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!