Who among us has not made a costly financial blunder? Come on; admit it -- we all make some dumb moves for which we have to pay a pretty penny. Research by the Consumer Federation of America and Primerica found that two out of three Americans say they have made at least one "really bad financial decision," and almost half of those questioned (47 percent) admitted that they had made more than one. The median cost of these bad decisions was $5,000, but the average cost was $23,000.
That we make financial boo-boos is not surprising, but the report also found that a large majority of those surveyed believe their ability to make financial decisions is "good" or "excellent," despite having made costly financial mistakes in the past.
Call it the "Lake Wobegon Effect," named after the fictional town where author Garrison Keillor noted that "all the women are strong, all the men are good looking, and all the children are above average." The Lake Wobegon Effect has come to mean the tendency to overestimate one's capabilities. In social psychology, it's called "illusory superiority."
Of course, if we are all so smart and confident in the world of finance, why are we shelling out thousands of dollars to cover our bad decisions? Even if you are from Lake Wobegon, you may be interested to know about these mistakes that I saw frequently when I was an investment adviser:
1. Failing to maintain an adequate emergency reserve fund. Maintaining six to 12 months of living expenses allows you to ride out many a financial storm without raiding your retirement assets. For those in retirement, carrying 12 to 24 months of expenses is even better.
2. Creating an overly optimistic financial plan. From the mid-1990s until the financial crisis of 2008, too many plans relied on annual investment returns of 10 percent. Those whose assumptions were more conservative faced far fewer surprises when the negative years rolled in.
3. Paying more fees than necessary. Why do investors consistently put themselves at a disadvantage by purchasing investments that carry hefty fees? Those who stick to no-commission index mutual funds start each year with a 1-2 percent advantage over those who invest in loaded managed funds.
4. Allowing your emotions to rule your financial choices. There are two emotions that tend to overly influence our financial lives: fear and greed. At market tops, greed kicks in and we tend to assume too much risk. Conversely, when the bottom falls out, fear takes over and makes us want to sell everything and hide under the bed. To prevent the emotional swings, create and stick to a diversified portfolio that spreads out your risk across different asset classes, such as stocks, bonds, cash and commodities.
5. Not having adequate insurance vs. purchasing too much insurance. Insurance is a necessary component of a financial plan. However, too often people shift from one extreme of not having enough coverage to the other, when they buy more insurance than they need. A good way to quantify your insurance needs is to use a life insurance calculator, like this one: http://www.lifehappens.org/life-insurance/life-calculator.
6. Assuming too big a risk. If you are going to make a risky investment, such as purchasing a large position in a single stock or making an investment in a tiny company, only allocate the amount of money you are willing to lose, that is, an amount that will not really affect your financial life over the long term. Yes, there are people who invest in the next Apple, but just in case things don't work out, limit your exposure to a reasonable percentage (single digits!) of your net worth.
7. Not asking for help. There are plenty of people who can manage their own financial lives, but there are also many cases where hiring a pro make sense. Make sure that you know what services you are paying for and how your adviser is compensated.
Hey, I've heard that even in Lake Wobegon, the average financial mistake can cost you $23,000!
(Jill Schlesinger, CFP, is the Editor-at-Large for http://www.CBSMoneyWatch.com. She covers the economy, markets, investing or anything else with a dollar sign on her podcast and blog, Jill on Money, as well as on television and radio. She welcomes comments and questions at firstname.lastname@example.org.)