Money makes the world go 'round, as the old song would have it. But even though tending carefully to our finances is extremely important, doing so can be challenging — our brains evolved to help us survive in the radically different world of the prehistoric past, not in the modern world where we have to decide whether to invest in stocks or bonds. As a result, it’s easy for us to make mistakes when tending our savings.
To help you avoid these common mistakes, we've compiled for you 8 tricks for becoming more rational with money.
Important: we are not professional financial advisers, and this does not constitute financial advice. Remember that all investments carry risks. Be sure to think carefully and thoroughly about any changes you make to the way you manage your money, and talk to a trustworthy financial advisor about anything you are unsure of.
1. Don’t keep savings in your checking account.
While it seems obvious that you should keep your savings in a savings account rather than a checking account, a surprising number of people miss it. Savings accounts typically pay you higher interest rates than checking accounts, and in fact, some checking accounts pay you nothing at all. But since savings accounts often have restrictions on withdrawals of your money, people frequently follow the path of least resistance and leave a lot of money in their checking accounts. Get more out of your bank by transferring any money you don't plan to use in the immediate future into your savings account. And be sure to check the interest rating you’re being paid, to confirm that it’s comparable with other banks (look for “high-yield” accounts). You can use websites like bankrate.com to quickly compare the interest you’ll earn from different types of accounts at different banks.
2. For longer-term savings, consider an IRA or a 401(k).
Savings accounts are good repositories for savings that you plan to hold on to for a few months or years, but if you're planning to hold onto your money for decades, it's wise to consider more permanent options. One common and relatively low-risk way to sock money away for the long run is the individual retirement account, or IRA. The chief benefit these accounts provide is tax exemption for the income you place in the account. The two most common types of IRAs — traditional IRAs and Roth IRAs — involve slightly different requirements and offer different tax benefits, but both are useful for saving towards retirement. Meanwhile, many employers offer 401(k)s — a type of pension account that allows you to deposit money from your pre-tax income. Some employers even match employee contributions to their 401(k)s. Do your future you a favor, and efficiently save money for retirement using these options.
3. Keep a close eye on your credit score.
It's obviously a good idea to keep tabs on your credit in the occasion that you need a loan, but your credit score can also serve as a coal-mine canary. Sudden changes in your score can indicate a missed bill payment or even identity theft, both of which might go unnoticed otherwise. Free credit-tracking services like CreditKarma can help you keep abreast of your credit situation.
4. Pay your credit card bill on time, every time.
Credit cards are very useful, but they're a terrible way to borrow money for the long term — they tend to charge very high interest rates compared to conventional loans if you miss your payments. And as mentioned, missing payments can mess up your credit quickly. One easy way to ensure that you never miss a credit card payment is to set up automatic payments every month — you won't have to worry about remembering to pay, and it'll help you avoid paying painful interest on a high card balance. You should only leave a large balance on your credit cards as a last resort. It’s not quite as bad as setting your money on fire, but it's close.
5. Choose your credit card wisely.
There's a huge variety of credit cards available, and some of them offer much better deals than others. If you plan on using credit cards regularly, make sure that you've picked out one that offers substantial benefits. For instance, some of the best cards out there offer 2% cash back on all your purchases, which is basically free money for you. It can be tough to find the best deal on your own, as they are constantly changing. Fortunately, there are services which evaluate the available options and help you find the best fit. Databases like NerdWallet and CardRatings are good places to start your search. Also note that opening a new card can hurt your credit score in the short term, but in the long term will improve your credit if you always make your payments on time.
6. Consider putting some of your savings in the stock market.
If you have money that you will not need for at least five years, consider investing a portion of it in the stock market. While the stock market is volatile and carries substantial risk in the short term, historically over long periods it has greatly outperformed all the other standard assets classes.
Take a look at this chart constructed by Wharton finance professor Jeremy Siegel, which tracks the return of different asset classes:
As you can see, the real returns of stocks — i.e., the returns accounting for loss in value due to inflation — over this 212-year period was about 6.7% per year. By comparison, bonds returned 3.5% per year, treasury bills returned 2.7% per year, gold returned 0.6% per year, and the U.S. dollar lost about -1.4% per year, because inflation causes a continual decline in value.
Note that these figures assume that all dividends paid out to you as a stock holder are reinvested back in the stock market. Sometimes you’ll see much higher numbers — such figures often fail to account for inflation, producing misleadingly large values. However, even the numbers above are somewhat optimistic because they don’t include the effects of trading commissions, management fees, and taxes. To put this in perspective, adjusting for inflation, if you’d invested $1 in stocks in 1802 (tax free with no commissions and management fees), it would now be worth $930,000. By contrast, investing $1 in bonds in 1802 would've yielded only $1,505.
The common wisdom holds that in order to balance risk and reward, a portfolio should mix stocks with other, safer asset classes, such as bonds. The longer you won’t need to touch your money for, and the more savings you have, the higher percentage you can afford to risk in stocks. Services like Betterment and Wealthfront can help you determine a reasonable ratio of stocks to other assets.
7. Index funds are often the best bet for investing in stocks.
As mentioned, stock markets have enjoyed a long-term upward trend. For many people, the easiest and smartest way to invest in stocks is via investment vehicles that track the broad stock market, such as exchange-traded funds (ETFs) and low-cost mutual funds.
Since their appearance in the 1970s, index funds have actually outperformed professional stock investors on average. To be more precise, on average investors who are trying to beat the market actually have approximately equaled the market’s overall return, but due to higher taxes, fees and commissions for active money managers compared to index funds, putting your money with a random active money manager would have caused you to lose out on average. What’s great about index funds, and ETFs in particular, is that there are really cheap ones out there that make it simple to get broad and diversified exposure to the whole stock market (including international markets).
8. Don't try to get rich picking your own stocks unless you're an expert.
The prospect of outsmarting the market as an amateur day trader certainly makes for a romantic prospect, but it's very rare in practice. Picking your own stock investments involves competing against thousands of professionals with hundreds of millions or even billions of dollars of resources at their disposal; it's an exceedingly difficult game to win. For those who really enjoy investing in an amateur fashion, Investing a very small portion of your money can be enjoyable if you view it as what it is — entertainment – but putting a large proportion of your savings at play by betting on individual stocks is seriously risky. Unless you’re an expert, it’s usually foolish to try to beat the market by picking individual stocks. Since most professional investors don’t even beat the market, index funds, which reduce risk by diversifying across a very large number of stocks, are often the safest way to expose yourself to the market.
Finally: University of Chicago professor Harold Pollack once said that “The best personal finance advice can fit on a 3"-by-5" index card." When challenged on this, he tried to create such an index card. Here’s what it looks like:
