Developing Habits To Boost Finances
Jonathan Clements
Apr 29, 2001
We're all on the financial treadmill. But only some of us are going forward.
Is your nest egg growing? Or do your financial goals seem ever more distant? As we manage our money, there are cycles of virtue and vice. Good financial habits beget further gains, while bad habits tend to snowball.
Here's a look at those virtuous and vicious cycles -- and how they help and hinder our finances:
Living Beneath Your Means
As Charles Dickens put it so succinctly in "David Copperfield": "Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."
This is where the cycles of virtue and vice begin. If your spending outstrips your income, the debts start mounting. But if you spend less than you earn, you have money to save. And the younger you start saving, the better off you will be.
"If you get into the habit from day one of doing a 401(k) and having a mortgage, that forces you to save," says Michael Maloon, an investment adviser in San Ramon, Calif. "You never get in a position where you're spending everything you earn. And that helps you avoid the cardinal sin of running up credit-card debt."
Pay As You Go
Most folks, of course, don't set out to amass credit-card debt. Instead, they slip slowly into hock. Making summer vacation plans? You could buy the airline tickets now, stick them on your debit card and get the cost out of the way before you climb on the plane. Once on vacation, you could use your debit card for the hotel bills, while paying cash for your meals.
But many folks, of course, don't pay as they go. Instead, they plan to pay after they go. The summer vacation gets stuck on the credit card, with the idea of paying off the tab during the fall.
But the credit-card balance never gets paid off, because by then there are Christmas gifts to buy. Suddenly, debt is getting piled on top of debt. "There's nothing more miserable than having the tan gone but the hotel bill continue," quips Minneapolis financial planner Ross Levin.
Interest Earned, Interest Incurred
If you spend less than you earn, not only can you stash that cash in the bank or a mutual fund, but also the money will earn investment returns, thus adding to the cycle of virtue.
Mr. Levin notes that "the most powerful tool in investing is compound interest," where you earn money each year both on your original investment and on the earlier gains you reinvested.
"People don't stop to think that it works the other way when they're charging on their credit cards," Mr. Levin adds. "People think they're buying something on sale, so they're saving money. But they put it on their credit card, and they end up paying more for it," thanks to the 17% or 18% interest rate that the credit card charges.
As those interest charges are added to the original credit-card balance, it makes it even more difficult to get out of debt. Suddenly, a little scrimping and saving isn't enough. Instead, to get back on track, you have to take an ax to your spending.
Breaking the Cycle
Even if your financial habits are less than stellar, you might get a few breaks along the way. Maybe you will get a pay raise, receive a tax refund, inherit some money or buy a house that appreciates.
But will you benefit from this bounty? If your lifestyle rises with every pay increase, you will miss out on a great opportunity to boost your savings rate. Similarly, if you tap your home's equity by taking out a second mortgage, you may fritter away your real-estate gains.
"You need to have the discipline to save the money," Mr. Maloon says. "Saving money is rewarding. It builds momentum. People begin to feel in control of their financial life. They see that, if they continue to do this, they will be able to retire. There's a certain empowerment there."
Gains Surrendered, Losses Sustained
There are only two ways to make a portfolio grow faster: You can save more or you can earn higher returns. At first blush, cranking up your investment performance might seem like the less-painful option. But like spending too much, pursuing higher returns can become a vicious cycle, for two reasons.
First, there is a tendency to trade too much, as you try to jump from one hot stock to the next. Even if you manage to score decent investment returns, those gains may slip away, as taxes, brokerage commissions and other trading costs take their toll.
Second, as you strive for higher returns, you may be tempted to make big bets on a single market sector or a few individual stocks. But this risk may not be rewarded, thus setting you back even further.
"People think their investment returns are going to make up for their lack of savings," says Eleanor Blayney, a financial planner in McLean, Va. "They decide that, in order to retire, they need to earn 15% returns. But then the market falls and, to meet their goal, they need to take on even more risk. At some point, you can take on too much risk."
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