- Personal Finance»
- Understanding Finance
Making Financial Decisions
Most of us make at least some bad financial decisions that cost us hundreds or even thousands of dollars each year. Over the course of a working career, these costs can put a significant dent into our retirement savings. By eliminating these costs now, we can improve our financial situation now and into the future. Here are some of our worst financial decisions we need to eliminate.
Buying Lottery Tickets
There’s a good reason state governments offer an expansive selection of brightly-colored lottery ticket near the checkout aisles of your local supermarket: They raise lots of money for the state. State lotteries pay out an average of only 60% of gross revenues on prizes. If you buy five lottery tickets per week, and each ticket costs $1, you’ll spend over $10,000 over the course of a 40-year career. If you instead invested this money at a 5% interest rate, you’d build a nest egg of over $33,000! Since you’ll win back an average of $19,800, you’ll be paying a voluntary “tax” of about $13,000.
Gambling at a Casino or Racetrack
Another almost sure-fire way to waste money is to gamble at a casino or racetrack. The payout ratios are higher than lotteries, with many casinos paying out 90% to 97%. But gambling at a casino with a relatively-high 97% payout ratio is still a bad decision since you’ll lose 3 cents of every dollar you bet. While this 3 cent loss is tamer than the 40 cent loss you’ll incur on every $1 lottery ticket, you’ll likely waste more money at the casino because most people bet much more money at a casino. For example, assume you’re playing a $1 slot machine with payout ratio of 97%. Thanks to your player’s club card, you can spin the wheel every 15 seconds on average. If you play for one hour, you’ll spin the wheel no less than 240 times, and wager a total of $240. On average, you’ll get back $232.80, and lose the remaining $7.20 to the casino. While that isn’t much, you’ll lose $28.40 if you play for a normal casino visit of four hours. And this assumes you resist the temptation to move up to the higher value slots.
Basing Your Investment Decisions on the Recent Past
Whenever you invest, you are likely to see disclaimers such as “Past performance is not indicative of future results”. This disclaimer warns us not to chase yesterday’s “hot” investments with our new investment money. By doing so, we risk buying high and selling low, which is the opposite of our investing goal of buying low and selling high. Unfortunately, the statistics show many retail investors fail to heed this disclaimer as they pile into yesterday’s hot investments, and then get burned when those investments plummet. We’ve had plenty of examples since the turn of the century. We watched retail investors pile into tech stocks only to get burned when they fell. Then, we watched investors pile into real estate only to get stung by the real estate bubble.
Not Contributing Enough to our 401Ks to Get the Match
Who wouldn’t want free money? Apparently, the answer is that many of us say “no” to free money when it comes to contributing enough to our 401K retirement accounts to get the full company match. In a typical 401K plan, the company offers to match 50% of an employee’s contributions up to a maximum of 6% of salary. Thus, the company is essentially offering 3% of the employee’s salary as “free money”. Despite this, about 20% of eligible employees don’t join their company’s plan, and many who do join don’t contribute enough to get the maximum matching company contributions.
Buying Mutual Funds with High Annual Fees
Many people buy mutual funds with high annual fees of 2% or more, or up-front loads reaching 5%. This behavior would be rational if the mutual fund managers consistently outperformed the market averages by enough to offset these fees. Unfortunately, the statistics show the majority of fund managers trail the market averages. For example, in 2011, 79% of large-company fund managers ran funds that trailed the performance of the Standard & Poor’s 500-stock index. Most people would be better off avoiding these high fees and buying low-cost index funds run by companies like Vanguard.
Paying Loads on 529 Plans
Savings for your child’s college education is an admirable goal, and 529 savings plans are a great vehicle for doing so. Most states offer two types of 529 savings plans. One type consists of 529 plans sold by investment advisors, while the other consists of 529 plans sold directly to retail customers. As you can guess, advisor-sold 529 plans often include high up-front loads or back-loaded fees, while plans sold directly to consumers typically have no loads and lower fees. Since the goal of buying a 529 plan is to save more money for your child’s education, skip the advisors and buy the plans direct.
Completely Trusting Your Financial Advisor or Broker
As we’ve seen too often, the only person you should completely rely on to manage your finances is yourself (with some exceptions for your trusted spouse, parents, children, etc.). With any other financial advisor, broker, real estate agent, mortgage broker or credit card issuer, remember that their goals and objectives do not match yours, and they will have at least some conflict of interest. To protect yourself, ask questions, don’t ignore red flags, check references, review statements, and get suspicious if anything sounds too good to be true (remember Bernard Madoff?).
Trying to Beat the Market
Many investors waste time and money trying to beat the market. They engage in many trades—and incur high transaction fees and investment taxes. They act on “hot” stock tips--though it’s unlikely the Wall Street professionals don’t have access to more recent information. They try to time the market—and miss out on market rallies. They invest in the mutual funds that outperformed last year—only to find that these funds are reverting to the mean this year. On average, most investors would earn higher returns by defining investment allocations that are appropriate for their goals and risk tolerances and then periodically rebalancing their portfolios to stick to them.