By John Wasik
CHICAGO, Sept 24 (Reuters) – It’s rear-view mirror
philosophizing time. As we head into the autumn of this
contentious election year, it’s a great time to reflect upon
what worked and what didn’t in the wake of some of the most
tumultuous upheavals in American economic history.
You could easily blame Wall Street for the 2008 meltdown,
but it’s also clear that American families weren’t prepared and
made mistakes too. A new study from the Consumer Federation of
America found that 67 percent of middle class Americans think
they made at least one “really bad financial decision,” and 47
percent said they had made more than one. The cost? the median
was $5,000, but the average cost was $23,000.
Further, the study, entitled “The Financial Status and
Decision-making of the American Middle Class,” also found that
outside of retirement funds and checking/savings accounts,
families had few other financial assets. Only 15 percent
surveyed held stocks and from 13 to 14 percent held either
savings bonds or certificates of deposits.
How could you avoid the same fate? Here are some key ways to
avoid the same financial blunders:
1. Failing to gauge portfolio risk
I don’t know about you, but I wasn’t surprised when the
market tanked as much as it did in 2008-2009. I thought it would
be worse. Yet I sure was blindsided as to how much it nailed my
retirement portfolio, which fell about 40 percent. After all, I
was diversified. Wasn’t that supposed to be a form of
protection?
I didn’t know that commodities, stocks and real estate
investment trusts would decline in lockstep. They usually don’t,
but they were highly correlated during the global downturn.
There was an easy way to avoid this kind of hit: Add more bonds,
which I did. They now comprise more than half of our portfolio.
2. Getting swamped by debt-to-income ratios
Of course, you’ve heard tales of homebuyers who got
mortgages they shouldn’t have qualified for just because they
had a pulse in the pre-2007 bubble years. The enduring truth is
that too much debt can always be toxic.
What’s a dangerous level? It’s pretty simple: If your
short-term debt exceeds your ability to pay it off every month,
it’s too much. Whenever you get beyond 40 percent of
debt-to-income, you’re getting into deep trouble. Most
middle-class families carried 20 cents in debt payments to every
$1 they earned in 2010, the Consumer Federation found. That’s
not unreasonable, but this is an average discerned by looking at
Federal Reserve data; millions of households are in trouble
because they owe more than what their homes are worth, which was
not explored in this study.
A worthy goal for reining in short-term debt is simply to
pay off bills each month – but that means keeping spending
within your income range and saving up for big ticket items.
Also, watch your credit rating and try to improve it to obtain
the lowest-possible financing rates.
3. Not having a big enough safety net
The typical American middle-class family has about $27,000
in financial assets (excluding pensions), the Consumer
Federation found. Is that enough to cover emergencies, long
unemployment stretches or unreimbursed medical bills? Probably
not.
The rule of thumb is to hold six months’ worth of salary in
emergency cash in money-market or savings accounts. It’s a good
place to start, but more of a cushion is needed because of bad
financial decisions. And even more for those facing long-term
unemployment. How do you stash away more when times are tough?
There’s no magic answer other than making it a top priority and
making some hard decisions about spending.
4. Not carrying enough insurance
There’s a basic trade-off with all insurance policies: The
more you’re willing to pay on a claim out of pocket, the lower
the premium. For example, if you get a catastrophic health plan
with a high deductible, your monthly premium will be lower.
To figure out what you can afford, look at your monthly cash
flow. If you need to reduce insurance premiums, you will need to
boost savings to cover the deductibles. You can also save money
on auto insurance by dropping coverage for comprehensive
coverage if the car is old.
5. Failing to invest
Saving is putting money in a protected place for rainy days.
Investing is putting money at risk in exchange for long-term
returns. You need to do both to survive the ravages of inflation
and financial events beyond your control. Surprisingly, only 21
percent of those middle-class Americans surveyed by the Consumer
Federation said they would invest in stocks, bonds and mutual
funds – even if they had $1 million to invest.
While I certainly don’t admonish anyone for steering clear
of market risk after 2008, you can find some balance through the
“bucket” method of risk management. Your “safe” yellow bucket
should hold money you need in the next few years for
emergencies, college, out-of-pocket medical expenses or taxes. A
“red” bucket is for money you can risk over decades for
retirement and future goals. You adjust the amount of money for
each bucket according to your needs, time of life and risk
tolerance.
Perhaps the greatest blunder that everyone is guilty of is
inaction. We wait for the market to become overheated instead of
taking advantage of dips to get better prices. We don’t sell our
losers and move on. We think we can time the bottom of the real
estate and stock markets.
I know I waited too long to add bonds to my portfolio and
reduce my stock and commodity market exposure, although it’s
since bounced back. One essential truth remains: In a society
that thrives on spending and consumption, increased saving can
help avert financial disaster in the future.
