Money Management

The real reasons behind your poor choices. 

We all know what sound financial advice looks like. Be disciplined with your money and don’t spend more than you earn. Save and invest for your retirement. Buy low and sell high. Sounds easy enough, right?

Then why is it so hard to follow these simple guidelines? Even financial professionals have a hard time making good financial decisions. This is because our brains are wired in a way that often makes irrational decisions not in our best interests. Cognitive biases and emotional decisions have a major impact on our financial decisions, often leading to bad choices. Here are five big reasons why you may be making bad financial decisions.

What is cognitive bias?

Cognitive bias is a type of mental shortcut that helps us make decisions more quickly by simplifying complex information. Although this may sound helpful, the problem with cognitive biases is that they can lead us to make inaccurate assumptions and judgments based on incomplete or incorrect data. There are many types of cognitive biases, but here are five of the most common ones that we fall prey to.

1. Confirmation bias

Confirmation bias occurs when we cherry-pick information that agrees with our existing beliefs while ignoring facts that challenge those beliefs. This type of bias can be especially dangerous in financial decision making, because it can lead us to overlook important details that could help us make better decisions.

A great example of this is when we choose investments. If we like a popular stock, we will look for data that confirms our beliefs and overlook data that doesn’t. Even top private equity funds ignored the red flags in Sam Bankman-Fried’s crypto platform FTX. Investors were drawn to SBF’s charisma and investors wanted to believe that SBF was the savior of crypto. They only listened to people who agreed and anyone who raised concerns was shunned. This led to a vicious cycle of investors reinforcing what they already believed. The end result? A million investors, including top private equity funds, lost close to $8 billion when FTX declared bankruptcy last year.

2. Availability heuristic

The availability heuristic is a mental shortcut in which we judge something based on how easily we recall similar situations from memory. For instance, if one stock has gone up in value recently, then we might assume, without doing additional research, that similar stocks will also go up in value. We tend to think that things that happened recently are more likely to happen again. Unfortunately, this type of thinking leads us to make hasty financial decisions or invest in stocks without properly researching them first.

For example, the number of cryptocurrencies on the market more than doubled to 12,000 from 2021 to 2022 as cryptos exploded in value. By the end of 2021, the market was adding 1,000 new cryptos per month. At its height in November 2021, the crypto market was worth close to $3 trillion, and new investors continued to pile their money into new cryptos. Since then, the market has shed two-thirds of its value and investors have lost $2 trillion. Thousands of cryptos have folded, and popular crypto platforms, funds, and exchanges have also gone under.

3. Anchoring bias

The anchoring effect refers to our tendency to rely too heavily on the first piece of information we receive (the “anchor”) when making decisions. This is why companies have the manufacturer suggested retail price (MSRP) on the price tag. That is the number they want you to refer to. So if they say a product’s MSRP is $100, but it’s 75% off, you think you’re getting a great deal at $25. But in actuality the price is relative, and the product may be worth only $10.

Anchoring bias leads us to place too much importance on a single piece of information and fail to consider other important factors when making a decision. This bias can lead us to spend more money than we should because we think we are getting a deal we can’t pass up.

4. Survivorship bias

Survivorship bias occurs when people overestimate their chances of success by looking at a group of successful people without considering those who failed (and were removed from the dataset). The news constantly highlights the entrepreneurs and startups that have hit unicorn status (valued at $1 billion). In 2022, there were close to 900 companies to join that exclusive list. What isn’t highlighted are the millions of small businesses that don’t reach that milestone.

This type of thinking can lead people to focus only on those who are successful without taking into account those who are not. For example, the chances of winning the grand prize in the PowerBall lottery is 1 in 292,201,338. Edwin Castro was the winner of the record-breaking $2.04 billion jackpot in November 2022. People reading about him may be motivated to go out and buy more lottery tickets in hopes of winning as well. What we don’t read about are the millions of other people who didn’t win the lottery.

Another example is investing. Some may see the success of Warren Buffett and believe they can do just as well by following his investing principles. Unfortunately, this can lead them to ignore risks or their chances of failure.

5. The sunk cost fallacy

The sunk cost fallacy leads us to continue to invest or spend money on something that we have already put resources into, even if we no longer believe it is the best course of action. This means we can end up spending a disproportionate amount of money, time, or effort on something because we don’t want our previous investment to go to waste.

This leads us to throw in good money after bad, instead of cutting our losses. For example, if we put thousands of dollars into a bad investment, we tend to double down because we don’t want to lose the money we already put in. This type of thinking often leads investors to make decisions based on emotion instead of sound research. When encountering this type of situation, it is important to take a step back and not let what you already invested influence your decisions. Often the best strategy is admitting our mistake and cutting our losses, so we can move on. You don’t want to make a decision based on past costs, but instead focus on present and future risks and rewards.

