At the start of every year, people seem to be more interested in getting their finances in better order — especially after they look at their credit card bills and realize they spent more than they thought they had this year. Creating financial goals for the year is something everyone would benefit from. But it might be even more helpful to examine our financial biases and our general attitude toward money before committing to any changes. That way, we have a better chance of changing our financial habits for the better and sticking to the resolutions we do make.
I’ve created three simple financial resolutions that are relatively easy to implement but will have a high impact.
1. Create a budget
Some people would rather sit in a dentist’s chair than go through the task of creating a budget. The most common complaint I hear is that a budget is too restrictive, much like a diet where you can’t have anything fun to eat. But budgets aren’t meant to be restrictive — they are meant to give the dollars you earn a purpose. By giving every dollar a purpose, we actually become more free. And who wouldn’t want more freedom?
The problem of having all our money at our disposal without a purpose is that our dollars are easily wasted. We buy things we don’t need off the internet, don’t realize how much we spend on a daily basis and are more inclined to buy things impulsively. Our financial priorities are easily shifted as what we need now becomes more important than saving. By giving every dollar a job to do, we can create a more peaceful financial life and have a better chance of accomplishing the following two resolutions.
2. Boost the emergency fund
I show my love through gift giving, which can often lead to me overspending during the Christmas season. If you knew how cute my kids are, you’d understand. So if, like me, you spend a little too much over the holidays, it’s vital to make sure that you have a healthy emergency fund that is truly set aside for emergencies only. An emergency fund is important because it provides peace of mind, reduces financial stress in the family and eliminates the necessity and cost of borrowing money in an emergency. A solid emergency fund is three to six months worth of living expenses for those employed in the traditional manner and six to 12 months worth of living expenses for those who are self-employed.
3. Set your retirement contribution amount
What makes a budget so vital to financial success is the ability to know ahead of time how much money we can contribute to our retirement accounts. What we don’t want to do is set an arbitrary withdrawal amount that goes into our retirement accounts each month and then determine what more we can contribute at the end of the year. The problem with this strategy is that in most cases there won’t be much left over at the end of the year as we have been vulnerable to making impulse purchases all year with any extra funds. By making a budget and sticking to it, we know exactly what we can and will contribute to our retirement funds each month.
While implementing these practical steps will move you forward on the path toward financial security, I’ve come to appreciate the importance of starting with the right mindset. We all have certain biases toward money and finances — and our biases make it more or less difficult to stick to our financial plan. There are more than 100 different biases toward money that psychologists have identified, but I’ll focus on three common ones.
‘Talking about money makes me feel dirty, I’d rather not have anything to do with it.’
Money is amoral, yet some hold the belief that money is dirty, or even evil. Money can certainly be used for good or evil, but it has no morality of its own. The problem with believing that money is evil is that this often translates into believing that having a lot of it is inherently bad. This in turn leads a person to avoid making financial decisions and provisions for the future because they would inevitably feel guilty for being financially well off someday. I have had clients who should have a healthy retirement account based on their income and lifestyle, but don’t because they have somehow managed to self-sabotage their financial lives by making poor decisions. The remedy for this kind of thinking is to address the root of this belief about money and to recognize that money is a tool, not something to be shunned.
‘I’ve already spent so much money on this, I can’t get rid of it now.’
This belief is also known as “the sunk cost fallacy.” It’s our inclination to keep putting money, time and other resources into something just because of all of the money, time and other resources that we have already invested in it. I see this play out all the time when people have purchased a certain type of insurance they no longer need, or isn’t suitable for them. They continue to pay for that insurance because stopping now would feel like they wasted all of that money, when in fact that money has already been wasted anyway. Or a person holds onto a bad investment because they’ve paid so much that they can’t bear to let it go. The antidote to this false belief is to think, as far as is possible, about the situation without considering the money spent. If you would not take it if it were offered to you now, then get rid of it. The fact that you’ve paid into it is ultimately irrelevant.
‘I’ll be able to save more money when I make more money, or when my expenses go down.’
There are two biases working together in this statement. The first one is the “planning fallacy,” which is our tendency to incorrectly judge how long it will take to complete a task. We tend to underestimate, not overestimate. Just think about how often we procrastinated in school and ended up staying up into the night finishing a task that we thought would only take us an hour or two. The problem with waiting to invest and save until the circumstances are better is that we give up the miracle of compounding. Compounding is how money grows and time is the essential ingredient.
The other bias at work is the “optimism bias,” which is our tendency to think more optimistically than we should. Thinking that our income will increase, or that our expenses will decrease, is an optimistic view that may not actually materialize. This bias also leads us to minimize the chance that a negative event can happen to us versus someone else. The “optimism bias” can affect our view of the stock market. In this high stock market valuation environment it is easy to think that it will continue in an upward trend for a long period of time. The best way to combat these biases is to set financial priorities and recognize the importance of things (like retirement savings) that won’t manifest until the future. The challenge is that it forces us to face yet another bias, “hyperbolic discounting,” which is when we assign a higher value to something we can attain now, versus something that has a higher value in the future. It’s both the reason why people will finance a car purchase for seven years and not contribute enough in their 401(k) to get the employer match.
Recognizing and addressing our biases will help us create better financial plans for the future and give us a greater ability to stick by our resolutions. This year, let’s try to identify the financial biases that have the greatest effect on us. We are all wired differently, and we all have a unique road ahead of us. Spending time learning about how our brains think about money will be well worth the effort and lead us to make better decisions. And with better financial decisions comes a more prosperous future.
Ash Toumayants is the founder of Strong Tower Associates, a Retirement Planning firm dedicated to helping clients in all stages of life prepare for retirement.