Common Financial Wisdom: Theory vs. Practice
In the financial world, there are a lot of rules about what
you should be doing. In theory, they sound reasonable. But in practice,
it may not be easy, or even possible, to follow them. Let's look at some common
financial maxims and why it can be hard to implement them.
Build an emergency fund worth three to six months of
Wisdom: Set aside at least three to six months worth
of living expenses in an emergency savings account so your overall financial
health doesn't take a hit when an unexpected need arises.
Problem: While you're trying to save, other
needs--both emergencies and non-emergencies--come up that may prevent you from
adding to your emergency fund and even cause you to dip into it, resulting in
an even greater shortfall. Getting back on track might require many months or
years of dedicated contributions, leading you to decrease or possibly stop your
contributions to other important goals such as college, retirement, or a down
payment on a house.
One solution: Don't put your overall financial life
completely on hold trying to hit the high end of the three to six months
target. By all means create an emergency fund, but if after a year or two of
diligent saving you've amassed only two or three months of reserves, consider
that a good base and contribute to your long-term financial health instead,
adding small amounts to your emergency fund when possible. Of course, it
depends on your own situation. For example, if you're a business owner in a
volatile industry, you may need as much as a year's worth of savings to carry
you through uncertain times.
Start saving for retirement in your 20s
Wisdom: Start saving for retirement when you're young
because time is one of the best advantages when it comes to amassing a nest
egg. This is the result of compounding, which is when your retirement
contributions earn investment returns, and then those returns produce earnings
themselves. Over time, the process can snowball.
Problem: How many 20-somethings have the financial
wherewithal to save earnestly for retirement? Student debt is at record levels,
and young adults typically need to budget for rent, food, transportation,
monthly utilities, and cell phone bills, all while trying to contribute to an
emergency fund and a down payment fund.
One solution: Track your monthly income and expenses
on a regular basis to see where your money is going. Establish a budget and try
to live within your means, or better yet below your means. Then focus on
putting money aside in your workplace retirement plan. Start by contributing a
small percentage of your pay, say 3%, to get into the retirement savings habit.
Once you've adjusted to a lower take-home amount in your paycheck (you may not
even notice the difference!), consider upping your contribution little by
little, such as once a year or whenever you get a raise.
Start saving for college as soon as your child is born
Wisdom: Benjamin Franklin famously said there is
nothing certain in life except death and taxes. To this, parents might add
college costs that increase every year without fail, no matter what the overall
economy is doing. As a result, new parents are often advised to start saving
for college right away.
Problem: New parents often face many other financial
burdens that come with having a baby; for example, increased medical expenses,
baby-related costs, day-care costs, and a reduction in household income as a
result of one parent possibly cutting back on work or leaving the workforce
One solution: Open a savings account and set up
automatic monthly contributions in a small, manageable amount--for example, $25
or $50 per month--and add to it when you can. When grandparents and extended
family ask what they can give your child for birthdays and holidays, you'll
have a suggestion.
Subtract your age from 100 to determine your stock
Wisdom: Subtract your age from 100 to determine the
percentage of your portfolio that should be in stocks. For example, a
45-year-old would have 55% of his or her portfolio in stocks, with the
remainder in bonds and cash.
Problem: A one-size-fits-all rule may not be
appropriate for everyone. On the one hand, today's longer life expectancies
make a case for holding even more stocks in your portfolio for their growth
potential, and subtracting your age from, say, 120. On the other hand,
considering the risks associated with stocks, some investors may not feel
comfortable subtracting their age even from 80 to determine the percentage of
One solution: Focus on your own tolerance for risk
while also being mindful of inflation. Consider looking at the historical
performance of different asset classes. Can you sleep at night with the
investments you've chosen? Your own peace of mind trumps any financial rule.