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FIXING MONEY PROBLEMS
When I started writing about finance, the world according to Wall Street was promoting something called the âefficient markets theory.â In a nutshell, this theory contends that the day-to-day price movements of stocks and bonds are ultimately rationalâbased on investors making informed and savvy choices about what to do with their cash at any given moment of the day. The idea was that we all went into the investment markets with a fist full of cash and all the accurate information weâd need. Then, our conversations would go something like this: âHmm, that stock is a bargain at this price: Buy! Those bonds arenât yielding enough: Sell and redeploy our capital!â As the market moved to reflect the increasing demand on the savviest investments and the dearth of buyers for the less attractive investments, the prices would shift accordingly and investors would make new choices. Supply and demand are always in sync and investors are always rational.
The bulk of the world has now recognized this controversial theory to be largely irrelevant to individual investors.
Itâs not that people never make rational decisions about their money. They doâjust not all the time and not even when taken as a group. Wall Streetâs favorite theory is now âbehavioral finance.â This theory explains why smart people often make dumb decisions about their money.
The great thing about this shift is that behavioral finance is something we all can relate to. We know instinctivelyâor from personal experienceâthat ignorance, fear, or greed can get in the way of making smart choices. Instead of decisions, we make excuses. Instead of making money, we make . . . well, a mess.
This book is going to tell you how to invest wisely. Investing 101 is simple. Itâs straightforward. Youâll get step-by-step instructions throughout. Anyone who reads and follows the directions will find investing easy to do. But if you let bad money habits overshadow your money smarts, your road to wealth will be long and bumpy.
How do you avoid that? Like anything else: You identify the problem and find a solution.
Here are some of the most common problems that face investors and simple ways to fix them. Many of these problems wonât relate to you, so skip them, unless you simply want to gloat.
Certain investment roadblocks are universal and can be relevant for any investor. Other problems are more likely to strike women than men, or men than women. The following sections look at all three types.
UNIVERSAL PROBLEMS
PROBLEM: Saving too little, or not at all.
âI would invest, but I just donât have the money,â says the well-dressed twenty-five-year-old driving a BMW. âIâm going to start as soon as I get a raise.â
Okay. That was a slight exaggeration. And it would be easier to save if you earned more money, but sometimes life is just not fair.
Now, be fair with yourself and answer honestly: When was the last time you bought lunch or dinner at a restaurant instead of going for the cheaper alternative of packing a sack lunch or making your own dinner? When was the last time you bought a suit, a high-tech gadget, or a pair of shoes that you knew you didnât need?
If you have a job that pays a decent wageâmeaning anything that keeps you above subsistence levelâyou can afford to invest. Spend $2 less per dayâthe cost of one Starbucks coffee or one snack from the vending machinesâand youâve got $60 a month. Thatâs enough to plop into an automatic investment plan with a mutual fund.
Still think itâs a matter of poverty, not spending habits?
DID YOU KNOW?
Saving Habits and Salary Bumps
A number of studies have been done about whether individuals can afford to save, based on their income. They have found that aside from people at the polar ends of the income scaleâthe very rich and the very poorâthe bulk of people in between think they could save, at least small amounts. Often, itâs a matter of whether they do, rather than whether they can. Increases in salary often lead to incremental increases in spending rather than increases in savings. This suggests that saving is a matter of habit, not income. If you arenât saving now, you wonât start when you get a raise.
SOLUTION: You need a budget.
A budget doesnât necessarily spell deprivation. In fact, a good budget is like a good diet. It feeds both your wants and needs in a healthy and sustainable way.
To put together a good budgetâa real budgetâyou need to gather some records:
âą Pull out your check register and bank statements.
âą Collect your credit card bills.
âą And find either your most recent tax return or your pay stubs.
Youâll need these to remind yourself of your monthly, annual, and semiannual expensesâfrom rent or house payments to car insurance. The chart on the following pages will help you plot out what youâre shelling out each month.
You thought you were going to make up a projected budget? People who try to make up budgets without looking at their actual expenses are kidding themselves. The amount that you think youâre spendingâor think you ought to beâis almost always less than what you actually spend. By writing down your actual purchases, youâre going to uncover your own personal money pitsâplaces where youâre spending more money than you meant to. It might be dining out. It might be dry cleaning. It might be a shopping habit.
This isnât about fitting your expenses into smaller boxes. This is about figuring out where your money is going and determining whether thatâs where you want it to go. If it is, leave things alone. But if lots of little outlays are robbing you of long-term happiness by making it impossible to save for big goalsâlike a house or car or retirementâyou might want to nip and tuck here or there. So, fill out the worksheet to find the flab in your financial life.
