loss, overspending, market losses, shrinking revenue, etc., that person enters a moral void. The upper brain shuts down and the lower brain goes on autopilot. Financial decisions are made out of fear rather than logic and factual information.

Changing the cultural response to financial crisis starts with changing our individual responses. My experience, as well as research from behavioral economists, suggests several steps to help make that change. I'll describe them in next week's column.

On the Edge of a Financial Cliff

From Rick Kahler

If some of my clients insist on responding to the current recession by getting completely out of the markets, buying gold, or stuffing their mattresses with cash, what is my responsibility as their financial planner?

I recently participated in an online discussion of that issue with some professional peers. One of them raised an important question. How far should planners go to try to keep people from making what the planner views as a serious mistake? It’s important to respect someone's competence and ability to make their own life decisions. On the other hand, should a planner stand idly by and watch someone walk off what the planner perceives as the edge of a financial cliff?

Part of the answer to this dilemma is to understand a planner’s legal obligation. This obligation depends on whether you are a client or a customer. If your planner is a fee-only independent planner, you are a client. If your planner works for a major investment bank, you are probably a customer, which means the planner has no obligation to put your interests first.

For planners who choose to put their client’s interest first, what are their legal responsibilities when, in the planner’s opinion, clients are about to do themselves financial harm?

Suppose I have a client who is about to do something that may be viewed by a court of law as “extreme” or “imprudent.” (An example would be putting all his money into one asset class like gold, cash, penny stocks, etc.) I would feel pulled from a position of liability to be certain I emphasized to the client that, given the research and data available, his actions could hurt him financially. I also would want to be sure the client fully understood and took responsibility for those actions.

As professionals, financial planners need to protect themselves by carefully fulfilling their legal responsibilities. During my career in real estate and appraising, I appeared in court many times—usually as an expert witness. I’ve learned that a lawsuit is the last way to settle a professional dispute. The best way to stay out of court is to be comprehensive and complete in actions, words, and documentation.

This brings us to the broader aspect of what financial planners owe to their clients. In my view, they first of all have an ethical responsibility to do no harm. They need to put the clients’ best interests first. They also need to educate themselves continually so the advice they give is as sound as they can make it.

Sometimes this ethical and legal responsibility requires planners to give clients information they may not want to hear. The planner needs to recognize and honor clients’ resourcefulness and opinions, and also recognize that in some cases they may not have all the facts or they are about to act based on delusional thinking or fear.

When clients are hovering on the edge of a financial cliff, planners don't want to shame them or abandon them to their fears. The challenge is to help them pause long enough to reach a more rational place so they can gather additional information.

When I work with clients in this way, my experience has been that they are almost always able to get past the fear that is pushing them to make imprudent decisions. This is one reason I have such a commitment to working, not just with financial facts and figures, but also with clients’ beliefs and emotions about money. It is one of the most effective tools financial planners have to help protect clients from themselves.

Staying In the Zone

From Rick Kahler

Try to imagine the enormous range of possible financial conditions in which human beings can live. At the lowest end is bare subsistence—those with the minimum food and shelter possible to sustain life. At the highest end is unlimited wealth—multi-billionaires who have more than they, their children, and their grandchildren could possibly spend.

Most of us, of course, live in relatively narrow bands somewhere in between these extremes. In our book Wired for Wealth, we describe these bands as “financial comfort zones.”

On the high end of our particular financial comfort zone are what appear to be the wealthiest people we know. On the low end are what we assume to be the poorest people we know. Those who share a financial comfort zone tend to have similar incomes, lifestyles, spending and savings habits, and beliefs and assumptions about money.

For those growing up in wealthy families, “normal” may include private schools, international travel, live-in household help, and expectations of an Ivy-League education followed by a lucrative career. Those growing up in families managing from month to month on limited incomes will inhabit a much lower financial comfort zone. Normal for them might include shopping at thrift stores, after-school jobs, and little or no expectation of higher education.

In both cases, the expectations people grow up with tend to keep them in their financial comfort zones. These zones are artificial financial boundaries that we impose on ourselves, and they are not necessarily defined by what we can or cannot afford. Yet we become uncomfortable if we move too far past them.

Certainly, people can and do expand their financial comfort zones. Children who grow up in low-income families, for example, may be able to get an education and go on to careers that bring them financial success far beyond that of their parents.

The real problems arise when circumstances unexpectedly push people out of their financial comfort zones. Suppose a relatively poor couple wins several million dollars in the lottery. All at once, they will have the means to move into a much higher financial comfort zone. Yet making that move will mean leaving behind their familiar expectations and way of life, which will separate them from their family and friends.

It’s no wonder that many people, coming into unexpected wealth, unconsciously feel a need to get rid of it. It’s one way to get back into the familiar zone where they know how things work, they are comfortable, and they belong.

The same thing can happen to a person in a higher financial comfort zone. Suppose a high-earning professional couple, who have grown up with wealth and an affluent lifestyle, have lost nearly half their net worth in the current economy. Then one of them is laid off. They aren't going to starve. In fact, they could scale back their spending a great deal and still live perfectly comfortably.

Yet this may not seem like an option to them. Just like the low-income lottery winners, changing their financial circumstances moves them out of the place they belong. It’s possible they may go into debt or spend down the assets they do have left, jeopardizing their financial future, in order to maintain a lifestyle that keeps them in their financial comfort zone.

Ironically, this couple would have a better chance of returning to their financial comfort zone if they were willing temporarily to move out of it on the low end. Becoming comfortable with less for now, in order to invest in one's future success, can be an important factor in building a financially secure future.