Cognitive biases can impact our financial decisions

We can be our own worst enemy when it comes to managing our finances. No matter how much knowledge you have about finance and investing, we are all still subject to various cognitive biases and emotional traps. We don’t always make decisions based on reason and long-term thinking; rather, our decisions are often driven by short-term desires and based on incomplete information. While cognitive biases can help us make decisions more quickly by simplifying complex information, these mental shortcuts can also lead us astray if we’re not aware of them. Try to recognize when you’re experiencing these common cognitive biases, and you’ll give yourself a chance to work against them and make informed, responsible choices with your money.

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There’s a simple way to figure out how much you need. 

Ask people about the best way to use your extra cash and you’ll probably get a lot of different opinions. That makes sense, since everyone is in a different financial place and has their own set of goals. But no matter what you hope to achieve, you need an adequate emergency fund to protect you against unexpected bills.

Many workers already have some emergency savings, with the median amount being about $5,000, according to a recent Transamerica survey. But is that actually enough? Here’s how to find out.

It all depends on your expenses

There are no hard-and-fast rules for how much you should keep in your emergency fund, but one of the most often-cited guidelines is at least three months of living expenses. For most people, this will probably amount to several thousand dollars, but it could be more or less than $5,000, depending on your lifestyle.

Three months of expenses might seem like a lot, but you can burn through that quickly in an emergency. Let’s say a tree falls on your house. A home insurance company will probably cover this, but you’ll have to pay your deductible first. That could easily be anywhere from $500 to $1,000 or more. You may also have to take immediate actions, like tarping or temporarily filling holes and replacing damaged items. The insurer might reimburse you for those eventually, but in the immediate aftermath, you could be on your own.

If you don’t have an emergency fund, you might have to charge these costs to a credit card, and that could lead to you carrying a balance. Once you fall into a cycle like this, it can be difficult to get out of. So it’s best to avoid it whenever possible.

If you don’t have any emergency savings right now, three months of expenses is a good target to aim for. You have some flexibility in how you calculate your monthly expenses. You could include everything you normally spend in a month or just the essentials. But you should note that if you do the latter and then you lose your job, you might have to tighten the belt until money’s coming in again.

Some people prefer to save even more than three months of living expenses. That’s up to you. This could be smart if you think it would be difficult for you to find a new job if you lost yours. Some people also feel more secure saving a little more when the economy is struggling.

How to build your emergency fund

A high-yield savings account is the best home for your emergency fund because it gives you easy access to your cash when you need it. And you can earn some interest on your money too. If you don’t already have one of these, now’s the time to open one. There are plenty of options these days that don’t charge any maintenance fees or have minimum balance requirements.

Once you have your account set up, decide how much you can afford to save per month. You could manually transfer the money or set up automatic transfers if your savings account allows that. Some accounts even enable you to automatically round up purchases to the nearest dollar and save the change, so you can grow your emergency fund without altering your lifestyle too much.

You may be able to progress more quickly if you have windfalls, like a raise or a tax refund, that you can save. But otherwise, just continue making a monthly contribution until you reach your goal. Then, you can decide if you want to save even more in your emergency fund or allocate your extra cash to something else.

Don’t tap your emergency fund for non-emergencies. A one-time, upcoming expense is something you can plan for. Save for this outside of your emergency fund. Only call upon your emergency fund for expenses that are completely out of the blue, like an insurance deductible or an appliance breakdown.

When you need to tap your emergency fund, be sure to replenish it as quickly as possible. And schedule some time to review your emergency savings at least once per year. You’ll probably want to set aside a little more over time as inflation drives up costs. But you may want to make bigger changes following major life events, like getting married or the birth of a child.

Emergencies are stressful enough without worrying about how you’re going to pay for them. Hopefully, your emergency fund can stay in your savings account for a long time. But if not, you’ll be glad you took the time to prepare.

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Put them on your list before you get too far into the filing process. 

Filing taxes is something many people opt to do on their own. But you may be stressed out about the idea of having to tackle your tax return without any help. And if you’re self-employed or own a small business, it’s really important to enlist the help of a tax professional, since that person may be able to eke out savings and deductions you wouldn’t know you’re eligible for.

But if you’re going to work with a tax preparer, it’s important you choose the right person for the job. With that in mind, here are eight questions that financial guru Dave Ramsey suggests asking your tax professional.

1. What’s the process like?

Each tax preparer has their own system for getting taxes done. Maybe yours like to do things remotely and you prefer to do things in-person. It’s important to ask that question to make sure you’re both on the same page.