MONTHLY BUDGET
Youâve done the worksheets, but still canât figure out where the money is going? Youâre underestimating some expense because youâre paying more cash than attention. Do this: Start carrying a notebook around with you. Jot down every expense, from the $1 bagel to the $50 you spend filling up your car. Review your notebook after a month. Include the expenses in the budget and see if thereâs something you can trim to add to savings. Realize that if you cut just $3.35 per day, youâve found $100 a month to save. VoilĂ .
PROBLEM: Getting greedy.
You bought a stock figuring that it was going to go to $50. Then lo and behold, it popped up to $65. Based on all of your market knowledge, this is an incredibly high price for this stock. Its price/ earnings ratio (see Chapter 5) has never been this high, and you canât imagine why it might be now. And yet, if it went to $65, it could go to $70, right? Maybe you ought to hang on just a little longer and see.
The fact is, the stock could go higher. Or it could go much, much lower. Consider 1999, when the prices of technology stocks had soared into the stratosphere and market pundits were contending that the sky was the limit. âItâs a new paradigm!â they shouted. It was hype. During the following three years, those stocks crashed and burned. A few have recovered. Many have not. People who were smart enough to sell when the prices were high made a killing. Those who got greedy got killed.
SOLUTION: Target price.
Every time you buy a stock, you should have a targetâa price at which you would either sell the stock or reevaluate its prospects before you decide to leave it in your portfolio (see Chapter 6). Donât let emotionâregardless of whether that emotion is fear, greed, or hopeârule your actions.
Evaluate all your stocks once a year. Make reasonable decisions about whether each one is a buy, a hold, or a sell. If you realize that you wouldnât buy a stock today given its future prospects and that there are better opportunities out there, sell it. Live with the idea that you may never sell at the peak. Thatâs okay, as long as you also donât sell at the nadir.
PROBLEM: Being tax-wise and bottom-line foolish.
I hear it all the time: âNever pay off your house. Your mortgage interest is tax deductible!â Iâm always tempted to respond, âOkay, humor me for a minute here and letâs go through the math. If I pay $1 in mortgage interest, Iâll get to deduct it, which will save me, say, thirty cents on my federal income tax return. Arenât I still out seventy cents?â
There are dozens of equally âtax-wiseâ investments being marketed in todayâs world. My favorite is the variable tax-deferred annuity. What these say they do is allow you to save additional money for retirement in investments that mimic stock mutual funds.
The money you invest in this type of annuity isnât tax deductible going in, but the investment gains are not taxed as returns and accumulate in the account. This allows you to trade all you want within the annuity and not immediately pay taxes on your gains. Thatâs the selling point that continues to push variable annuity sales ever higher. Roughly $90.6 billion in variable annuities were purchased during the first half of 2007. Total assets in these accounts were nearly 1.5 trillion, according to LIMRA International Inc., an insurance research and consulting firm.
Annuities are able to offer this benefit because theyâre an insurance product. The insurance you get with an annuity generally is a guarantee that if the stock market crashes, which causes you to have a heart attack and die, your heirs are guaranteed to get at least as much as you originally invested in the annuity. Thatâs not much of a guarantee, but you pay for it dearly. The typical mortality and expense ratio on an annuity is around 1 percent. In other words, if the investments you hold within the annuity yield 10 percent, youâll get 9 percent of that after the mortality expense is taken off the top. (To get a good read on the dollars-and-cents impact of that fee, read âThe Real Cost of Fund Feesâ in Chapter 8.)
But thereâs a second cost too. Ironically, itâs a tax.
When you earn a profit on a long-term investment in a taxable account, you pay tax at preferential capital gains ratesâusually 15 percent. However, money pulled out of a retirement accountâand tax-deferred annuities fall into this categoryâis taxed at ordinary income tax rates, which can be as high as 35 percent. Even though you donât have to pay taxes right away on money earned in an annuity, when you do pay, the tax rate is so much higher that it almost always overwhelms the short-term benefit of the annuity.
SOLUTION: Do the math.
Figure out whether the tax benefit of an investment is worth the cost. All too often, itâs not.
FOR WOMEN ESPECIALLY
By and large, women start investing later in life than men, set less money aside, and invest more conservatively. That has the unpleasant effect of leaving them poor in their old age. Some 80 percent of the elderly people living in poverty are women. So whatâs their excuse?
PROBLEM: Emotional spending.
Do you shop when you have a fight with your boss or your spouse? Do you find that you âneedâ to hit the mall whenever youâre feeling down, as a way of boosting your spirits? Letting your psyche drive your spending is a common problem.
The bad news is your credit card balance is likely to rise faster than your spirits. As a result, youâre sentencing yourself to a life of servitudeâworking harder or more hours to pay your debts, which makes you all the more depressed.
If you need to get rid of your boss or your spouse, stop spending and start saving. Having money in the bank creates financial independence, which can lead to emotional and physical independence if you want it to. But how do you reverse the emotional drag that youâve previously shopped away...