Each day, we make choices about money and our personal finances, some are big, other small. Examples include buying a cup of coffee, or deciding which stock to invest in. But for most people, some of the biggest financial decisions in their lives will probably be buying a home, paying for education, or saving for retirement.
For these big ticket items, it pays to roll up your sleeves and plan ahead. Here are some tips for approaching your financial decision making.
Tip 1: Assess Your Financial Reality
There is nothing wrong with dreaming big, but when it comes to planning your personal finances, it’s helpful to underpin your dreams with a realistic amount of cash.
Before setting targets for your regular savings rate (or booking your next Caribbean cruise), it is probably a good idea get an overview of what your monthly earnings and (essential) expenditures are. From wages to interests on the income side and from rent to regular insurance payments on the expenditure side – there is nothing like writing these numbers down. In the process, you might also find ways to twitch your budget here and there.
Tip 2: Identify Your Goals, and Estimate the Costs
Now that you have a better understanding of how much money you can set aside for your first apartment or your children’s education, it’s time to tackle your financial goals. As a first step, it helps to document your goals by time horizon, says Morningstar’s director of personal finance Christine Benz.
Group your goals into one of three bands
- Short-term goals (achieve in five or fewer years),
- Intermediate-term goals (five to 15 years), and
- Long-term goals (15 years or more in the future).
Try to be as specific and detailed as possible.
This process usually gets tougher with the second step: estimating the cost of each goal. The problem is that not every financial goal comes with a clearly marked price tag. Even short- and medium-term expenditures are not that straightforward to estimate, especially in current times of double-digit inflation rates; and estimating the cost of multiyear goals such as retirement and college expenditures is even trickier.
Costs for apartments vary from one region to the other just as much as the cost of putting your offspring through university.
Retirement expenditures meanwhile are a function not only of region, but also of lifestyle and life span. This guide to guessing how long you will life might also be of help, and Christine Benz has compiled a guide to estimating your retirement cash flow needs.
Tip 3: Don’t Forget Your Debt – and Your Emergency Fund!
It might be easy to get carried away with your wishes, hopes and dreams, but do give weight to what makes sense from a financial perspective. Think about those high-interest mortgage loans or other debts that eat income month after month. The sooner you pay those off, the better it will be in the long run.
But also keep in mind that life rarely follows your plan 1:1. From small nuisances like a broken washing machine to major events such as the loss of a job – it’s a good idea to be prepared with an emergency cushion. Generally speaking, three to six months of your general living expenses (housing, insurances, food, utilities) should be a decent starting point to be put into a safe and easily accessible investment. Checking and savings accounts, CDs, and money market accounts are places to keep those emergency funds.
Tip 4: Prioritize Your Goals
Now that you did your groundwork, you are almost there. You have an idea of what your future needs are and how much they might cost. It’s time to prioritize your goals, given your own individual circumstances. Benz stresses that the following hierarchy will make sense in many different situations:
- High-interest-debt paydown/emergency fund (tie)
- Retirement savings
- College savings
- Other short- and intermediate-term goals (within reason)
As a rule of thumb, many recommend you should save anywhere between 10 and 20% of your income, but a better approach might be to calibrate your personal savings rate to factor in your own situation.
“By using your own financial goals to formulate concrete savings targets–and periodically revisiting them to take into account changes in income, expected market returns, or proximity to the goal date–you have a better shot at reaching your financial goals than if you fall back on rules of thumb. Rather than setting a savings rate in a vacuum, start with the amount that you’ll need to amass for a given goal, then work your way backward to determine how much you’ll need to save on an ongoing basis”, Christine Benz recommends.
Tip 5: Have a Plan
Whether you find you have 50, 500 or 5,000 dollars to spare – it always pays off to start saving as early as possible, and to consider reinvesting your earnings. That way, you can take advantage of the power of compounding.
Make sure you consult your financial advisor when building your portfolio. Morningstar is all about empowering investors success, and you will find and array of tools and intelligence that will help you weigh your options and our websites.
Whatever your choices will be, make sure to diversify your investments, research your holdings, and select a strategy that suits your overall tolerance for risk.
Tip 6: Don’t Rush into Things Unprepared
Markets are not always kind to investors, and 2022 has been one of those years. As a long-term investor, you are well advised to keep an eye on your goals. But unfortunately, sometimes our minds “misbehave”, as behavioral economists note.
In his book “Misbehaving: The Making of Behavioral Economics”, Richard Thaler, Nobel laureate and professor of economics at the University of Chicago’s Booth School of Business, expands upon why people act so badly when it comes to decisions about money.
One example: He found that most people do little or no analysis when doing things like paying off credit card bills and are often look at the wrong things. When faced with several bills, most people will pay off the biggest balance first, not the one with the highest interest rate, which is going to cost more over time.
Mental accounting also leads us to make other bad decisions – such as selling or buying an asset at the wrong point in time. Our brains are hardwired to our emotional circuits, and more often than not, we don’t think logically when it comes to investing and money. The pain of a loss is a much more powerful emotion than experiencing a gain.
“If you want to make changes to how you handle your money, a good place to start is to take stock of the attitudes and beliefs that you currently hold about money and ask, “Is this healthy? Is this serving me well? Is this even true?”, he says.
If you want to maintain your cool, you must see past the current immediate crises. “We can do this by turning our attention away from the uncertainty of things we can’t control and toward things that are certain and things we can control”, advises Sarah Newcomb, Ph.D., behavioral economist for Morningstar. While risk is unavoidable, panic is optional, she argues. More times than not, it might pay to not check your balances, to stick to your plan and refrain from clicking that buy or sell buttom at the wrong time.
But that being said, nothing lasts forever, and as you go through life cycles, make sure to…
Tip 7: Review, Monitor and Adjust, As Required
The last thing is something most of us end up putting off for one reason or another. All you have to do is schedule regular check-ups, so you can review, monitor and adjust your plan, as required. This is a very important task, as Morningstar’s director of personal finance Christine Benz explains.
“Investors often make the mistake of checking up on their portfolios too frequently, or worse yet, only after big market moves, when they’re most inclined to make rash decisions. To help avoid that pitfall, schedule regular check-ups in advance. For most people, one comprehensive portfolio review per year is plenty, and much better than obsessing on a daily basis. Year-end–ideally around Thanksgiving, before the holidays gear up–is a good time to conduct your annual portfolio review, because you can still make adjustments for the year,” she says.
If you feel there are specific areas that need more work, you can go back to any one day of the challenge to find relevant articles and tools to help you. If you feel information overload setting in, here are some tips Benz recommends to help you focus on the most important factors: Create an Investment Policy Statement and also follow the steps in my “quick and dirty” portfolio checkup.
Benz’s book 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances has a complete section on keeping your portfolio in peak operating condition, and provides step-by-step guidance to help you complete a host of other financial-planning tasks.