Most net savers — a rare but dignified bunch — tend to have similar financial habits. A person in this group typically spends less than she makes, lets money accumulate in a checking account, and then wonders what she should do with the excess. If the stock market is trending down she thinks, “I’ll wait for it to go lower before getting in.” If it’s going up she thinks, “I’m just going to wait for a pull back before I invest.” This leads to atrophy until one day she gets bored, realizes the cash balance is too high and determines to put excess funds into the first thing that strikes her fancy. That could mean paying down debt, investing, or turning on HGTV and figuring out how she is going to flip properties.
Most investors would be better served by automating the process, or creating a strategy that divides the anticipated savings between cash accounts, retirement accounts, taxable accounts and debt payments and then setting the monthly transfers to each one on autopilot. (For related reading, see: How to Avoid Common Middle-Class Money Traps.)
Eliminating Emotion and Atrophy
The first step is to create a budget and determine how much excess is available every month. Websites and applications like Mint.com are completely free and make this process incredibly easy. They allow consumers to aggregate their financial lives in one place. Combining the transactional data from bank accounts, credit cards, student loans, car loans, mortgages, and investment accounts provides the user with a clear picture of her net worth and cash flow broken down by category.
Second, once a budget is created and the anticipated excess savings is earmarked, it’s imperative to determine how much should be added to each account. It’s important to remember that not all accounts are created equal. For example, maxing out a Roth IRA is a terrific idea for long-term money, however, if the funds are going to be needed in the near future, a cash account may be a better choice.
Third, if the plan involves paying off debts, determine the order in which the loans should be paid off. The goal should always be to pay down the highest interest loans first, adjusting for any tax deductions. If the plan involves investing, determine the appropriate long-term allocation. The overall mix between stocks, bonds, cash, and alternative investments should account for the investor’s age, goals, and risk tolerance. (Every investor has a different set of goals, risk tolerance and tax situation — discuss your plan with your financial professional before making any investment decisions.)
Fourth, the most important part is establishing automatic transfers that will take place every month. Automatic bill payment solutions provided by lenders and ACH transactions facilitated between banks and investment companies make the process seamless. When the cash goes into a debt account, consumers need to make sure it’s being used to pay down principal rather than prepay interest. When the cash goes into an investment account, consumers need to make sure it’s being invested according to the prescribed allocation. (For related reading, see: Diversification and Lessons from a Normalizing Market.)
It’s as easy as that. Technology simplifies the automation process and does consumers the favor of taking emotion out of the equation. Studies have shown people make terrible financial decisions when they are emotional or when they overthink things. When left to their own devices, people tend to poorly time the stock market, buy expensive things they can’t afford or invest in their friends’ doomed-to-fail startups. Additionally, money invested more frequently compounds faster. As an example, after 30 years, assuming a return of 6%, a person that added $1,000 to her account every month would have earned about $56,000 more than the person that contributed $12,000 once at the end of every year. (For related reading, see: 8 Common Biases That Impact Investment Decisions.)