A new year is a useful time to consider large and small ways we can improve our lives. We can be more generous to the people around us and improve our physical and mental health. We can also take small steps to put our financial houses in order.
Of course, your overall finances depend on your income and prior wealth, and on big-ticket items such as your housing, student loans, and car. Still, a succession of smart decisions helps you stay on a methodical path. Most of us can save a little more, and a little smarter, than we currently do.
This stuff really isn’t rocket science. Yet financial planning is easy to screw up or avoid — either because it’s boring or because it’s intimidating. Few hard deadlines force you to pay attention, so it’s easy to put things off.
As you contemplate the financial hangover from the holiday season, this is a great time to align your everyday personal decisions with your long-term financial goals. Below are a few suggestions that may help in the coming year.
1) Pay off (or chip away at) your credit card debt
High-interest credit card debt is the worst financial burden facing many Americans. Over the past 50 years, the average return on stocks was about 9.8 percent. The Federal Reserve reports that the average annual rate imposed on Americans who are paying credit card interest is 13.93 percent. That’s the rate of return you get — tax- and risk-free — on every dollar you devote to paying down your credit card debt. Doing so will get you to your financial goals faster — dollar for dollar — than almost anything else you can do with your money.
2) Buy an hour’s time with a financial adviser or accountant
When it comes to retirement savings, a financial adviser can be either part of the problem or part of the solution. Much depends on which advisers you listen to, and for what purposes.
A lot of advisers provide biased, self-serving advice. In a famous empirical study by Sendhil Mullainathan and colleagues, the majority of audited advisers steered investors away from the excellent and economical investments that would be chosen by independent experts into wasteful, actively managed funds that, oddly enough, tend to pay larger commissions to the advisers. Against fierce industry opposition, the Department of Labor is now seeking to curb such behavior.
This is a real problem, but it shouldn’t sour you on the importance of seeking financial advice. A good financial professional, facing the proper incentives, can offer genuinely valuable advice. A good accountant can play a similar role. You can ask about whether to prioritize your retirement savings over saving for your kids’ college, how you might set aside more for your retirement, the pluses and minuses of a Roth IRA, disability insurance, and whether you are financially ready to buy your dream home. A financial adviser provides critical distance and another pair of eyes for some important life decisions.
The key to finding an adviser who will actually work for you is simple: Pay the adviser out of your own pocket. So-called fee-only investment advisers typically bill by the hour and eschew commissions and other third-party payments. If you’re not sure if an adviser gets paid on commission, ask cordially but directly at the beginning of the meeting about how this adviser is paid — in all of her dealings with you.
You might feel some initial sticker shock when asked to pay (say) $250 for an hour of someone’s time. But remember the old adage: If it’s free, you are the product.
The reality is that you’ll pay a lot more in the long run if you go with a nominally free financial professional whose business model is to make extra money by steering customers to particular retirement and investment products.
It’s almost embarrassing to run the numbers. Suppose you make an appointment with a financial professional to discuss your $100,000 retirement account. She doesn’t charge you anything for the visit, and she gives you basically sensible advice. But she convinces you to buy her firm’s preferred investment, which costs you a smidgen more every year — say, 0.2 percent — than an otherwise identical competing product. Let’s assume for simplicity that both investments return 6 percent every year, not counting fees. After 10 years, you will have overpaid about $2,900, compared with what you would have gotten had you paid $250 for independent advice. After 20 years, the gap is $11,000. After 30 years, it exceeds $30,000.
3) Pay cash up front
One smart way to save money is to lay off your credit or debit card and to simply pay cash. Experiments confirm commonsense reality: Many of us spend more when we can deploy a brightly colored piece of plastic rather than actual cash dollars.
Ignore that nice credit card rewards program, too. Economists Sumit Agarwal, Sujit Chakravorti, and Anna Lunn examined what happened when credit cardholders received a $25 cash-back reward. Average monthly spending increased by $79, and average monthly debt increased by $191. It’s better to pay cash, spend less, and give yourself your own reward program.