2. What tax help can you give me?

You want a tax preparer who will do more than just copy numbers from forms into a software program. Ask your tax preparer what they bring to the table. Can they help you identify credits and deductions you may not have known about? You’ll want to make sure you’re getting good value for your money.

3. What tax info will I need to provide?

The sooner you know what tax documents your tax preparer will need from you, the sooner you can get organized. These documents may include a W-2 from your employer summarizing your wages and 1099 forms from your bank and brokerage account showing how much income you earned from things like interest and dividend payments.

4. How can I improve my tax situation?

Your goal may be to pay the IRS as little as possible, both now and in the future. A good tax professional should be able to offer you customized advice based on your specific circumstances.

5. What should I do this year in light of my tax situation?

Maybe you underpaid your taxes in 2022 and now owe the IRS money. A tax preparer might suggest you take steps like maxing out your IRA account (which you can do up until the tax-filing deadline) to lower your tax bill for 2022. It’s good to have that conversation upfront in case the suggestions your tax preparer has take time to put into place.

6. Can I call you throughout the year for advice?

Taxes are something you pay year-round, so you should have access to tax help and support year-round. It’s a good idea to hire a tax preparer who’s available 12 months a year, and not just during the filing season.

7. How will my side gig affect my taxes?

If you picked up a side job in recent years, you’re in good company. But it’s important to understand the tax implications involved. Not only must you pay taxes on those added wages, but they might bump you up into a higher tax bracket. So it’s a good idea to strategize around that.

8. What other services do you offer?

Your tax preparer may do a lot more than just submit returns to the IRS. Maybe they can help you organize your small business accounting or set up a small business if that’s a route you’re looking to take. It pays to find out what options are available to you.

If you’re going to work with a tax preparer, it’s essential that you find the right person for the job. Following Ramsey’s advice could help you feel more confident about the tax professional you’ve chosen to sign up with.

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I have always relied on the kindness of landlords. 

I’ve made my peace with being a renter, but I still want to buy a home again, and I’m fortunate enough to have found myself living in a city that offers affordable home prices. Many Americans aren’t this lucky, and indeed, the median purchase price of a home as of Q4 2022 was $467,700, according to the Federal Reserve Bank of St. Louis. For a reality check about the state of housing prices, note that at the start of the COVID-19 pandemic (Q2 2020), that same figure was $322,600.

Even though I live in a pretty inexpensive city, I’m still going to be signing on to pay a lot of money in the course of buying and owning a home. And one of the oddest reasons why I’m so excited to get a mortgage loan directly relates to my experiences as a renter.

Landlord maintenance has been uneven

I’ve lived in rental housing of all types (multifamily houses, apartment complexes, single family homes) in several different states and cities. I’ve rented from individuals and larger property management companies. And while in some cases, I had excellent experiences with landlords, in too many others, I have not.

I’m the kind of tenant who is easy to work with, pays rent early every month, and leaves a home cleaner than I found it (I have had my ENTIRE security deposit returned to me on multiple occasions). Unfortunately, this has not always meant that problems with my rentals have been addressed promptly and correctly.

In one case, the dangerous mismanagement of an apartment complex I briefly lived in spurred me to move out after just 10 weeks (and discovering my lease was invalid) — and I had just moved from another state without the ability to check out the apartment ahead of time. This was easily the most stressful and extreme example of my struggles with rental landlords, but far from the only one. In other cases, a relatively minor but incredibly annoying problem like a leaking sink was finally fixed — after weeks of me politely calling and texting. Ultimately, I’m looking forward to buying a home so I can just fix problems myself.

Homeowners are responsible for maintenance and repairs

While it may seem weird to eagerly anticipate spending money on routine maintenance and surprise repairs, I intend to rely as much as possible on a home maintenance fund I’ll be saving up in the meantime. I have friends who’ve gone into debt to fix unexpected problems with their homes, and I want to avoid this if I can.

It’s also extremely likely that I’ll be buying an older home (as my city is full of them, and a new construction home will be far out of my budget), making it even more important that I’m ready to handle issues as they crop up — because they most certainly will.

So, although it is a bit strange, I can’t wait for the day that I notice a leak, or my heater stops working, or any one of a myriad other things that can go wrong with a house. I won’t be happy to spend my own money, but I will be thrilled that I get to pick up the phone and call someone to fix the problem and know it’ll be done sooner rather than later.

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Be mindful of these before you submit your application. 

Personal loans have long been a popular borrowing option among consumers. And as of the fourth quarter of 2022, U.S. personal loan balances amounted to a whopping $222 billion, according to TransUnion.

