When I was young and stupid, I became addicted to spending. I got my first credit card in college, and over the next fifteen years, I accumulated $35,000 in debt. I'm debt-free now, and have even begun building a nest egg, but I didn't reach this place without making a lot of financial mistakes along the way. And I still make mistakes. Dealing with mistakes and setbacks is an important tool in your personal finance arsenal.
The best defense is a good offense. I used to spend a lot of time reacting to problems: bounced checks, car repairs, soccer injuries, and — worst of all — my own dumb choices. I never could seem to get ahead.
Then I realized that the best way to defend against financial setbacks was to actually prepare for them before they arrived. Simple, I know, but it's the simple stuff like this that forms the basis of smart personal finance. Two methods in particular helped me deflect many setbacks:
- Education — I finally became frustrated with my lack of financial literacy, so I decided to do something about it. I read personal finance books. I read magazines. I read blogs. Most importantly, I talked with those friends that I knew had control of their finances. They were happy to give me advice. I was happy to listen.
- Preparedness — I started an emergency fund. Setting aside $500 or $1000 in an online high-yield savings account is cheap insurance. If you have cash cushion, your financial plans can't be derailed by a single stupid mistake. (Unless it's a big mistake.)
Picking up the pieces
Education and preparedness will only get you so far; you're still going to make mistakes now and then. You need to know how to pick up the pieces. Nothing will make things whole again, but there are a few things you can do to minimize the damage:
- Don't panic. When you suffer a setback, or when you realize you've made a mistake, your stomach gets tied up in knots. It's easy to feel overwhelmed. Relax. Take an hour or two to distract yourself. Better yet, sleep on the problem — it's amazing how a little time can provide increased perspective.
- Back out of it, if possible. Some smaller mistakes can be reversed. Did you just blow a wad of cash on an Xbox 360 or some new clothes? Are you feeling buyer's remorse? Return the items, if you can. Or sell them to recoup some of your loss. Did you sign up for a gym membership that you now regret? You may be able to cancel the contract during the grace period. If you make a mistake, first try to undo it.
- Evaluate your options. Not all mistakes and setbacks can be reversed. If a little old lady runs a stop light and totals your car, there's no undoing the damage. Make the best of your situation. Focus on your long-term goals, and make a list the of options available to you. Don't make a rash decision. Be smart.
- Don't let it get you down. When things go wrong, it can be tempting to ease the pain by spending more money. We buy things to make ourselves feel better, but the spending actually has the opposite effect. We feel guilty about what we've purchased, and this guilt makes us want to go out and spend more. Fight that feeling. Don't let one problem snowball into two or three.
- Learn from your mistakes. Figure out where you went wrong. How did that traveling salesman sell you those over-priced steak knives? What can you do in the future to prevent yourself from doing the same thing again? It's a fine line to walk: you don't want to beat yourself up, but you don't want to keep making the same stupid mistakes, either.
- Don't fall victim to the sunk-cost fallacy. I recently had coffee with Debt Kid and listened to his story. After some initial success with day-trading, DK found himself down $2,000. Rather than accept his losses and move on, he threw good money after bad. He lost $30,000 of his mother's money. Then he began to borrow to recover his losses. Ultimately, he found himself $250,000 in debt! This is the sunk-cost fallacy in action. Just because you've already spent $200 on a gym membership you never use doesn't mean you need to keep spending money on it. Cut your losses. Get out as soon as possible.
Stupid in real life
Although I make fewer mistakes than I used to, I still do dumb things from time-to-time. Last fall I was talking to a friend who worked at the corporate offices of The Sharper Image. He told me that the company's stock price had fallen, but management was certain they could turn things around. It was just a passing remark in a much larger conversation, but it made me think.
The next day, I bought $3,500 worth of Sharper Image stock at $3.14 per share. This was a bulk of my Roth IRA money for 2007.
This was dumb. (And it was a repeat of a similar stupid move I had made — but survived — earlier in the year with Countrywide.) I didn't research the stock. I was gambling, plain and simple. And I lost. The Sharper Image declared bankruptcy recently, cutting the value of my investment from $3,500 to around $200. There's a chance it will drop to zero.
I could let this get me down — and believe me, I think my choice was plenty stupid — but I've tried to put a positive spin on it instead. I view this as a costly learning experience. I believe that the average investor should steer clear of stock-picking and focus on indexed mutual funds (that's where 95% of my money is). This has only strengthened this conviction, especially for myself.
When I told my friend Paul about this experience, he had some great advice: “Until you can remove emotion from the decision, and until you have a basis for making a data-driven decision, you'll make mistakes like this.” He's right. Even after years of following the slow, sure path to wealth, there is still a part of me that looks for a quick fix. The way to counter that is to become better prepared and better educated so that I'm not tempted to make similar mistakes in the future.
Addendum: For more on this subject, check out Jim's follow-up at Blueprint for Financial Prosperity: Early mistakes are lessons in disguise.