One final tip: When sellers offer easy payment plans that help you manage your cash flow, they’re lending you money. The implicit interest rate is often surprisingly high. Suppose, for example, that you are buying an annual gym membership. You can pay $550 up front or make 12 monthly payments of $50. The payment plan is pretty good by the standards of such things. There is only one extra payment. You might feel really good if this payment plan allows you to avoid charging $550 on your credit card. There’s only one problem: The effective interest rate on these 12 payments is nearly 20 percent. That’s worse than your credit card.
There’s a simple lesson in all this. If you need to borrow, get money from a bank. Otherwise, pay cash.
4) Don’t time the market based on political events
Donald Trump’s election victory underscores the role of political risk in one’s investment portfolio, and the potential opportunities from timing the market based on surprising political events. Journalist Kurt Eichenwald sold his stock portfolio and went all-cash, "just in case" of a Trump victory.
I hate to say this but, against my investment advisor's recommendation, I sold all stocks and went all cash months ago, just in case.— Kurt Eichenwald (@kurteichenwald) November 9, 2016
Mr. Eichenwald was not alone in this assessment. Stocks rose sharply after Hillary Clinton won the first presidential debate and when damaging material emerged about Donald Trump. Stocks correspondingly fell when public statements by FBI director James Comey damaged Hillary Clinton. A widely-cited analysis of stock market futures pricing suggested that the markets would regard a Trump victory as a harmful event roughly similar to 9/11.
I received many concerned emails from family and friends asking how they should adjust their investments given this risk. I responded that they should sit tight. So far, anyway, that has turned out to be good advice. The S&P 500 is up about 5 percent since election day.
But I didn’t suggest sitting tight because I thought the market would rise after a Trump victory. Quite the opposite. I told a friend on election night that I expected the stock markets to drop 1,000 points the next day.
What I did know — why I advised people to sit tight — is that it’s a fool’s errand to time markets based on transient events, whether these are major political upsets or surprising economic news. An impressive research literature suggests that almost all of us are terrible at figuring out the best times to buy and sell, and that people who try to time the market usually wind up with lower, not higher, returns.
To the extent that a Trump victory increases your personal and financial risks, you might want gradually reduce the mix of stocks in your portfolio. And it never hurts to increase your personal savings. But lurching to an extreme position — like dumping all your stocks — in response to the day’s headlines is almost certainly a mistake.
5) Perfectly safe long-term bonds are still risky
In one sense, the safest investment on the planet is a 30-year Treasury bill, because it is backed by the full faith and credit of the United States. There is essentially no chance that the US government will default on these obligations. And if a Treasury default ever were to occur, it would be the result of an unprecedented catastrophe. I somehow doubt that your Google stock or alternative investment would be worth all that much in that world, either.
In another sense, though, long-term government bonds carry significant risk. Although the specific payout from that bond is incredibly secure, its economic value if I need to sell is surprisingly volatile. This is because the value of a bond moves in the opposite direction of interest rates: when interest rates rise, as they’ve done over the last two months, the market price of existing bonds goes down. When interest rates are low, even a small change — say 0.25 percent — can cause a big swing in bond prices.
I own some shares in Vanguard’s Long-Term Treasury Fund Investor fund, which specializes in US Treasury securities with maturities exceeding ten years. On November 7, each share was worth $13.11. Since then, the yield on a 30-year T-bill has ticked up from 2.6 percent to about 3.1 percent. As a result, the value of my Long-Term Treasury Fund Investor shares have correspondingly declined by almost eleven percent since then to about $11.67.
I’m happy to have these in my portfolio. Over the past decade, long-term T-bills have done well. When things happen, the price of long-term Treasuries generally moves in the opposite direction from the S&P500, which helps diversify your risks. But long-term bonds carry risks like anything else. Don’t load too much on these if your goal is to protect yourself against broad economic risks. If you are trying to play things safe, your bond investments should be weighted towards shorter-term securities that are much less volatile — and, of course, command correspondingly lower returns.
