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Avoiding financial blunders and building wealth

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Avoiding Financial Blunders

John Wasik, Reuters
Sep 27, 2012 - 8:40:21 AM

How the middle class can avoid financial blunders

As we head into the autumn of a contentious U.S. election year, it’s a great time to reflect upon what worked and what didn’t in the wake of some of the most tumultuous upheavals in North American economic history.

You could easily blame Wall Street for the 2008 meltdown, but it’s also clear that average families weren’t prepared and made mistakes too. A new study from the Consumer Federation of America found that 67% of middle class Americans think they made at least one “really bad financial decision,” and 47% said they had made more than one. The cost? The median was $5,000, but the average cost was $23,000.

Further, the study, entitled “The Financial Status and Decision-making of the American Middle Class,” also found that outside of retirement funds and checking/savings accounts, families had few other financial assets. Only 15% surveyed held stocks and from 13 to 14% held either savings bonds or certificates of deposits.

How could you avoid the same fate? Here are some key ways to avoid the same financial blunders:


1. Failing to gauge portfolio risk

I don’t know about you, but I wasn’t surprised when the market tanked as much as it did in 2008-2009. I thought it would be worse. Yet I sure was blindsided as to how much it nailed my retirement portfolio, which fell about 40%. After all, I was diversified. Wasn’t that supposed to be a form of protection?

I didn’t know that commodities, stocks and real estate investment trusts would decline in lockstep. They usually don’t, but they were highly correlated during the global downturn. There was an easy way to avoid this kind of hit: Add more bonds, which I did. They now comprise more than half of our portfolio.

2. Getting swamped by debt-to-income ratios

Of course, you’ve heard tales of home buyers who got mortgages they shouldn’t have qualified for just because they had a pulse in the pre-2007 bubble years. The enduring truth is that too much debt can always be toxic.

What’s a dangerous level? It’s pretty simple: If your short-term debt exceeds your ability to pay it off every month, it’s too much. Whenever you get beyond 40% of debt-to-income, you’re getting into deep trouble. Most middle-class families carried 20 cents in debt payments to every $1 they earned in 2010, the Consumer Federation found. That’s not unreasonable, but this is an average discerned by looking at Federal Reserve data; millions of households are in trouble because they owe more than what their homes are worth, which was not explored in this study.

A worthy goal for reining in short-term debt is simply to pay off bills each month – but that means keeping spending within your income range and saving up for big ticket items. Also, watch your credit rating and try to improve it to obtain the lowest-possible financing rates.

3. Not having a big enough safety net

The typical American middle-class family has about $27,000 in financial assets (excluding pensions), the Consumer Federation found. Is that enough to cover emergencies, long unemployment stretches or unreimbursed medical bills? Probably not.

The rule of thumb is to hold six months’ worth of salary in emergency cash in money-market or savings accounts. It’s a good place to start, but more of a cushion is needed because of bad financial decisions. And even more for those facing long-term unemployment. How do you stash away more when times are tough? There’s no magic answer other than making it a top priority and making some hard decisions about spending.

4. Not carrying enough insurance

There’s a basic trade-off with all insurance policies: The more you’re willing to pay on a claim out of pocket, the lower the premium. For example, if you get a catastrophic health plan with a high deductible, your monthly premium will be lower.

To figure out what you can afford, look at your monthly cash flow. If you need to reduce insurance premiums, you will need to boost savings to cover the deductibles. You can also save money on auto insurance by dropping coverage for comprehensive coverage if the car is old.

5. Failing to invest

Saving is putting money in a protected place for rainy days. Investing is putting money at risk in exchange for long-term returns. You need to do both to survive the ravages of inflation and financial events beyond your control. Surprisingly, only 21 percent of those middle-class Americans surveyed by the Consumer Federation said they would invest in stocks, bonds and mutual funds – even if they had $1 million to invest.

While I certainly don’t admonish anyone for steering clear of market risk after 2008, you can find some balance through the “bucket” method of risk management. Your “safe” yellow bucket should hold money you need in the next few years for emergencies, college, out-of-pocket medical expenses or taxes. A “red” bucket is for money you can risk over decades for retirement and future goals. You adjust the amount of money for each bucket according to your needs, time of life and risk tolerance.

Perhaps the greatest blunder that everyone is guilty of is inaction. We wait for the market to become overheated instead of taking advantage of dips to get better prices. We don’t sell our losers and move on. We think we can time the bottom of the real estate and stock markets.

I know I waited too long to add bonds to my portfolio and reduce my stock and commodity market exposure, although it’s since bounced back. One essential truth remains: In a society that thrives on spending and consumption, increased saving can help avert financial disaster in the future.

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