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The Financial Hierarchy Explained - and What it Means for Financial Decision-Making


Behavioural scientists in the personal/consumer/household finance domain are trying to make people off better, financially. But very often the meaning of being ‘better off’ is assumed. And I think it's time to actually explain what the assumption is. A tool often laying at the foundation of financial advice (actual financial advice, by professionals) is the financial hierarchy, which is essentially the picture linked to this article. It is often depicted as a pyramid, as one tier builds on the others. The idea is that you move upwards, and preferably not downwards.


 


So where do we start? Well we start with the lowest tier: surviving. This is very much a basic ‘must have’. The aim is to have your income be greater than your expenses. There’s a multitude of ways to do that but there’s two core basics: either you increase your income, or you decrease your expenditures. For the former, I have written an article on behavioural science based reasons and tactics for getting promoted (and therefore earning more). In terms of the latter, I have written many an article on reducing your spending (part 1 and part 2!), how to budget, etc. There’s ways to do it and they’re all behavioural science informed! What you may come against is that your find out that you have a rather extreme money personality, or that you have some really unproductive attitudes towards money (fear of losing it all, extreme risk aversion, etc.). They’ll likely need to be fixed to drive real and sustainable behavioural change.

Once our income covers more than just our basic expenditures, we need to start de-debting. This just means paying down debt, preferably the most expensive one first (although there’s behavioural alternatives to this). If you’ve been successful in addressing your unproductive money attitudes and some quirks in your money personality (spendthrifts I’m looking at you), the likelihood of you taking on new debt should have decreased. The most expensive debt is often credit card debt. I have written an article on how to carefully select a credit card (because a good choice can definitely minimize debt) as well as how to manage one, both in terms of spending and repayments. Never, ever only just repay the minimum if you can pay more. Words to the wise.



Moving onto the third tier: learning. Bit of an abstract name for this one, but it is essentially savings focused. Which is ironic, because in step 2, the money that you had left over by your income exceeding your expenditures could have been considered savings, albeit savings with the purpose of repaying the debt. This third tier is all about stacking up money, without a direct purpose. And that’s where things get a bit more difficult. Money that’s just siting in an account ‘doing nothing’ is not very satisfying. This isn’t fun. It may be peace of mind, but it sure isn’t fun… And then the longer you stare at the balance of your savings account, the more ideas come to mind as to how to spend this money in a fun way. Don’t fall into this trap. Tips for leaving your savings alone are to hide your savings accounts. Tips for actual saving is to set up a goal. A SMART goal: so a goal that’s specific, measurable, attainable, relevant and time-based. For example, you want to save $10,000 (specific) by January 2024 (time-based), by setting aside $200 every week (measurable), which is 10% of your post-tax wage (attainable) to be able to go on your honeymoon, without having to dip into your current savings (relevant).

Now quick note here: before we start saving for honeymoons, vacations and retirement, we need to build an emergency buffer first. The order of elements mentioned in the pyramid also matters. An emergency fund is there for a rainy day: if your car breaks down it means you can dip into your savings, rather than dipping into your credit card balance, to get it fixed. After this has occurred, the main priority is to fill the emergency fund back up again, before continuing to save for your other goals. It’s not an issue to have multiple savings goals at the same time, but there should be a hierarchy to them.



Tier 4: investing. Investing can take a lot of forms and it really depends on your goals in life, your current situation (how stable are you in terms of finances, but also things such as job stability, having to move, needing to have liquidity etc.) as well as your risk appetite. And here is where the financial advisor comes in (if you can afford one) or where you need to do a lot of research yourself. Do me (and yourself) a favour and don’t just endlessly consume ‘finfluencer’ content and just go by what they say. Do proper research. Things that do definitely help is to talk to a tax agent to see if there’s a way to cut down on taxes paid, for both income and investments as well as being part of an employer matching scheme, if your company (or country) has that system in place. Matching schemes are where, if you put money into a 401(k), which is the American system, your employer also puts some money in. Sometimes they match you for every dollar, or $0.5 to the dollar, but in the grand scheme of things, it’s free money. So take it! Next is investing in index funds (or ETFs). These are investment vehicles that capture the market, or a sector of the market. For example, you could be invested in the S&P500, which is the Standard & Poor's 500 Index; a market-capitalization-weighted index of 500 leading publicly traded companies in the States. Or you could invest in the global Copper sector by buying a global copper ETF such as COPX. These are relatively low risk investment vehicles, meaning that they aren’t really that volatile, but that doesn’t mean that they cannot lose you money; you can always lose money during investing.



Tier 5, something I have a lot less experience with as I am a 27 year old who only recently finished her PhD and therefore isn’t ‘rolling in it’: wealth optimization. Honestly, if you get to this stage you’re probably wealthy enough to get yourself a financial advisor, so I advise that you do, rather than taking advise from someone like me, or worse, a finfluencer. A financial advisor can talk you through even better ways of avoiding wealth and income tax (not evading), as well as help you diversify your investment assets. You may move out of index funds and ETFs and into more speculative type investments such as crypto, real estate or even start your own business, or invest in individual businesses. This is so highly personalized that it is difficult to tell what form it may take. Last, but not least, rather most: tier 6: ‘freeing’ or better known as: financial independence. Here this is defined as all your passive income (read: all income not gained from having to have a job or current time trade-off) being able to cover all of your expenses (and preferably then some). This is also very much the aim of the FIRE movement. At this stage, you literally do not have to work. You live that ‘dividend lifestyle’. This obviously takes a lot of smart financial decision-making, support, good financial advice, amazing planning and, to be fair, luck.


 

There are other financial hierarchies out there. Simply googling gives you plenty. This one and this one are also good examples, although they do differ a bit. Some hierarchies also have a tier for protection and safeguarding (insurance) and others have ‘legacy’ as the top tier, which also requires you to plan for future generations and their wealth, as sustained by your current wealth. Regardless of which exact pyramid you roll onto, I hope this article has clarified what it means for a behavioural scientist, or anyone in an adjacent domain, to want to make people better off, financially. If you have any questions, do reach out, you know where to find me 😉

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