6) Keep a financial diary
It’s hard to make a sensible financial plan when you don’t know what you’re spending. So keep a financial diary for a few months, in which you record everything that you spend. You can do that in a notebook or a spreadsheet. Many apps and websites can help with this, too. You might be surprised at what you learn. Make sure that you include everything on your credit card bill, too — like that old identity protection service or electronic subscription you forgot you even had.
7) Look for savings on your cellphone and cable bills
Your cellphone bill is a target-rich environment for saving money. Do you need so many minutes on your calling plan? (Probably not.) Are you willing to sacrifice some real or perceived network quality for cheaper service? And if you haven’t shopped around for cellphone service in the past two years, you are probably overpaying.
Your cable bill also rewards a closer look. Many of my University of Chicago students have cut the cord entirely and get their entertainment from affordable services such as Netflix or Amazon.com. My wife and I are too sports-addicted to go this far, but it’s worth a thought.
For reasons that now embarrass and baffle me, we rented our cable box — until we read that there’s no good reason to do this.
8) Build up three months' worth of expenses in a strategic reserve
You can't follow a sensible plan if you are always frantically managing your daily cash flow. I know this one from experience. When our daughters were young, my wife and I were always juggling our money to finish out the month without bouncing a check or failing to pay our big day care bill. We were so frantic that we made avoidable mistakes. We accumulated punishing credit card bills because our plastic got us through various immediate crises.
We weren’t alone in this struggle. Eldar Shafir and — again — Sendhil Mullainathan document how the continual need to address short-term crises erodes the cognitive bandwidth people require for effective budgeting and long-term planning.
One way out of this trap is to build up a strategic reserve, which you keep separate from your normal bank account, so you won’t be tempted to spend it. Ideally this reserve should cover a few months’ living expenses in case you get sick or lose your job.
Accumulating this reserve is definitely hard. You won’t do it overnight, either. But it’s worth it. You’ll be ready for a real emergency such as your car getting totaled, a burst water main, or losing your job. A strategic reserve brings enormous peace of mind, too. You don’t have to frantically check your bank balance or waste time juggling expenses to navigate short-term financial challenges. Now you’re ready to really save and invest for the long term.
9) When you’re ready, start an investment account dedicated to your children’s college
If you have young children, this might be a good year to open a dedicated college account, to which you make modest contributions straight from your paycheck.
Coverdell accounts are simple and economical. These allow you to put aside $2,000 for a given child every year. And 529 accounts allow you to set aside much more. These also provide nice opportunities, if you are lucky enough to have generous relatives, for others to kick in a little something on birthdays and holidays. As with retirement accounts, it's important to choose an account with low fees.
Some smart people recommend against these accounts. They argue that it’s easier to borrow to cover college expenses than it is to make up a retirement shortfall. They also argue that setting aside funds in a college account will reduce your child’s financial aid.
These points are well taken. Don’t feed your 529 or Coverdell if you lack a proper strategic reserve, or if you struggle with credit cards. The bulk of your savings should be in your retirement. If your employer offers matching 401(k) contributions, take full advantage of that first. Your retirement accounts are treated favorably by most colleges' financial aid process, too.
Here at Vox, Libby Nelson noted another smart option: You might open a Roth IRA account on the understanding that it will be used for your child’s college. Depending on your income, you can contribute up to $5,500 ($6,500 if you are older than 50) in after-tax income every year.
Roth IRAs have three nice features. First, you will never be taxed on your investment returns, which helps your retirement. Second, you can withdraw your contributions (though not your investment returns) anytime without penalty, so you can use the principal to help pay for your child’s college, saving the rest for your retirement. Third, Roths aren’t counted in basic financial aid formulas. Whatever way works best for you, you should open some modest college savings account. Tax savings on all three options are good, and the compound interest adds up. If you contribute $100 per month into a reasonable stock fund starting the day your child is born, you can reasonably expect to accumulate more than $30,000 before her freshman year. Average in-state tuition and fees for four-year public colleges is about $9,400. This modest, methodical strategy goes a long way.
