Hi Rinkydoo-ers! My name is Jesse, and I typically write on the Best Interest. But today, Brandon was generous enough to let me write here. And specifically, we’re gonna talk about mechanical engineering. And money too, of course.
This post will look at some clear parallels between engineering (in my case, mechanical engineering) and personal finance. At the very least, I hope you walk away with some new knowledge about the engineering world. At best, you’ll develop new mental connections that help you understand why particular personal finance basics are so crucial to long-term success.
So let’s dig into the first engineering idea.
You’re probably pretty familiar with friction and drag, even if you’re not aware of it.
Friction occurs when two solid surfaces move against one another. It’s what warms your hands when you rub them together in the cold. It’s also what allows a car tire to stick to the road, even in a sharp turn.
Drag is pretty similar, except it deals with a solid moving through a fluid. Think about the resistance you feel while swimming, or the phenomenon that heats up a meteor as it enters Earth’s atmosphere. Fluids–water or air or something else–resist against the solids moving through them.
Both friction and drag can cause big problems in engineering, because they add resistance to otherwise efficient systems. But we have certain workarounds.
For instance: bearings permit wheels to rotate more smoothly. Aerodynamic or hydrodynamic designs can allow structures to move more smoothly through fluids. But despite our best efforts, tiny amounts of friction and drag will still be there, adding small inefficiencies to your masterpiece design.
Money: …are like fees and loan interest
In personal finance, fees and loan interest play an analogous role to friction and drag. In fact, many financiers use the term “performance drag” to describe the fees and expenses in an investment.
First, they represent wasted effort. Friction and drag can slow down your car, wasting gasoline for nothing in return (and we know car ownership is expensive!). But, they are “necessary evils” if you want to drive. Similarly, fees (e.g. a mutual fund’s expense ratio) represent money that you have to kiss goodbye. But, those fees provide you with the privilege of investing. They’re a necessary evil if you want to save via mutual funds.
Similarly, taking a loan will force you to pay interest on that debt. That interest is gone, never to be seen again. But, it’s a “necessary evil” that you must pay for the privilege of taking that loan. You were given more buying power–for a car, a house, or college–than you otherwise would have had. And that comes with a cost.
Like an engineer making choices to minimize aerodynamic drag, we too can make choices that minimize our fees or interest payments.
Personally, I choose to invest in low-cost index funds. Some mutual funds charge you 2% of your total investments every year. Some charge 1%, or 0.5%.
But most index funds–which utilize passive, hands-off, low-effort techniques–only need to charge minimal amounts to stay in business. Personally, I pay an average of 0.08%. The “friction” or “drag” is still there, but I’m trying to keep it as low as possible.
Engineering: Factors of safety…
If you’re designing a bridge, what’s the worst thing that could happen? In my opinion, it would be that the bridge fails when there are people using it. Agreed?
As engineers, we take extra measures to ensure that doesn’t happen.
We design the bridge so it can withstand the weight of 200 cars, even though it could only physically fit 100 cars.
We assume that the steel we use might be weaker than normal, which forces us to add extra supporting beams.
This bridge is going in an area that experiences 5.0-level earthquakes every 100 years? We’re going to make sure it can withstand a 7.0 earthquake, just in case.
These are all various factors of safety, and we combine them all to design a bridge that is significantly stronger than it needs to be. When the worst case happens, this bridge will still be ok. That’s what is most important.
Money: …are like the Emergency Fund
In personal finance, we want to implement a system that supports us even under worst-case conditions, and won’t fail even if the fates conspire against us. That’s where the emergency fund comes in.
If you’re unfamiliar, an emergency fund is simply a pile of cash that you vow not to spend unless there is an emergency. An emergency might be that you lose your job, or that the furnace goes out in winter, or that the roof blows off in a windstorm.
Going to Freddy’s Bachelor Party is not an emergency. No offense, Freddy.
Two important details, in my opinion, are that your emergency fund should be 1) liquid, and 2) stable.
Liquid means that it’s easily accessible, such as in a bank account. Owning a rental house is not liquid, because you need time to sell it to turn it into cash.