You may be thinking of applying for a personal loan today if you need money. But before you do, be mindful of these pitfalls.

1. They can almost be a little too flexible

When you take out a mortgage, you can only use your proceeds from that loan to buy a home. And when you sign an auto loan, you can only use that money to finance a vehicle purchase.

Personal loans let you borrow money for anything you want. You can take the money and use it to renovate your home, buy furniture, go on vacation, or purchase 600 T-shirts with your favorite catchphrase on them.

Yes, the latter probably isn’t a very good idea. The point, however, is that the option exists. And that’s not necessarily a great thing.

It’s nice to have flexibility as a borrower, but that might lead you to borrow money for a non-essential reason. And that means you’ll be racking up interest charges when you probably shouldn’t be.

2. Falling behind on your payments could lead to serious credit score damage

Any time you fall behind on a loan payment, your credit score could take a major dive. Personal loans are no exception.

Even though personal loans are unsecured, which means they’re not tied to a specific asset as collateral, you’re still required to keep up with your payments on schedule. If you don’t, and you’re reported as delinquent to the credit bureaus, your credit score might plunge, making it extremely difficult to borrow the next time you need to.

3. You might get stuck with a higher interest rate due to today’s borrowing environment

The Federal Reserve has been raising interest rates in an effort to slow the pace of inflation. The Fed doesn’t set consumer borrowing rates directly, which means it technically has no say as to what personal loan lenders charge.

But when the Fed raises its benchmark interest rate, which it did seven times in 2022 and once already in 2023, that tends to drive up the cost of consumer borrowing on a whole. Right now, you might get stuck with a higher interest rate on a personal loan than you’d like. This holds true even if you’re a borrower with solid credit.

Granted, if you take out a personal loan, you might snag a lower interest rate than you would with, say, a credit card. But that doesn’t mean you won’t get stuck overpaying due to factors you’re completely not in control of.

Borrowing money with a personal loan may be an option worth exploring this year. But before you sign that loan agreement, keep these potential issues in mind — and see if it’s worth pursuing another borrowing option, like a home equity loan, or holding off on taking out a loan altogether.

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We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers.
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The number depends on what you spend and what you earn. 

Age 45 is an interesting one. You’re maybe a bit too old to be staying out till 3:00 a.m. with your buddies, but you’re probably not quite ready to start meeting up for dinner at 5:30 p.m. so you can make sure you’re in bed by 9:00 p.m.

Age 45 is also an important one financially. At this point, you’re probably halfway through your career, which means retirement should be on your radar. And if you have kids, you may be starting to think about (or worry about) paying for college.

So how much savings should you have by age 45? It depends on how much you spend each month and how much you earn each year.

What your savings account balance should look like by age 45

As a general rule, you should have a robust enough emergency fund to cover a full three months of bills. But you may want to aim higher.

See, the point of having enough money in your savings account to pay for three months of expenses is to get you through a period of unemployment (and also, to cover other unexpected expenses that might arise). But by age 45, you probably won’t want to take any old job if you lose yours. Rather, you might have specific needs. And you’ll want the flexibility to spend more time looking if the right fit doesn’t materialize within three months.

That’s why having enough savings to cover six months’ worth of essential bills is really a better bet by age 45. It could take the pressure off if you’re let go at work, or if major home repairs start to pop up as your house ages.

What your retirement plan balance should look like by age 45

If you’re 45 years old, retirement isn’t exactly right around the corner. But it’s also not so far away. And so at this point, you should ideally have a decent chunk of money saved up in an IRA or 401(k).

Fidelity says that by age 40, you should aim to have three times your salary socked away for retirement, and by age 50, you should aim to have six times your salary. So if we meet those figures down the middle, it means that by age 45, you should ideally have 4.5 times your salary set aside for retirement. If you earn $90,000 a year, it means you’re in good shape if you have $405,000.

That said, many people’s retirement plans lost money in 2022 due to stock market volatility. So if you had 4.5 times your salary before the market took a dive, but you have a lower balance now, don’t worry — you’re still in good shape, and once the market rebounds, your balance might climb back up.

What to do if you’re behind on savings

Whether you’re behind on regular savings, retirement savings, or both, it may be time to make some lifestyle changes. That could mean taking a closer look at your spending and finding ways to cut back on non-essential expenses, like takeout meals and subscriptions. Along these lines, if you commonly take a vacation every year that costs your family $5,000, you may want to opt for a staycation for the next few years and bank that money instead.

By age 45, you should be in a good place with regard to both emergency and retirement savings. If that’s not the case, all definitely isn’t lost. But it is time to get serious about buckling down and make savings your priority.

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We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers.
The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.Maurie Backman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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