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How do I make better saving/spending decisions?
One of our readers asked how should people make better saving and spending decisions. This is a great question and one that probably bedevils most folks. Part of the problem is the overwhelming number of advertisements we see each day compared to the number of messages we see urging us to save. One of our challenges is to learn how to block out all of the messages that are attempting to get us to part with our money!
Let's look at the savings side first. There is an abundance of research indicating that the best way to save is to put ourselves on an auto-pilot program. A great example of that many of us are familiar with is the 401k plan. (For some it is a 403b or 457 plan.) How does this plan work? In the past you needed to sign up for this program through your employer and designate a percentage of your pay that would go into this plan on a pre-tax basis. Unfortunately, signing up for the plan was voluntary and unless you proactively completed the paperwork, you were left out of it. Increasingly more and more employers are setting the 'default' status as enrolled for new employees which means you would proactively have to opt-out if you did not want to save. This is a good thing. Many of these plans also have a 'save more tomorrow' feature which increases the saving percentage automatically when you get a raise.
There are two questions that may arise now: how much should I be saving and how do I apply these concepts to savings in other accounts such as IRAs or non-retirement accounts? How much you save should be tied to a retirement projection. You need to have some sense of how much you are going to need in retirement to complement Social Security. Until you have defined your goal it is difficult to determine exactly how much you need to save. For most folks, I recommend trying to maximize your employer-provided savings as you receive a nice tax deduction for doing so.
More importantly, is how you apply this auto-savings feature to other accounts. You need to determine an amount that will be contributed automatically each month to these accounts through an electronic funds transfer. So, let's say you are saving for a specific goal such as your next auto or home improvement such as a bathroom remodel. You have decided you need $25,000 for this goal and wish to have the funds for this goal in three years' time. I would set-up a savings account either through your bank or an online bank that offers a decent savings rate. (Yes, I know that is hard to find these days.) You will then schedule an automatic monthly transfer of approximately $700 to this new savings account from your checking account. The key is to ensure it happens automatically.
Now, this is just one example of how to set things up to occur automatically. Remember, the government if very good at collecting its taxes automatically from your pay check so you want to do the same for yourself. As far as improving the amount you save, if the example above sounds like a big leap from your current level of savings, you should employ a concept called 'ooching'. This is a term I came across recently after reading a book called Decisive by Chip and Dan Heath. Let's say you are currently only saving 6% in your 401k but you know that you need to save more- a lot more to meet your goals. You are having a tough time making ends meet as it is and the idea of saving more just seems too hard. You want to 'ooch' your way to a higher savings rate. What you should do right now is to increase your savings amount by 1%. (Yes, I mean right now you should do this. Not tomorrow, or the day after!) Give it a few months and see how things go. Will you really miss that 1%? If not, after another three months you should 'ooch' a bit more by increasing your savings rate another 1%. Give that another few months. Next time you get a raise, let's say it is 4%, I want you to increase your savings rate by 2%- half goes to you to help you keep up with current expenses, the other half goes to helping you keep up with future expenses.
In summary, when it comes to making better saving decisions you want to automate as much as possible, and then 'ooch' your way to higher savings.
What about spending? This is very difficult for some people. The main problem is credit cards. Now, I can hear many people saying to themselves 'but I pay it off in full each month.' Congratulations! That is certainly good, but it is not good enough if you are not meeting your savings' goals each month. The problem with credit cards is that it makes spending more much easier. There is a ton of research on the 'pain of payment' and how it is much better to use cash for most of your everyday spending purchases. Why? Because the pain of using cash makes it easier to control your spending. For more on this, I strongly recommend this very informative and very funny video by Dan Ariely.
To add one final comment on spending, while using a debit card in lieu of a credit card is certainly a better option, it is only marginally better. Utilizing cash is still the best method to help control spending because of the concept of 'pain of paying.' Now, if you watched the video there are times where it makes sense to not use cash as you would want to maximize your enjoyment of the experience. Vacations are a good example. You just need to be careful to set some type of budget for your trip so you do not undo all of the hard work that you accomplished throughout the year!