And by stable, I mean you can depend on it’s value. Some folks I know invest their emergency fund, but I do not think that is stable. If you absolutely need $10,000 to replace your roof, you can’t afford to have a market recession turn your $10K emergency fund into $8K. To each their own, but I would not recommend investing with your emergency fund. It’s just not safe.
How much in the Emergency Fund?
How much money should you have in an emergency fund? Great question, with a few different answers.
Early on in your financial journey, a common recommendation is to save $1000 in an Emergency Fund. That should cover a down payment on a one-off car repair or house repair. It might not pay for the full amount, but many services will be willing to work with you if you are able to give them $1000 cash up front.
As you grow in your financial life, a common Emergency Fund amount is 3-6 months of household expenses. The idea is, “If you get laid off, you need money until you can find a new job.” That’s what this bigger e-fund will cover.
So, if my household spends a total of $4000 every month, I should keep somewhere between $12000 and $24000 in my Emergency Fund. That’s a pretty wide range, right?
The right number for you depends on your risk posture and your job stability. If you’re a software programmer and your job market is pretty hot, you might only need the low end of that range.
But if you worry about your potential for finding a new job, perhaps 6 months (or more) living expenses might be the right number for you.
Earlier we talked about factors of safety as a means of preventing worst-case scenarios and catastrophic failures. In general, factors of safety are vital. But sometimes, engineers can be so conservative in their assumptions that they over-design their product.
As a simple example, let’s look at a tennis racket. The racket needs to be strong enough to support a high-tension string, and stronger yet for larger forces when a quick impact is made with a tennis ball.
At first blush, the solution might be easy: let’s create the racket out of solid steel. Ain’t no way it’s gonna break!
But, as you might guess, a solid steel tennis racket might be 50 times heavier than a typical tennis racket. That’s way too much. It was made so strong–so over-designed–that it’s essentially useless in it’s real purpose: to actually play tennis. So while it might never break (which is good), it’s not good engineering.
There’s an alternate type of over-design: too many components, too many moving pieces, or too much complexity.
Picture a newfangled hammer with an LED light, a compartment for nails, and magnets to pick up something you dropped. It also is Bluetooth enabled and has a USB port, so you can upload your hammer statistics to the Cloud. Your hammer even has a unique identifier on the Bitcoin blockchain.
Well…what’s wrong with the old school hammer that, you know, just hammered nails?
Money:…too “safe” with money, too “complex” with money
The analogy to the extra-safe tennis racket is an extra-safe financial plan.
Take the poor schmuck who puts all his life savings under his mattress. Not only is he missing out on investing opportunities, but he’s even succumbing to the slow death of inflation. His choice in “safety” is actually counter-productive, and is antithetical to what a financial plan should actually be.
Sure, we don’t want our financial plan to “break,” but choosing a path that is too safe will not lead to long-term success.
Similarly, one can choose the complex form of over-design in their financial plan.
They hand pick stocks like a Wall Street expert, despite their lack of knowledge. Around every corner, they see another 2008 Recession looming. They move money around on a daily basis, especially when one bank has a fractionally better interest rate than another. Even if you understand Bitcoin, that doesn’t mean it needs to be part of your financial plan.
Oh, and credit cards? You better believe they wrote a custom algorithm to make sure they maximize all their points. “We actually got a plaque at P.F. Chang’s because we earned a month’s worth of free meals on our Discover Plus Asian Cuisine Bronze Select Card.“
What’s wrong with the basics?! Create a budget. Have an emergency fund. Spend less than you earn. Maximize your employer’s 401(k) match. Pay down your debt.
The steps for financial success aren’t that complex. Yes, they take time. Yes, they take discipline and effort. But they do not involve complex algorithms or insider knowledge or chow mein. Don’t over-design your personal finances.
Let’s ship it to market
The time for design is over with. Our analysis is complete, and we’ve even manufactured a few forced jokes in there. You folks can be my testing crew, but otherwise this engineer’s job is done.
I hope you learned something useful, or at least interesting, today. It turns out that a lot of engineering principles and ideals have parallels in personal finance. Thanks again to Brandon for letting me write on Rinkydoo Finance today!
If you enjoyed it, I publish ideas like these every week on the Best Interest.