As humans, there are so many psychological biases that makes us terrible at managing and growing our money. In this post I want to show three ways we all screw ourselves over financially and how setting up money systems is the best way to overcome our worst financial habits.
Everyone Thinks They Can Time the Market (Yes, even you)
Ask any money manager, professional investor, or financial advisor who has been alive for more than 30 years if it’s possible to time the market. You’ll have to wait patiently for several minutes while they enjoy a good hard laugh. Nobody can time the market. Not you, your neighbor, your dog, or any other human alive on this planet.
And yet, most of us (me included) seem to think we have a strange ability to do so. We think we know when to jump in and out of the market to maximize our investment returns and make the market look like a chump. More often than not this leads to us losing money and under-performing the market.
Check out this graph of the S&P 500 over the last 10 years. There have been countless times throughout this time period where the market sentiment has turned sour and investors have sold out of stocks completely in fear of the next recession looming around the corner.
But despite all the panic and hesitation to invest, the market has steadily climbed higher and higher. I’m not saying it will continue to do so forever. In fact, it is guaranteed to drop at some point in the future, but the point is that nobody knows when. And for everyone that has panic sold over the past 10 years, they have missed out on an incredible amount of growth.
As the old saying goes, to be a successful investor it’s not about timing the market, it’s about time in the market.
Everyone Thinks They Can Pick Individual Stocks and Funds to Outperform the Market (Yes, even you)
The second way we consistently shoot ourselves in the foot financially is by attempting to pick individual stocks and actively managed funds in an effort to outperform the market. Not only is it incredibly hard to pick which stocks will do well and which ones won’t, but passively managed funds have consistently beaten actively managed funds over the years.
In my post “Why It’s So Hard to Outperform Index Funds” I explained that a small percentage of stocks account for a disproportionately huge percentage of market returns, which explains why index funds almost always outperform actively managed funds. If an index fund holds every stock in the market, it’s guaranteed to hold the extreme winners. By comparison, most active funds are highly unlikely to hold all the extreme winners.
Here’s a graph that shows the returns on individual stocks compared to a benchmark from 1980-2014. Most stocks under-performed the market average significantly, while only a tiny percentage of stocks (“Extreme winners”) wildly outperformed the average and accounted for most of the growth in the market.
Everyone Thinks They Can Control Their Spending (Yes, even you)
The third way we screw ourselves over financially is by thinking we’re better at controlling our spending than we actually are.
With credit cards becoming more prevalent and cash becoming an heirloom of the past, most of us use credit cards for nearly all our purchases. Most of us can agree they’re far more convenient and easier to use than cash, but research has shown that credit cards actually cause us to spend significantly more without realizing it.
When we make a purchase with a credit card, it’s so quick and easy that we usually don’t associate swiping the credit card with real money leaving our bank accounts. Since there is no physical exchange of currency between us and a vendor, we’re far less likely to even remember the purchase taking place. This leads to us making more purchases and failing to keep track of exactly how much we spend on a monthly basis.
This is also why we experience the “Wow, I spent that much this month?” reaction when we receive our credit card statements. Most of us simply aren’t as good at tracking, budgeting, and controlling our spending as we think we are.
Systems are the Solution
Fortunately there is a simple solution to these three money problems: systems. Setting up money systems to automatically move our money around for us is the easiest, most efficient way to manage and grow our money more effectively. To illustrate exactly how money systems can work, here’s an example of how I use them:
1. Automatic 401(k) Contribution From Each Paycheck
When I receive my paycheck every two weeks, I designate 25% of it to be deposited in my 401(k) account. I never even see this money since it never hits my bank account. Not only is this the number one way I’m able to make sure I grow my wealth, but it also reduces the net pay I see on my paycheck and conditions my brain to think that I have less money available to spend.
I am always astounded at the growth of my 401(k) because I only look at the balance of it once a month when I’m updating my net worth. It sits on automation, taking money from each paycheck, collecting the employer match, investing in the 80/20 stock/bond split no matter what the market is doing, and re-balancing itself once a year.
2. Automatic Transfer to Ally Savings Account
Next, the rest of my paycheck is dumped into my checking account. As soon as it hits this account, 90% of it is automatically set to transfer to my Ally Savings Account, which yields 1.05% interest. This might not sound like a lot, but Ally has already paid me over $25 this year in interest. I’ll gladly take those 3 free burritos.
This step is actually extremely important because I use my checking account to pay for my credit card bills, and by keeping only a small sum of money in this account (usually a few hundred dollars or less) I subconsciously know that I need to be frugal with my credit card spending. By artificially forcing my checking account balance to be small, I force myself to keep my spending fairly low.
3. Automatic Transfer to Vanguard Index Funds
The final money system I have set up is to transfer a certain percentage of money in my Ally Account weekly to my Vanguard brokerage account to purchase index funds. Every Monday I make this transfer to ensure that I am dollar-cost averaging my savings into index funds.
Just by setting up these money systems I am forcing myself into good money habits. These systems help me avoid all three money problems I listed above. I’m not tempted to time the market because I have weekly transfers to ensure I am investing my money no matter what the market is doing. I’m not tempted to pick individual stocks and managed funds because I force my money to be funneled into index funds each week. Lastly, I force myself to only have a small balance available for spending by keeping my checking account balance artificially low.
If you want to establish good money habits, set up systems that force you to have good habits. Think of it as “set it and forget it”. Once you set up your money systems, you don’t have to stress about whether or not you’re making the right financial choices constantly. You just set up your systems and live life as you normally would. Through these systems you can build a well-oiled, smooth running money manager that makes your financial life easy.
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Zach is the author behind Four Pillar Freedom, a blog that teaches you how to build wealth and gain freedom in life.
Zach's favorite free financial tool he's been using since 2015 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
Although the bulk of his net worth is invested in index funds, his favorite place to invest in individual stocks is M1 Finance, a site that allows you to build a custom portfolio of stocks for free.
His favorite way to save money each month on his recurring bills is by using Trim, a free financial app that negotiates lower cable, internet, and phone bills with any provider on your behalf.
His favorite micro-investing app is Acorns, a free financial app that takes just 5 minutes to set up and allows you to invest your spare change in a diversified portfolio.
His favorite place to find new personal finance articles to read is Collecting Wisdom, a site that collects the best personal finance articles floating around the web on a daily basis.
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