The 7 deadly financial mistakes

striatic

(MoneyWatch) Who among us has not made a costly financial blunder? Come on; admit it -- we all make some dumb moves for which we have to pay a pretty penny. Research by the Consumer Federation of America and Primerica found that two out of three Americans say they have made at least one "really bad decision," and almost half of those questioned (47 percent) acknowledged that they had made more than one financial bad decision. The median cost of these bad decisions was $5,000, but the average cost was $23,000.

That we make financial boo-boos is not surprising, but the report also found that a large majority of those surveyed believe their ability to make financial decisions is "good" or "excellent," despite having made costly financial mistakes in the past. "Considering their past mistakes and the complexity of the financial services marketplace, we were surprised at how highly most middle class Americans rate their ability to make a variety of financial decisions," said CFA Executive Director Stephen Brobeck.

Call it the "Lake Wobegon Effect," named after the fictional town where author Garrison Keillor noted that "the women are strong, all the men are good looking, and all the children are above average." The "Lake Wobegon Effect" has come to mean the tendency to overestimate one's capabilities. In social psychology, it's called "illusory superiority".

Of course, if we are all so smart and confident in the world of finance, why are we shelling out thousands of dollars to cover our bad decisions? Even if you are from Lake Wobegon, you may be interested in these mistakes that I saw frequently when I was an investment advisor:

1) Failing to maintain an adequate emergency reserve fund. Maintaining 6 to 12 months of living expenses allows you to ride out many a financial storm without raiding your retirement assets. For those in retirement, carrying 12 to 24 months of expenses is even better.

2) Creating an overly optimistic financial plan. From the mid-1990s until the financial crisis, too many plans relied on the expectation that annual investment returns would average 10 percent. Those whose assumptions were more conservative faced far fewer surprises when the negative years rolled in.

3) Paying more fees than necessary. Why do investors consistently put themselves at a disadvantage by purchasing investments that carry hefty fees? Those who stick to no-commission index mutual funds start each year with a 1-2 percent advantage over those who invest in actively managed funds that carry a sales charge.

4) Allowing your emotions to rule your financial choices. There are two emotions that tend to overly influence our financial lives: fear and greed. At market tops, greed kicks in and we tend to assume too much risk. Conversely, when the bottom falls out, fear takes over and makes us want to sell everything and hide under the bed. To prevent the emotional swings, create and stick to a diversified portfolio that spreads out your risk across different asset classes, such as stocks, bonds, cash and commodities.

5) Not having adequate insurance/purchasing too much insurance. Insurance is a necessary component of a financial plan. However, too often people shift from one extreme of not having enough coverage to the other, when they buy more insurance than they need. A good way to quantify your insurance needs is to use a life insurance calculator, like http://www.lifehappens.org/life-insurance/life-calculator.

6) Assuming too big a risk. If you are going to make a risky investment, such as purchasing a large position in a single stock or making an investment in a tiny company, only allocate the amount of money you are willing to lose, that is, an amount that will not really affect your financial life over the long term. Yes, there are people who invest in the next Apple, but just in case things don't work out, limit your exposure to a reasonable percentage (single digits!) of your net worth.

7) Not asking for help. There are plenty of people who can manage their own financial lives, but there are also many cases where hiring a pro makes sense. Make sure that you know what services you are paying for and how your advisor is compensated. For example, if an advisor is paid on commission, that means he has an incentive to sell you one product over another, regardless of whether it's in your best interest. Better to hire a fee-only advisor who adheres to the fiduciary standard, meaning he is required to act in your best interest.

Hey, I've heard that even in Lake Wobegon, the average financial mistake can cost you $23,000!

Distributed by Tribune Media Services, Inc.

[crondanet5]

Mistake Number 9: Not having a will or a Living Trust

[twmat311]

Interesting how the old rule of 3 months of reserve cash is now 6-12 months; wonder what percentage of the US has that on hand. Are any kids out there being taught this (school or elsewhere)? I assume you'd have to start saving this pretty much right after graduation - and the kids I generally see tend to live for the moment, after seeing their elders' life savings go down the chute.

[petroliapete]

Lake Wobegon?? Holy Cow!!! I haven't heard about that since I was a kid. Mom was a huge Garrison Keiler fan. Makes a lot of sense though. I have historically fallen squarely into the "overestimate one's capabilities" category. The older I get though the more it becomes apparent....

Well done and well said.

[bread58]

To the first commenter, while people always say they can't save any money, I beg to differ. I find myself surrounded every day by people driving unnecessary SUVs (and luxury SUVs at that), talking on their iPhone 5, watching their 52" HD TV with NFL Sunday ticket, playing their XBox and one of their 37 games, going out to eat in restaurants several times a week, and on and on and on.

My wife and I have no debt of any kind. Even our house is paid off. And we're in our early 40s. It's because we make disciplined financial choices, prioritizing our freedom over owning more and more "stuff."

The first person you pay every month--even before the landlord/mortgage--is yourself. You take X% of every check and put it away in savings, then you FIND a way to live on the remainder. If that means you can't buy a latte on your way to work, so be it.

[SallyLu27]

Yes, but what if you're not buying any of that "stuff", try to be frugal when grocery shopping, and not eating out more than once a month at the most (and when we do eat out, it isn't at an expensive restraunt)? We also do not have any credit cards, no car payments, but we do have a mortgage. And every bit of our money goes toward bills. I do put money in savings, but as soon as I get a small amount (usually about $1000) an unexpected expense comes up and I need to use it. Not everyone makes enough to put X% out of every check into savings, and still have enough left over to pay normal cost of living expenses.
It is really awesome that you've been disciplined and have worked hard toward financial freedom. It is true that many people spend money on frivilous stuff and always complain that they are broke. But not everyone and just because you were able to do it, doesn't mean that everyone can no matter how hard they try.

[mld1979]

I can't do number 1 above, because I don't have the means to get anywhere NEAR that I can't put ONE month of resources aside.

It's sound advice, but not only impractical, but utterly impossible for many to do.

[davidjones022]

Good advice, however, the economic situation prevents us from making logical financial decisions. It currently amounts to one big catch 22.

How can you give your word that you will repay a credit debt if your employer doesn't keep their word when hiring you? Employment practices are out of control, and a person (manager) is always going to do what is best for them in any given situation.

"Hard work is the price we must pay for success" Benjamin Franklin

Hard work is supposed to pay off, and a reasonable person assumes that if they are working hard and maintain a good Employee review that they will keep their job and be able to keep their obligations with credit card companies, mortgage companies, etc...

This absolutely NOT true today.

Good financial advice at this point would be to ensure your company is part of a UNION.

[petroliapete]

seriously?? Inserting politics into this?? what a shame.....