Understanding the mistaken ideas, destructive behaviours and areas of ignorance that can threaten your long-term financial health
Fact #1: Money can be a deeply complex subject and managing it isn’t always easy. Fact #2: Investing is full of unknowns; the stock market is inherently risky and economic events are notoriously hard to predict, much less understand. Fact #3: Our finances can generate strong emotions and those emotions can interfere with our ability to make sound financial decisions.
All of which is to say that when it comes to personal finance, mistakes are inevitable.
But there’s a difference between a miscalculation and a fatal error. When it comes to managing our money, there is a group of blunders and pitfalls that are much more serious than a simple mistake. Consider them the “deadly sins” of personal finance – the poisonous ideas, dangerous misperceptions and destructive financial behaviours that can sabotage our efforts to achieve financial stability and permanently derail us from achieving our financial and life goals.
Avoiding these deadly financial sins is crucial if your goal is to ensure a prosperous future for yourself and your heirs. If you can learn to identify and be on guard against the following 12 mindsets, behaviours and areas of ignorance, you can go a long way toward protecting and preserving your wealth for the long term.
1. Not being honest about your limits
You’ve probably heard about the ancient wisdom of ‘know thyself.’ It’s one of the most important financial lessons out there. Failure to understand the limits of either your knowledge (what you know, what you don’t know and how to tell the difference) or your emotions (how much risk you’re willing to take, how much of a loss you’re willing to accept and how you’re likely to react if you’re forced to accept one) can be a sure path to money trouble.
When times are good and the market is rolling along, it’s easy to become caught up in the optimism and overlook our reaction to risk and loss. Similarly, when everyone around us is making money in a hot new idea with which we’re not familiar (AI startups, marijuana stocks, Chinese equities, hedge funds or whatever other idea the market is currently infatuated with), it’s easy to forget that such investments might be beyond our level of investment knowledge or acumen.
Figuring out these limits isn’t hard – start by asking yourself some basic questions regarding what you know about basic financial products such as stocks and bonds, and basic financial strategies such as RRSPs, TFSAs and life insurance. Then, do the same for your risk tolerance: how does the idea of losing money on a given investment make you feel? Do you enjoy the ‘thrill’ of investing? Or does news of a stock market downturn make you anxious or nervous?
These are very basic questions, but your honest answers will give you a clue about how you might react to market ups and downs, and the kinds of situations that are beyond your level of financial know-how. That self-knowledge can help you avoid difficult financial situations before you get into them.
2. Not knowing what you’re getting into
Your sixth-grade teacher explained the consequences of not doing your homework. Your teacher was on to something and could very well have been speaking about your finances as much as your multiplication tables. The failure to do your homework before you make a financial decision – to make a purchase or investment based on intuition or impulse without shopping around or doing some research first – is a sure way to destroy wealth.
Behind every sound investment is a complex decision, one that needs to be researched, analyzed and carefully considered for its potential to make a profit and fit into your overall portfolio. The same can be said for most major purchases and how they might fit into your overall life goals. If you don’t know what you’re getting into before you make these decisions – if you haven’t looked at the potential, the risks, the factors that could affect your decision one way or the other – you turn every financial decision into a guess or a gamble. Not good.
For some, doing the homework means digging into annual reports, seeking out other opinions, shopping around for the best deals and doing online research before making major purchases. For others, it means hiring investment advisors, accountants and other professionals who can do the work for them. Either way, being deliberate about your decisions before you make them is the best way to build and preserve your wealth over the long term.
3. Not figuring out the right withdrawal rate
For anyone depending on their investment portfolio for a portion of their basic living expenses (as most retirees do), calculating an appropriate portfolio withdrawal rate is a critically important task. Failure to do so may not lead to immediate financial disaster but, over time, spending beyond your portfolio’s means could lead to considerable hardship.
Over the years, many experts have given their opinions regarding how much retirees can reasonably withdraw from their portfolios without ever running out of capital; today, most of those experts agree that it’s somewhere in the neighbourhood of 4% of total portfolio value per year. But such advice is a general rule of thumb – determining the right withdrawal rate depends largely on your individual lifestyle needs, your longer-term goals and, of course, your personal risk tolerance.
To make sure that you avoid this deadly sin, make sure to estimate your annual living expenses, then compare these to your expected sources of income in retirement. Figure out a reasonable rate of return for your portfolio and compare expenses to income. Then perform a number of “Monte Carlo” simulations to model out the impact of your anticipated withdrawal rate on your portfolio, given a number of market conditions.
If the above advice leaves you scratching your head, it’s a good idea to talk to an experienced professional who can help you crunch the numbers and review your options. Sure, it’s a bit of work but, without that kind of detailed review, you could be taking a big gamble with your financial future.
