The Impact of Financial Mistakes

1
Aug

The Impact of Financial Mistakes

The Impact of Financial Mistakes

“I think making mistakes and discovering them for yourself is of great value, but to have someone else to point out your mistakes is a shortcut of the process.”

Shelby Foote

Owning Up To Financial Blunders

Have you ever made a big financial mistake? You’re not alone. According to a Consumer Federation of America report from 2012, 67% of middle class American consumers (those with annual incomes of < $100,000) owned up to a “really bad financial decision”, resulting in an average loss of $23,000.

And apparently, having more money doesn’t automatically make you smarter! Among upper income Americans (yearly incomes of $100,000 or more), 61% confessed to making a fiscal misstep.  The average loss for this demographic was $61,000, 265% more than their middle class counterparts.

One of the report’s most telling details is that over 80% of those surveyed felt that their ability to make financial choices was “good” or “excellent”. However, there was an overwhelming correlation between losses and the lack of professional financial advice. A full 17% of middle class respondents said they “wouldn’t seek any information or advice, and just make a decision,” yet this group fared worse and suffered more losses than those who sought professional help.

If four-fifths of those responding are “good” or “excellent” at making financial decisions, then why have nearly two-thirds admitted to making a bad choice – with nearly half saying they made more than one? There seems to be a serious disconnect here.

Measuring Long-term Losses: Opportunity Cost 

Bad financial choices might result in an immediate dollar loss, but there is a lingering impact called opportunity cost. An opportunity cost is what that money could have earned over time – had it not been lost.

To give some perspective, let’s say a poor decision at age 40 causes a shortage of $50,000. Since life expectancy is just shy of 80, the period of opportunity cost would be almost 40 years. Using a 5% annual rate of return, the eventual opportunity cost would be a seven-fold increase of $351,999.

Of course the real opportunity cost could be higher or lower, as rates of return are variable, but the point remains the same: the cost of lost money is ongoing, not a one-time event. 

Keeping the opportunity cost in mind, here are some further observations:

  1. Since the opportunity cost adds up over a longer period of time, financial mistakes made early in life are the most costly. Financial planners often counsel younger clients to take greater risks, telling them “you can afford to invest aggressively!” As a result, younger investors are encouraged to put most or even all of their money into stocks, as they would have “time to recover” from any shortages. But as we mentioned previously, early losses grow into even larger deficits over time.
  2. Minimizing and avoiding losses are essential in building long-term wealth. Whether it comes from poor financial choices, bad spending habits, faulty accounting or an economic downturn, your financial potential will be negatively impacted by any lessening of your net worth. This doesn’t simply include avoiding risky investments, but avoiding, when possible, high fees, penalties, and future taxes. Too many people max out their 401(k)’s according to “typical” financial wisdom, but the size of their retirement accounts are misleading, as the fees will continue to erode their returns and Uncle Sam will take his share every time income is withdrawn.
  3. The best financial advice is the kind that minimizes loss rather than trying to squeeze higher returns (with risk) from existing assets. Advisors and strategies should be chosen on the basis of whether their methods are proven to be safe and sustainable in all kinds of market conditions, not their performance over the last few years.  Slow and steady might not sound as sexy as home run with a hot stock, but when you understand that you’re not just risking the money you’re “betting” on that stock, but also the money it can earn you in the future, you can see why it pays to be prudent.

How to Avoid another Financial Mistake

Don’t be a Lone Ranger—open yourself to seeking and accepting advice from those you trust and keep on growing your financial IQ.  Keeping an open mind will allow you to see unique perspectives and potential blind-spots and avoid unwanted financial mistakes.