Tuesday, November 24, 2009

The Silent Course of Financial Mistakes

One of the problems with financial mistakes is that they can go unnoticed for a long time before a crisis erupts. For example, one could spend many years undersaving for retirement only to discover at age sixty or sixty-five that one has not accumulated enough to afford a comfortable retirement. But prior to such a discovery there are no signals, no warnings: no bells go off to warn about lack of savings, no statements caution “careful, this amount of savings seems low for your age.” In some of my work I have found that people start planning for retirement or make changes to their retirement savings accounts when they witness negative shocks to those around them (older siblings or parents) but, clearly, relying on such signals is insufficient.

This is the case not only for assets but also for debt. One could pay the minimum amount due on credit cards and have the debt pile up until it is too large to be paid off. Of course, borrowing at rates of 18% or higher makes the debt balloon, but the law of compound interest can cause debt to accumulate rapidly if one does not understand that interest accumulates on interest. The consequences of this can be devastating. People who have accumulated a significant amount of debt may have to postpone retirement or work a second job or sharply decrease their standard of living after retirement. They may even end up in bankruptcy. Throughout the current financial crisis, we’ve witnessed people losing their jobs and having little savings to fall back on, with many ultimately losing their homes. As a result of this crisis, saving has increased to an unprecedented level, but it is unfortunate that it took a negative shock to lead to appreciation for having a buffer stock of savings. Wouldn’t it be better if good saving habits were instead the result of routine assessment and maintenance of one’s financial “health”?

If we consider how we take care of our finances in light of how we take care of our physical health, we might come to some interesting conclusions. Everyone knows that regular health screenings are important. Underlying health conditions are not always obvious: nothing hurts, no obvious symptoms are experienced, everything seems fine until one finds a lump while taking a shower. In matters of health, we know that it is best to catch a health condition before it is at an advanced stage. Doctors have long recommended regular physical checkups, and we subject ourselves to routine tests and visits to the doctor even when we feel healthy and in good shape. We also take the usual health precautions, getting flu shots in the winter, washing our hands carefully, taking vitamin and mineral supplements (at least for those of us over…ahem, 40). Recommendations like these abound in doctors’ offices, in the media, and in everyday personal interactions. Everyone knows what precautions they should be taking on a daily, monthly, and yearly basis to maintain their physical health.

But how about financial health? What are we doing to make sure we are doing well in our financial planning? What precautions are we taking to make sure our finances stay healthy? Are we setting aside a buffer stock of savings that can shield us against negative shocks such as loss of income or an unexpected expense? Are we managing our debt wisely and making good investments?

Health maintenance is not exactly fun. I do not particularly enjoy having needles stuck in my arms, spending time reading old magazines in doctors’ waiting rooms, or the fearful anticipation in opening a letter that contains test results. Yet, most of us do exactly this and we advise our friends and loved ones to do it too. Maintenance of financial health won’t be any more fun than getting regular checkups, but it can be just as important. Financial markets are more complicated today than they’ve ever been and we are more responsible for our own financial well-being than ever before. Regular financial checkups can help to prevent a poor investment decision from causing long-term damage to a retirement plan or keep an accumulation of debt from growing to a point that it’s impossible to recover from. Just as regular medical checkups can keep us healthy and provide a better quality of life, so regular financial checkups can keep our accounts in good shape and ensure financial well-being for years to come.