There is no doubt that financial literacy has enjoyed a great boost, thanks in no small part to the internet and the decentralization of information. However, there are some very basic financial mistakes that we continue to make even though most people know better. In this article, we'll look at these potentially damaging oversights and why we continue to make them.
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1. No Emergency Fund
It is true that most emergencies can be smoothed over by paying with a credit card and paying it off later. However, the biggest danger that comes with being short on ready cash is being ruined by the loss of a job. If you don't have savings to cover two or three months - or even two or three weeks - you'll either have to find a job quickly or begin selling whatever you can.
So why do we do it? One common reason that seems logical is that the money in the emergency fund is more efficiently used in paying down outstanding debts. This reduces the overall amount of money you'll pay in interest on your debts. It stands to reason that having fewer debts will allow you to pull that "credit" you've paid down if something should happen. However, if you've ever tried to get a loan when you've been unemployed or under-employed, you know the terms get worse and sometimes you'll be refused credit on any terms.
In short, there is no replacement for having a cash cushion rather than depending on the goodwill of banks. The 2008-2009 credit crises has driven home the fact that when people are hurting from economic factors, the banks are often hurting too - and thus reluctant to lend. (Do you have enough savings to cover the costs of unforeseen crises? We show you how to plan ahead. See Build Yourself An Emergency Fund.)
2. Improperly Insuring
Most people carry enough life insurance to cover any debts and provide for loved ones. However, these same responsible folk often overlook non-fatal dangers like disability, theft, fire and so on. We don't like to think of losing our legs in an accident or watching all our possessions go up in smoke, but it is worth the discomfort of considering these outcomes because it is usually possible to insure against them at reasonable rates if you shop around.
3. Not Writing a Will
Although most of us carry life insurance, we don't like dwelling on the thought that we will die - and could die very suddenly. So we end up putting off writing a will until we're "older" or, if we have a will, we update it less frequently than we should. Unfortunately, not having an updated will raises the probability that the settling of the estate is likely to be a nightmare for your executor and beneficiaries. To paraphrase Ben Franklin, nothing is certain except death and taxes, and both of these should be considered on an annual basis. (Many people try to avoid this process altogether, making things difficult for heirs. Check out Top 7 Estate Planning Mistakes.)
4. Ignoring Costs and Benefits
We are increasingly bombarded by advertising that frames wants as needs, and tends to muddy the financial part of the picture with deals, rebates and payment options. As a consequence, our current thinking tends to overstate the short-term benefits of owning a particular item now, and understate the long-term costs of paying for it.
Realizing that everything put on credit today is simply taking money from our earnings tomorrow can be very sobering. Even cash purchases cost more than you think. This quickly becomes apparent if you frame every purchase in terms of the labor you must perform to earn the purchase price in after-tax dollars. You don't need to take this to extremes that will result in you buying only the absolute essentials, but you may find that the real costs will take the luster off many of the perceived benefits that aggressive advertising creates.
5. Buying on Rises; Selling on Dips
You can believe in a stock and its business, own it while it gradually gains value, and still lose money. Much like falling prey to advertising, getting beat by the market is largely a psychological quirk. Many people tend to throw more money into a position when it is rising, and confirming their beliefs about the stock. When the stock hits hard times or simply falls on market whims, the same people quit buying or even begin selling.
You can take a one-year chart of any stock and see dips where, if you had bought, your profits would be much larger than only buying on the spikes in value. Sadly, very few investors can stay disciplined when the animal spirits are raging. Fortunately, strategies like dollar-cost averaging (DCA) can short-circuit our tendency to buy more when we feel we are right and to buy less or nothing when it looks like we are wrong. Before automating your investment in a stock, it is important to dig into the financials and the stock's story to make sure it is worth the long-term vote of confidence you'll be giving it through DCA or value averaging (VA).
The Bottom Line
In the end, your success on avoiding these potentially damaging financial mistakes depends heavily on your perspective. Sure you don't want to think about being horribly injured or your apartment being robbed, but there is a lot to be said for the peace of mind that comes with being prepared for these contingencies. You also don't want to have money and not be able to enjoy it, but there has to be a reasonable and real advantage that justifies the cost of a purchase. Similarly, when a stock you are confident in takes a dip, you can see it as a disaster or an opportunity to buy. Enlarging your perspective can be difficult, but the benefits that come with it clearly outweigh the costs. (When you're short on cash, a strict budget is the best tool for finding financial stability. See Budgeting When You're Broke.)
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