Money mistakes are easy to make, especially if you’re not aware of what to watch out for. Behavioral biases are often at the root of many common money mistakes. The more you’re aware of potential biases and the financial mistakes they lead to, the less likely you’ll fall victim to them.
Mistake #1: Not Knowing the Odds
Ignoring underlying percentages, also known as base rate neglect, is a good example of an irrational tendency that can lead to poor financial decisions.
It would be difficult to find a better example of base rate neglect than the lottery. Millions play the lottery despite odds that are overwhelmingly against winning the jackpot – about 1 in 42 million for the California lottery. Media coverage of jackpot winners makes the possibility of winning money seem within arm’s reach, and the low barrier to entry (often just a few dollars per ticket) makes playing attractive. Yet you are 34 times more likely to be struck by lightning than to win a lottery jackpot.
Compound Interest Can Make Bad Spending Decisions Worse Over Time
With this lottery example, the consumer ignores the aggregate cost of their decisions over time. The lottery players tend to view each ticket as an individual transaction, but they overlook the long-term cost of playing and the extremely low odds of success. While buying a few lottery tickets per week may seem like a harmless diversion, over the course of 30 years, a $50 per month lottery habit costs more than $41,600, assuming a 5% interest rate with monthly compounding.
Mistake #2: Treating Dollars Differently
Another common mistake is the mind’s tendency to place different values on dollars depending on where the dollars originate. This bias is called mental accounting. By definition, all dollars are equal and should be treated as such, but the reality is that people tend to treat money differently depending on where it comes from.
Watch Out for “Tax Refund Sales”
An example of mental accounting is how people spend their tax refunds. After tax season, consumers are frequently bombarded with advertisements for “tax refund sales.” Many people treat their tax refund money differently than their other cash, being more likely to spend their tax refunds on large purchases like furniture and electronics while being careful with money in their savings account. Remember that your tax refund is simply a return of a portion of your wages, nothing more. $1,200 in tax refund money is the same as $1,200 saved by setting aside $100 each month for a year.
The next time you feel tempted to make a big purchase with money from your tax refund, ask yourself if you would make the purchase using money in your savings or investment account. If the answer is no, then consider holding off on the purchase, because the odds are that you’ve fallen victim to mental accounting.
Mistake #3: Failing to Plan Is Planning to Fail
Another unfortunate mistake is not having a financial plan. Many Americans put off financial planning until it’s too late. In fact, a survey in 2017 found that 49% of adults ages 55 to 66 had no personal retirement savings at all.
The importance of a financial plan is difficult to overstate. Another study revealed that those who planned for retirement amassed three times as much wealth as those who did not.
Understanding How Interest Compounds Is Critical
Often a lack of financial literacy can explain why so few people save enough money for retirement. In a survey of Americans over the age of 50, about one-third of participants were unable to answer a simple question involving compound interest correctly:
Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow? More than $102; exactly $102; or less than $102?
Without a basic understanding of compound interest, it is virtually impossible to ascertain the future value of your savings balanced against the value of your current consumption. Recognizing that money can grow over time when invested wisely can have a huge impact on a retiree’s future.
Making mistakes with money can be expensive, but there are ways to improve your odds. The insight necessary to avoid financial mistakes isn’t always intuitive, which is why working with a CERTIFIED FINANCIAL PLANNER™ professional can bring a helpful perspective to your financial life.
By David Zuckerman, CFP® - August 09, 2023
www.letsmakeaplan.org/