Make This Year Better by Asking the Right Question
This post is by guest writer Carl Richards. Carl is a financial planner, contributor for The New York Times and Morning Star, and author of Behavior Gap: Simple Ways to Stop Doing Dumb Things With Money.
With 2012 still fresh and new, it's a great time to make a plan to have a better year financially than we did in 2011. But figuring out how to make smart decisions about money can be a frustrating experience. In large part it comes from the sense that it should be easy. After all, it should be a simple math equation, something that fits in a spreadsheet, right?
I think a significant part of our frustration with money comes from the fact that making smart decisions is not as simple as finding the right spreadsheet. Emotion and how we feel about money plays at least as large a role as the calculator.
Given the role that emotion plays in our financial decisions, I've found it far more interesting, and frankly more helpful, to focus on asking the right questions, instead of obsessing over one-size-fits-all answers. By learning to ask better, or at least different, questions we can have some hope of having a better experience.
This approach reminds me of the old Stephen Covey lesson about spending our entire lives climbing a ladder only to find out it was leaning against the wrong wall. As we start to ask ourselves different questions about money we can make sure that we're climbing a ladder leaning against the right wall.
To get started, I suggest asking yourself and/or your partner some of my favorite money questions.
1. What's important about money to you?
I've asked this question in hundreds of interviews over the years, so I'm no longer surprised when the initial answer is silence. We're not used to thinking about the importance that we place on money and why. This question is not about goals, like saving for education or retirement; it's about values, like security, freedom, flexibility, and peace.
The goal of this question is to define your financial values and help you get to the “why” of money. Don't stop with the first answer or even the second. Most often I hear people say things like security. But keep pushing. What's important about security to you? Think of the answers as a progression of values and your goal is to keep digging until you can say, “There is nothing about money more important to me than XXX.”
One time I had this discussion with a very successful professional couple. The wife was in the prime of her career as a successful emergency room physician. Like many people before her, the first answer to this question related to security. But as we continued to push, the answer became, “I'd like to have more time.” When I asked why time mattered, she got very quiet, and then said, “I finally want to have time to have a child.”
The most important thing about money to this emergency room doctor was getting to the point where she would have the security and the flexibility to have a child. Of course your answer will vary from this doctor, your friends, and your neighbors, but that's why this is so important. Once you become really clear about what's important about money to you, then you have the emotional context to talk about goals. To return to the ladder example, it's about defining the wall you want to lean your ladder against.
2. Where do you want to be financially in three years?
The context for answering this question should be based on what you learned in the first question. Whenever possible, the answers should be specific and measurable. Think in terms of defining and setting goals.
For instance, if one of the most important things about money to me is providing opportunities for my children, I might set a goal to start saving for education. But of course that's not specific enough. The next step requires that you define exactly how much you want or can afford to save. I found it to be most helpful to make these goals specific in terms of time frame and dollar amount.
They need be no more complicated than, “I will save $100 a month on the 15th of each month into my child's 529 account.” Picking the specific numbers and even the timing may take some work to figure out for your particular situation, but plenty of online savings calculators exist to help you figure out the best number for you.
It's important to notice that so far we haven't talked all about rates of returns or specific investment products. So far this is just about the plan, not the product; it's about a process of planning. The other thing that's important during this step is to let go of the need for precision.
While we want the goals to be specific and measurable, you also have to realize that often these are guesses. You don't really know how much you'll need to save to meet an educational goal, for instance, because too many assumptions go into it. So what we need to do is avoid getting hung up on the need for precision at the expense of getting started. Realize these are guesses, make the best guess you can, and get to work.
3. What good habits will help me reach my goal?
When it comes to money, behavior plays a massive role in our success. The big problem is most of us behave poorly if left to our own devices. The solution is pretty well documented at this point: we have to find ways to automate good behavior.
If you determine that you should be saving $100 a month towards education, don't make that decision every month, make it automatic. It's as simple as signing up for an automatic withdrawal out of your checking account and into your child's 529. If we make this into a decision that requires action on our part every single month, we will fail. If it's going to require you take out your checkbook, write a check, address an envelope, put a stamp on it, and put it the mailbox you can tell it's not going to happen. There will always be other things that we would rather spend $100 on. So take advantage of automation.
Another example of good behavior that we can automate is rebalancing our investment portfolios. This is a pretty simple concept. I believe it's one of the most important things we can do to avoid the big behavioral mistake of buying high and selling low that we're also prone to commit.
Here's the deal: let's say you determine that the 529 education account should be put 60%into stocks and 40% into bonds. So you setup the account and invest in broad-based index funds to ensure diversification. Now comes the avoiding temptation part.
Perhaps you set up the account in mid-2007 right before the massive declines of 2008 and early 2009. After watching the market go down 20, 30, or 40%, you'd probably feel like selling what you had invested in stocks. But clearly that decision doesn't match with our goal of rebalancing. The key to investing success is pretty simple: buy low, hold on to it, and sell it for a higher price later. But instead we're tempted to buy high (when we feel good about things) and sell low (when we feel bad). It's why the behavior gap exists.
Going back to the earlier example, emotionally we wouldn't want buy more stocks to get our portfolio back up to a 60/40 value split. Instead, we'd be tempted to liquidate our stock holdings. By adopting rebalancing as part of our investing strategy, we avoid this temptation because it automates behavior.
So if we started in 2007 with 60% of our money in stocks, and the market declined, we would now have something less than 60%, let's say 50%. However, if you've automated the rebalancing process, you'd be taking money (10%) from the bond side of the portfolio that did relatively well (high) and move it into the stock side of the portfolio (low) to restore the 60/40 split.
Avoiding the greed trap
There are a lot of benefits that can come from rebalancing, but none is more important than effectively automating the good behavior — avoiding the big behavioral mistake of getting scared out of our portfolio after a market decline. It also works to prevent us from getting greedy after a market is having huge run.
Warren Buffett said the key to investing success is being greedy when others are fearful and fearful when others are greedy. But unless you see Buffett in your mirror, it's almost impossible to do unless you automate that type of behavior through disciplined rebalancing. There are plenty of services out there that will actually rebalance for you.
Each of these questions demonstrates my primary goal in writing The Behavior Gap. It wasn't to provide another step-by-step personal finance book, but to help people think through the questions we need to ask ourselves. By providing a framework, there's the opportunity to have more meaningful discussions about money.
Plenty of great resources cover the specifics of how to implement financial decisions, including J.D.'s book, and the ongoing discussion on this site. My hope is that we also can take a little time to have some more meaningful, honest conversations about money with the people we love to make sure that the ladders we are climbing are leaning against the right walls.