You might also worry that you’ll be penalized for your 529 or Coverdell through reductions in financial aid. The financial aid hit is actually mild. For every $100 you accumulate there, your annual expected financial contribution will grow by at most $5.64, with less of a hit if you have modest assets or many children — or if you don’t receive financial aid at all. The tax bite also declines over four years as you deplete these accounts.
Intangibles matter, too. The best savings plan, like the best diet, is the one you actually follow. Your kids provide powerful psychic rewards for saving. In one study, low-income parents nearly doubled their savings when the money went into an envelope with their child’s picture on it.
10) Check the fees on your investments
Mutual funds list an "expense ratio," which tells you how much you’ll lose each year due to overhead. Barring unusual circumstances, you shouldn’t invest in funds with an expense ratio higher than 0.3 percent — and you might be able to do even better. Almost all of my retirement savings are in total stock and bond market index funds with annual expenses of about 0.1 percent.
Don’t be fooled by mutual funds that charge higher fees and claim they’ll be able to deliver above-average returns. They probably won’t, and meanwhile the higher fees will eat into your savings. Instead, look for index funds, funds whose goal is to provide customers with a broad portfolio of assets at the lowest cost. Large providers such as TIAA-CREF, Schwab, Vanguard, and Fidelity offer them, and studies suggest they will maximize your returns in the long run.
11) Seek cheap thrills
Cultivate some new cheap sources of pleasure that protect your budget without making you feel that you're missing out. Taking a friend to a high school basketball game, finding that inexpensive Middle Eastern restaurant, or hitting the state park or a public beach are all pretty fun. They don’t cost much, either.
Not coincidentally, cheap thrills are often shared experiences with people we like or love. A long line of psychology research initiated by Thomas Gilovich documents that memorable experiences give us more lasting happiness than do enjoyable new things.
12) Quit smoking (and cut down your restaurant drinking, too)
I’m a zealot about smoking, not least because both of my in-laws died horribly and young from lung cancer. Smoking is expensive, too. The national average price of cigarettes is about $6.25 per pack. A pack of cigarettes costs more than $10 in many localities. So pack-a-day smokers are spending thousands of dollars on cigarettes every year. You can save a lot of money by quitting or cutting down. If you do this, make sure to do something you enjoy with some of the money you save. That will help your finances. It may also lengthen your life by bolstering your mojo to keep it up.
Watch your drinking, too, particularly when you are dining out. Vox readers already know that alcohol is a serious public health problem. More to the point of this column, alcohol is the most notoriously high markup on restaurant menus. Economists debate why the markup is so high. One theory holds that consumers like to buy expensive wine to signal their affluence and sophistication. Another theory holds that restaurants dramatically overcharge for things like coffee and wine because these complement the ambience, which is nominally free. Whatever the explanation, you can save a lot of money by not buying into it.
13) Raise the deductibles on your auto and homeowners insurance
Your auto and homeowners insurance may be ripe for savings. Insurance policies come with a deductible — the amount you have to pay out of pocket before the insurance company will start picking up the tab. The higher your deductible, the lower your insurance premium will be. So get the largest deductible you can handle on your auto and homeowners insurance.
Of course, this runs the risk that you’ll have larger out-of-pocket costs. That’s okay, because you’ve got your strategic reserve (see above) if you require costly repairs.
High-deductible policies carry lower monthly premiums for two different reasons. Most obviously, these insurance policies are less generous. Insurers don’t bear the costs of covering smaller claims. There’s another factor, too: Consumers who buy high-deductible policies are generally a safer group. By purchasing these policies, you are lumping yourself in with a better risk pool, and thus pay lower premiums.
Harold Pollack teaches social service administration at the University of Chicago. He is co-author with Helaine Olen of the new book The Index Card: Why Personal Finance Doesn’t Have to Be Complicated