How Worried Are You? We Asked, and You Told Us.

From Rick Kahler

If you want to know what people think, just ask. When I asked for views on the current economic and political situation through a recent online poll, more than 100 readers responded. One percent are elated, 12% are optimistic, 34% are concerned, and 53% are irate.

Investment losses aren't the biggest worry. Not many respondents have panicked, sold investments, and moved to cash. What really has them worried is the unprecedented increase in our national debt to bail out failing companies and stimulate the economy. A second fear is the possibility of higher inflation.

Only 34% of the survey respondents were "extremely concerned" about losses in their investment portfolios. However, 77% were worried about the record deficit spending, bailouts, and stimulus bills. Many (62% were extremely concerned) fear that the record peacetime government spending will lead to increased or hyper inflation.

The expansion of government control or the prospect of government ownership of private companies was an extreme concern to 68% of those who answered the survey. And 63% were also extremely concerned about the expansion of government programs like health care, education, and more regulations on businesses. Only 29% were extremely concerned about the possibility of prolonged deflation.

When asked what they believed to be the major causes of our current economic crisis, those surveyed chose these from the available options:

• Poor lending decisions made by bankers (91%)

• Poor borrowing decisions made by consumers (90%)

• Government policy (86%)

• Unethical lenders (86%)

• Rampant corporate greed (72%)

• 1999 legislation that opened up competition among banks, securities companies and insurance companies (59%)

• The economic and domestic policies of the Bush administration (53%)

• Inherent weaknesses in capitalism (29%)

I was especially interested in the suggestions respondents had to resolve this crisis and keep it from happening again. An overwhelming 92% said we need a new emphasis on financial literacy courses taught in our schools. I hope both educators and parents take note.

Even though rampant corporate greed was listed fourth among the causes, 72% of those taking the poll felt those on Wall Street responsible for this crisis should have criminal charges brought against them and be incarcerated. Next in the list of fixes were: a significant reduction in government spending (74%), more regulation of the mortgage lending process (72%), and new tax cuts or an extension of the Bush tax cuts (64%).

Our respondents don’t think much of the idea of increasing government control of industries like banks, insurance companies, or auto makers. A whopping 82% disagreed that the answer to our economic woes is the nationalization of key industries.

Over 86% of those taking our poll were middle class, defined by President Obama as people making less than $250,000 a year. Yet 76% of the respondents did not favor higher taxes on the wealthiest Americans. Another round of bailouts isn’t going to gain much public support, with over 66% opposing any more government spending on stimulus, bailouts, and shoring up the banking system.

Finally, we asked what our respondents are doing as a result of the crisis. It was no surprise that 89% said they have cut personal spending, 87% have increased saving, 83% have decreased debt, and 78% have increased what they are putting into investment accounts. Despite the avalanche of bad financial news in the media, only 15% reported selling their investments and going to cash.

The good news, to me, was that those who took the survey were not giving in to short-term panic. Instead, their biggest concerns were whether short-term attempts to solve the financial crisis would harm their children's financial future.

Teaching Kids About Money

From Rick Kahler

One of the many challenging questions for parents is how to teach kids about money. Right now, with so many news stories shouting that “the financial sky is falling,” it’s even more of a challenge. How can we can teach kids to be careful about money without scaring them to death? How do we help them learn the value of thrift without instilling money scripts that will turn them into fearful misers?

Trust me, if I had the definitive answer to this question, I would write another book and it would become an overnight best seller. In the meantime, here are a few suggestions that might help you come up with your own answers.

1. Use an allowance as a starting point. As a kid, I didn’t get an allowance and had to work for all my spending money. While there are some good points to that, I believe it also provided some of the foundation for a few of my money scripts, like “You’ve got to work hard for money.” However, children who get everything they need through generous allowances could develop beliefs that they don’t need to work because the money will always be there.

My wife and I have tried to balance these extremes with our kids. They start getting an allowance at age five. This gradually increases until age 10, when the amount is frozen. This slowly motivates them to understand they need to work if they want to earn more. We offer them optional chores they can do for pay if they want to earn extra money.

 As kids become teenagers and their needs and wants increase, they also become old enough for part-time jobs and can gradually become responsible for more and more of their own expenses. My kids haven’t reached this age yet; in a few years I’ll let you know how well this works.

2. Don’t use allowances as a punishment tool. We rarely punish the kids by taking away an allowance. In my view, this would be appropriate for a money-related offense, such as stealing money from a parent’s wallet or deliberately breaking something that needs repaired or replaced. For non-money lapses, it seems more appropriate to apply non-money consequences.

3. Let the kids spend their money however they wish—at least on anything that’s legal. This was hard for me. It was tough in the early days watching them blow every weekly allowance and end up with nothing to show for it. Slowly, though, they are learning the benefits of saving over instant gratification. They both have turned into savers.

4. Establish clear expectations. Who pays for birthday gifts when they go to friends’ parties? Do teenagers with part-time jobs need to buy their own clothes, pay for car insurance, or save a percentage for college? Discuss these questions with the kids and come to a clear agreement about who pays for what.

5. When it’s gone, it’s gone. I think one reason my kids have begun to learn to save is that we are consistent about not giving them extra money. If they blow their entire allowance the day after they get it, they’re broke for the rest of the week. We don’t slip them an extra five bucks “just this once.” Saying no to kids’ pleas isn’t easy, but it is one of the most important money lessons we can teach them.

As parents, it’s important to remember that kids learn more from what we do than what we say. The best thing we can do to teach our kids to manage money well is to learn to manage it wisely ourselves.