Even though you may think you’re handling your money rationally, there’s many psychological factors that even very sophisticated people fall victim to. Learn how to fix these big money mistakes below.
I just finished reading the fantastic “Why smart people make big money mistakes and how to correct them.” The authors focus on the behavioral economic factors that cause us to do boneheaded things with our money. The book concludes with actions for people to take to overcome some of their irrational financial behaviors.
See if you’re making some big money mistakes, and learn how to fix them:
1) Raise your insurance deductible. Gary Belsky & Thomas Gilovich explain that because we count highly memorable events as more probable events (think fear of airplane crashes), we tend to overestimate the odds that we’ll have to file an insurance claim for life, auto or health. Therefore, we pay too much in premiums for low deductible policies. Instead, raise your deductible from, say, $100 or $250 to $500, $1000 or more.
2) Next, create an emergency fund to “self-insure” against paying deductibles and for other smallish losses. Read my other articles about paying less for auto insurance premiums, and also about using catastrophic/high-deductible health insurance. Because we think about all the terrible things that could happen to us, no matter how unlikely, we sometimes buy insurance we don’t need. Go here to learn about insurance you should avoid.
3) Pay off credit card debt with emergency funds or other non-retirement savings. Often times, we use ‘mental accounting’ to separate different accounts of money in our mind. We might treat our emergency fund as sacred, and at the same time max out our credit cards. Once you accept that a dollar in your emergency fund has the same value as a dollar on your credit card, you’ll realize that making 5% in a money market fund and paying 14% in credit card interest at the same time just doesn’t make sense. Besides, if you have an emergency after doing this, you can just put it on the plastic. (Of course, once you pay off your credit card debt, keep paying your full bill every month!)
4) Switch to index funds. I often champion the virtues of low-fee index funds. They give you instant diversification and ensure that you’ll beat about 80% of actively managed mutual funds by just matching market returns. Also, they let you put your investments on near-autopilot, freeing up your time to do the things you really love without worrying about quarterly earnings reports or whether your fund manager really knows what he’s doing investing in Siberian oil fields. Be honest with yourself that you probably don’t have any business trying to outperform investing professionals (who themselves often don’t have any business doing it.) Also, DON’T be fooled into picking the latest ‘hot’ fund or stock. Funds with high recent past performance are often just random aberrations, and are likely to perform worse than average going forward.
5) Review your assets and track your spending for a month. Take a snapshot of your personal wealth by tallying up all your debts and savings. Then, track your spending for a month. This second part is hard, but the rewards are absolutely huge. You may think you know where your money is going, but if you’re one of those people that have credit card debt or just can’t seem to save enough, you must do this. Even if you’re pretty on top of your money, tracking where your cash is going can be very revealing (I know it was for me.) Fortunately, credit cards and online software like Mint or Quicken help you do this pretty painlessly. Just make sure to account for cash expenditures too.
6) Set up a payroll deduction. We often find it painful to send our hard-earned dough to a savings account when that money’s already in our checking account. Eliminate this phenomenon (called ‘loss aversion’) by making investments straight out of your paycheck through a payroll deduction. That way, you’ll miss the money less since it will never feel like you had it in the first place. Your 401k plan is a great place to start, but you should also consider automating the rest of your money to build wealth without thinking about it (hardly.)
7) Max out your retirement savings (or at least the employer matching part until you can save more.) Retirement accounts like 401ks, 403bs, and IRAs are great places to build wealth because of their tax savings. Read more about retirement savings here. At the bare minimum, max out your employer’s matching portion of your 401k. (It’s free money!) This is so important that you should do it at the expense of putting more money towards paying off your credit card debt! (And I really hate credit card debt, so that’s saying a lot. Pay that plastic off as your second highest financial priority.)
So there you have it, 7 steps to fixing some of the biggest and most common money mistakes that even smart people make. As always, email me with questions about your particular situation, or leave a comment and I’ll answer back as soon as I can.