Thursday, August 23, 2012

When to Ignore Conventional Financial Advice

Hey everybody.
So nowadays, with the internet providing everybody and her mom with access to financial advice, I'm sure that everyone who aspires to be more financially savvy has come across "conventional financial advice". Conventional financial advice is stuff like "pay off your credit card debt", "establish an 8-month emergency savings fund", "contribute the maximum to your 401(k) plan" and "start saving for retirement in utero". :-) And for the most part, this "conventional" financial advice is tried and true and sound. It's well meaning. It's meant to keep you out of financial trouble and it usually does. I mean, how can effectively earning a rate of return of 20% on your money by paying down high interest credit cards hurt you? The problem with most financial advice is that it doesn't take into account your emotions and how you feel about your money.


This isn't exactly a novel concept, but a lot of times, our money issues are not so much economic in nature, as they are emotional in nature. And I've found, in my own life, that's it's important to make decisions that make me feel particularly empowered - whether or not they are the most direct path to a financial goal.In keeping with the title of this post, here are some pieces of financial advice you can ignore and I will also state when you can ignore them.

1. PAY OFF ALL OF YOUR DEBT AS QUICKLY AS POSSIBLE
You'll hear the financial experts spouting this maxim all of the time. And with good reason, the high interest rates that credit card companies charge you, coupled with the fact that such interest is compounded so quickly, makes it in your best interest to get it out of your hair as quickly as possible. But this maxim neglects to take into account the fact that a lot of times, people get into credit card debt not because of outrageous spending habits, but because they had an unexpected expense and didn't have savings to cover it.

In these harsh economic times, people might have to rely on their credit cards to get them through to the next payday. Although it's not preferable, it makes sense to use a line of credit when you have nowhere else to turn financially. But there's a way to avoid this situation altogether. I recommend that you pay as much as you can to your credit card company, but that you save 10% of your income religiously. Part of my rule comes from the conventional financial advice of pay yourself first, but it has a different rationale. When you save 10% of your income and build up an emergency fund, you can take a portion of that emergency fund (let's say half) at some point in the future and make an even more substantial payment toward your credit card balance(s). Also, as a result of having an emergency fund, you won't have to rack up credit card debt every time something unexpected comes up.

Moral of the story: if you find yourself always having to rely on your credit card for necessities even though you pay more than the minimum every month, try continuing to pay more than the minimum, but saving as much as you possibly can (using what extra money you would have put toward your credit card debt to build up decent savings for a rainy day). Having a savings fund will make you feel more empowered and in charge of your financial future, even if you take slightly longer to pay off your debt. And when you feel empowered about your financial situation, you are much more likely to make positive decisions regarding your money.

2. LIVING BELOW YOUR MEANS IS THE BEST WAY TO SAVE.
Once again, this maxim above is well-intentioned and is preached in order to prevent people from "balling out of control" or living a profligate lifestyle. But it just isn't true. I'm sure all of us have tried cutting expenses, clipping coupons, and denying ourselves the little wordly pleasures. But the problem with this is that aside from it being no fun, you can only cut expenses so much. Mr. Inflation - the father of all evil - will not look at your paycheck and say hey, "she's living below her means, so I guess I'll cut her a break and stop making prices go up". Things will keep on getting expensive no matter how much we cut back on luxuries. So, the best way to save and get ahead is to expand those means, while continuing to live beneath them.

How can you go about expanding those means? Well, usually taking on another job is no fun, so try to find something that you enjoy doing to earn extra income. Sell old items on eBay. Try babysitting your neighbor's child or DJ'ing  at your local bar. If you played in a band in college, start playing around your city again. I know a whole lot of people are cobbling together multiple jobs nowadays, but if you're one of those fortunate souls who has a job that pays enough to live on, having a side gig might help you expand those means even more in addition to your annual raise.

Moral of the story: if you're feeling squeezed financially, continue living below your means, but constantly be on the look out for ways to increase your income. Treat your own personal finances like a business and always grow your revenue. A company that had to rely solely on cutting expenses would soon go out of business because it would have to eventually begin cutting employees. And of course you can't run a company without employees. Similarly, you can't outpace inflation indefinitely by trying to do more with less.

3. CONTRIBUTE THE MAXIMUM AMOUNT POSSIBLE TO YOUR 401(K).
As with all of the other conventional financial advice, I understand why the experts spout this piece too. Most 401(k) plans have a matching plan where they will put in a certain amount of money if you contribute a certain amount. And although I advocate contributing to your 401(k) plan and preparing for retirement, I'm also an advocate of only contributing the amount necessary to get the company match. After that, I recommend contributing the maximum amount possible ($5,000 in 2012) to a Roth IRA, for multiple reasons. A 401(k) usually has very limited investing options, and the more limited you are, the less likely you are to earn an outsized return on your money. Second, because 401(k)s are tax deferred as opposed to tax exempt Roth IRAs, there are withdrawal penalties even for the money that one has contributed, in addition to  tax penalties for money withdrawn before 59.5 yrs. old. Roth IRAs have penalties for early withdrawals also, but you can withdraw all of the money that you contribute to it without penalty because the money you contribute is after-tax money. Moreover, you can use up to $10,000 in contributions and capital gains to purchase your first home or pay for qualifying educational expenses.

Moral of the story: a Roth IRA is a much more flexible home for your investment dollars, so it's better to max that out than tying up your money in a 401(k) plan just because you get a company match. What's more, you feel so much more empowered when you know that you are saving for retirement AND have ready access to your money when you need it. In fact, although I recommend having a separate savings account, I think it's okay to use your Roth IRA as a savings fund. In the worst case scenario, you will only incur trading costs and maybe miss out on potential stock gains, but this negative series of events doesn't compare to the harsh financial penalties of withdrawing from your 401(k) prematurely.

There are plenty of other pieces of conventional financial advice that one should ignore, even though in general I think the conventional wisdom is right. But when making financial decisions, you should try to strike a balance between achieving the highest rate of return on your money and feeling more secure/confident/stronger about your financial situation as a result of your decisions. Let me know if you think of any piece of financial advice that doesn't make sense to you and we can try to figure out together if you should disregard it. Until next time...

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