4. Forgetting that ‘stuff’ happens
At the start of this article, we spoke a little about mistakes – how every one of us will make at least a couple over the course of our lives. The same can be said for unfortunate circumstances. Whether it’s a leaky roof, a bum transmission, a broken leg, a family member who needs some help or a stock portfolio that takes a hit early in your retirement years, sooner or later, ‘stuff’ happens to everyone. When it does, you’ll need a safety net. If you don’t have one, you risk transforming difficulty into catastrophe.
Some of us are fortunate enough (or frugal enough) that if a financial mishap or unexpected expense occurs, it won’t make a serious dent in our ability to fund our ongoing retirement. If that describes you, then please go ahead to the next point on this list. For everyone else, building a ‘just in case’ fund of easily accessible cash that can cover your basic living expenses for six months or longer if you’re faced with an emergency should be a top financial priority.
Hopefully, you’ll never have to use your emergency fund. But even if you don’t, keeping that cash in a short-term GIC or high-interest savings account is a pretty attractive idea these days. With interest rates having risen from their decades-long lows, your emergency fund can earn a bit of a return while it’s sitting there as your safety net.
5. Believing the hype
Let’s face it: the financial world can often seem like a big hype machine with hot tips, trendy investment strategies and ‘get in now before it’s too late’ types of ideas all over the place. It might be entertaining, but getting caught up in this hype machine can be a recipe for financial destruction.
Unfortunately, our current media landscape of quick social media videos, Mad Money-type talk shows and expert-of-the-month podcasts can all make it seem as if successful investing is a game or a gamble, rather than the rational, reasoned process that it really is. The most recent example of this phenomenon is with meme stocks – companies whose stock price has been driven up due to social media attention, online discussion and influencer speculation rather than their business fundamentals. If you’re quick enough, or lucky enough, some of these hyped-up ideas and industries can make you a lot of money. But the tables can turn incredibly quickly, and a phenomenal gain can rapidly turn into a catastrophic loss.
Don’t let excitement lead your investment process. Sure, gambling on a hot tip, a market rumour, a no-revenue idea stock or ’the next big thing’ can be fun and, potentially, even profitable. But it is a fundamentally different enterprise than making an investment based on the careful study of an opportunity. Following the hype too often – or with too much of your money – leads to addiction. And like any addiction, it can make an absolute mess of your finances… and your life.
6. Not respecting debt
An obvious sin, but one into which all too many fall. Taking on too much debt – a big mortgage, a home equity line of credit, a car loan, high-interest credit card debt or all of the above – can be one of the surest ways to financial ruin.
The financial consequences of not respecting the power of debt are clear. A sudden spike in interest rates (such as we’ve seen over the past couple of years) can force a 180-degree turn in your financial circumstances. And if you don’t have the flexibility to restructure or ‘roll over’ your debt into a longer term (many fixed-rate mortgage holders are facing just such a situation right now), you could create a very serious threat to your wealth.
Perhaps a less-obvious consequence of not respecting debt is the mental toll which it takes. Debt is not only a financial burden, it’s a psychological one as well and the constant anxiety and worry about what you owe can weigh greatly on even the most experienced financial minds.
All of which is to say that respecting the power of debt and keeping it at a reasonable level should be an important financial priority. For many people, that means becoming debt-free – nothing wrong with that. But a more balanced view is to see debt as a tool that works much like fire: if used properly, it can greatly benefit your life (with a mortgage, for example, or a loan to purchase a rental property or small business opportunity). If used unwisely, it can hurt you and potentially even burn down your entire financial house.
7. Believing that you have a crystal ball
Investment markets are inherently complex, with a number of widely unpredictable factors (economic events, geopolitical occurrences, government policy, trader sentiment, advancements in technology and social trends, to name just a few) that can have a significant impact on the performance of any asset. This central fact explains why basing investment decisions on short-term asset price predictions, economic forecasting, guesses about the short-term direction of inflation/interest rates/tax policy/other economic factors can be so very dangerous.
Most great investors know this. Warren Buffett, Peter Lynch, Prem Watsa and other ‘giants’ of the investing world freely admit that their ability to predict market movements or economic events is limited. And, while they try their hardest to understand and analyze business developments and long-term trends, they shy away from speaking in certainties or getting into any investment for which success hinges on correctly guessing what will happen a few weeks or months hence. If even the best of the best can’t do it with 100% accuracy, what makes the rest of us think that we can?
Perhaps the most dangerous aspect of this sin is how it distorts one’s mindset. Instead of crafting a long-term financial strategy based on individual goals, risk tolerance and emotional discipline, it suggests that market timing is possible, guessing actually works and quick trading is the key to investment success. Nothing could be further from the truth.
8. Having a closed mind
If you’ve ever had a heated discussion with someone about a contentious topic – be it politics, religion or who makes the best pizza in your town – you know how difficult it is to change someone’s mind. This difficulty has been studied extensively in personal finance: it’s called confirmation bias, the tendency to ‘overweight’ information that confirms what we already believe, while discounting information that contradicts those preset beliefs. In the context of our personal finances, that kind of closed-mind thinking can be a huge threat.
