Gather Little by Little

One of the many magazines I enjoy reading is Smart Money, from The Wall Street Journal. For other magazines I read, see My Magazine Reading List.

In the July issue, Smart Money highlighted 7 Money Mistakes. I thought it was a really good article, and wanted to summarize it for you.

#1 Saving with the right hand and spending with the left

This mistake addresses the issue of how people save money, but spend unwisely. Some examples include:

• Keeping a savings account that pays 5% interest while paying Visa 15%
• Thinking a tax refund equals money you can blow, while in reality you’re just giving the government a free loan
• Obsessing over the price of a new car and working hard to get the best deal but failing to monitor your weekly grocery bill and sticking to a budget

In Summary: Make sure you focus on the whole picture and not just individual accounts or purchases.

#2 Playing it too safe

People are so loss averse that they tend to focus on the obvious losses and not the more subtle losses and savings that can occur. For example:

• Quick to sell winning stocks, but slow to sell losing stocks
• Putting too much in money-market funds and not enough in stocks
• Making an effort to avoid a $4 surcharge, but spending $4 too much for something by not shopping around
• Driving 5 miles out of your way to save 5 cents per gallon on gas prices, but forgetting the additional gas consumption and wear and tear on your car that end up costing you more than you saved.

In Summary: Make sure you take a broad view of your finances. Smart Money recommends seeking how the assistance of a financial planner whose job is to provide a perspective when you’ve lost yours.

#3 Looking into a cloudy crystal ball

This mistake focuses on something called “the availability bias”. This is a mental shortcut we use to gauge risk. It involves us has humans, relying on past events or emotions to make decisions and evaluate risk. We seem to want to ask what is the best or worst that could happen, rather than asking what is most likely to happen. Some examples are:

• Having life insurance, but not disability insurance, even though we are more likely to miss an extended period of work than we are to die.
• Purchasing extended warranties (btw, stores make a lot of money selling you these along with the sales people who get commission)
• Purchasing security features we don’t need. One example is buying car stereos with removable face plates. People who purchased these paid more for these units, but 75% stopped removing the face plate after 1 year. I’m guilty as charged on this one.

In Summary: This mistake doesn’t advocate not planning for the worst (or best), it just suggests being practical and making good decisions based on what is most likely to happen and to a lot your fears or the worst or best situation to taint your decision process.

#4 – Living in the moment

Procrastination is the root problem here. When faced with what we perceive as an unpleasant, complicated, or overwhelming task we will simply put it off and doing something else easier. The tendency to procrastinate is the reason more than 50% of employees don’t contribute to their 401(k) plans. We would rather look at the immediate impact than the delayed or long term rewards.

In Summary: Don’t procrastinate. Set-up automated transfers to your 401(k), IRA, or other savings plan. Calculate the long term benefits so you can see the numbers.

#5 – Throwing good money after bad

The main issue here is something called the sunk-cost effect. For those that may listen to the Dave Ramsey show, he often refers to this and uses this to assist his callers with making financial decisions. Sunk-cost effect basically refers to us making decisions based on the money we’ve already invested in something and not on the future gains or losses. Some examples noted:

• Holding onto lagging mutual funds because of a paid upfront sales charge
• Making repairs that cost more than your car is worth

In Summary: Sunk costs shouldn’t matter. They’re gone. Make decisions by looking at the future gain or loss expectation. Smart Money recommends getting a second opinion from someone that didn’t make the initial decision and isn’t weighed down by sunk cost.

#6 – Letting your ego get in the way

Studies show that we often overestimate our abilities. As a result, we often make high-risk investments, overtrading and not making our investments diverse enough. As a result we might get lucky on a few, but overall we end up losing money.

In Summary: Be a long term investor. Investing requires a lot of homework. If you don’t have the time, put your money into a no-load equity index fund and let others do the homework for you. If you are trading as a hobby, set aside a small fixed amount of funds for it. The best treatment for overconfidence is big losses (i.e. learning the hard way).

#7 – Following the crowd

Don’t make financial decisions because other people are making them, or because your friend recommends you should. The article references the 1987 23% plunge in the Dow Jones Industrial Average and other massive stock markets around the world. The reason for this drop is still a topic of hot debate. Smart Money says that behavioral economists saw that investors acted like lemmings.

In Summary: Maintain a long term strategy and don’t get queasy just because the market drops. Go against the herd, a study showed that going against the herd yielded future returns.

Credits to Smart Money for another great article.

Update: The full Smart Money article is now up online.