That’s why most people who are good with money get into the habit of keeping their minds open before they make financial decisions, and actively seek out different points of view regarding financial strategies, investment ideas or spending choices. Sometimes they’re persuaded by these different opinions and sometimes not. But either way, they recognize that the process had value: by considering multiple sides of a financial issue, their decision is dispassionate and rational, rather than emotional and impulsive.
The next time you face an important financial decision, seek out a second opinion. This could come from a qualified professional such as a wealth advisor, a financial planner, an accountant or someone in a similar role. Or it could be a close friend or life partner who knows you well enough to identify your blind spots and challenge you when you’ve got your thinking wrong. Wherever it comes from, a second opinion will give you the additional confidence which comes from knowing that you’ve reached a conclusion based on rational analysis rather than ‘gut feel.’
9. Inability to admit that you’re wrong
Most of us who have been earning, saving and investing money for a while have a couple of stories about the not-so-smart financial decisions which we’ve made. Many of the world’s smartest and most knowledgeable money managers have gone on the record with similar stories of the bad ideas or ‘unforced errors’ that they’ve made on the way to wealth.
If you want to get good at money – managing it, making it, using it to achieve your life goals – you need to be able to admit your mistakes and learn from them. In practical terms, that means being able to accept losses from time to time. It means thinking about the things which you did wrong as much as celebrating those things that you did right. It means getting rid of the ‘losers’ in your portfolio and re-deploying capital into more promising opportunities, rather than hanging on to bad investments in the hope that they’ll come back.
Here’s the hard truth about investing (and, if we’re being honest, about life itself) – no matter how prepared you are, no matter how much you’ve thought about it or how much research you’ve done, no matter how much skill or experience you’ve acquired, sometimes things just don’t work out the way we want them to. If you can’t learn from that experience, you’re almost certainly in store for a lot of financial turmoil.
10. Going ‘all in’
Excess and money are never a good match. When it comes to your finances, going ‘all in’ on anything – allocating a significant chunk of your net worth or your cash flow to a huge mortgage, a single stock or investment property, or holding the vast bulk of your net worth in a single operating business – can lead to very bad things.
Instead of managing your money in extremes, follow the age-old wisdom and aim for balance in all things. If you have too much home or too much car for your cash flow, plan to downsize. If your portfolio is overloaded in a single investment or single asset class, diversify into different baskets. Unless you’re willing to commit several hours a day in front of a computer screen researching such opportunities and constantly tracking what’s going on with them, be cautious with speculations and ‘moonshots’ and, instead, emphasize conservative, blue-chip companies with proven track records.
Above all, be on guard against the mindset that leads to all-in thinking: the mistaken idea that you have to swing for the fences with every investment idea, or that you have to go big or go home when it comes to your life goals. Most of us can get by most of the time by taking a smoother, steady-as-she-goes approach that doesn’t expose our finances to excessive risk.
11. Paralysis
Patience is a virtue, we’re told. And that’s as true in financial matters as it is in life – we can often save ourselves considerable headaches by waiting a bit and taking a sober second (or third) look at a spending or investment decision before we commit. That said, there are times when the fear of doing something wrong or doing it at the wrong time leads to a kind of investment ‘paralysis,’ which actually amplifies our risk and poses a danger to our long-term financial circumstances.
This is often the case with making investment decisions. At times, investors may think that the stock market is too expensive, so they don’t invest. Or that the threat of a downturn is imminent, so they don’t invest. Or upcoming tax changes, next year’s election, a war halfway around the world, or the price of oil or gold or pork bellies or some other reason is creating too much uncertainty, so they don’t invest.
The fact is, there is no such thing as the ‘perfect’ time to invest and there will always be a degree of uncertainty and guesswork involved in any financial decision. What is certain, however, is that constantly delaying or pulling back from making financial decisions based on fear or anxiety of what might or might not happen in the short term is often the exact thing that will short-circuit your ability to build wealth. For many people, this kind of constant procrastination can be a significant factor behind a lifetime of financial difficulties.
Getting your financial timing perfect is a notoriously difficult thing to do –even the professionals have a hard time accomplishing it. And, over the long term, it’s often unnecessary anyway. Because market upturns last longer than market downturns (about four years versus nine months on average for the U.S. market), picking the absolute bottom before you buy probably doesn’t mean as much as you might think. So go on and get started.
12. Not living your life
Our final point is perhaps the most important. The belief that money is the key to happiness can lead to serious misfortune. Not because it leads to financial destruction, per se, but because it leads to a misspent life – a life spent pursuing an abstract number rather than spending time with friends and family, seeing the world, pursuing a passion with which you’ve always been captivated or contributing time or money to a cause or organization about which you care deeply.
Make no mistake: money will always be an important skill to master. But never forget that a life well lived is one that is rich not only in money, but in meaning and memories. The purpose of learning how to avoid the deadly sins of personal finance is to build and secure the funds to allow you to live your ideal life. Not realizing this essential fact is the most serious sin of all.