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March 5 18 Comments latest by Financial Lessons

This is a guest post from J.D. Roth, who writes about smart personal finance at Get Rich Slowly.

When I was young and stupid, I became addicted to spending. I got my first credit card in college, and over the next fifteen years, I accumulated $35,000 in debt. I’m debt-free now, and have even begun building a nest egg, but I didn’t reach this place without making a lot of financial mistakes along the way. Dealing with mistakes and setbacks is an important tool in your personal finance arsenal.

Preventing problems

The best defense is a good offense. I used to spend a lot of time reacting to problems: bounced checks, car repairs, soccer injuries, and — worst of all — my own dumb choices. With all the crap life dealt me, I never seemed to get ahead.

Then I realized that the best way to defend against financial setbacks was to actually prepare for them before they arrived. Simple, I know, but it’s the simple stuff like this that forms the basis of smart personal finance. Two methods in particular have helped me deflect many setbacks:

Education — I finally became frustrated with my lack of financial literacy, so I decided to do something about it. I read personal finance books. I read magazines. I read blogs. Most importantly, I talked with those friends that I knew had control of their finances. They were happy to give me advice. I was happy to listen.
Preparedness — I started an emergency fund. Setting aside $500 or $1000 in an online high yield savings account is cheap insurance. If you have cash cushion, your financial plans can’t be derailed by a single stupid mistake. (Unless it’s a big mistake.)

Picking up the pieces

Education and preparedness will only get you so far; you’re still going to make mistakes now and then. You need to know how to pick up the pieces. Nothing will make things whole again, but there are a few things you can do to minimize the damage:

Don’t panic. When you suffer a setback, or when you realize you’ve made a mistake, your stomach gets tied up in knots. It’s easy to feel overwhelmed. Relax. Take an hour or two to distract yourself. Better yet, sleep on the problem — it’s amazing how a little time can provide increased perspective.
Back out of it, if possible. Some smaller mistakes can be reversed. Did you just blow a wad of cash on an Xbox 360 or some new clothes? Are you feeling buyers remorse? Return the items, if you can. Or sell them to recoup some of your loss. Did you sign up for a gym membership that you now regret? You may be able to cancel the contract during the grace period. If you make a mistake, first try to undo it.
Evaluate your options. Not all mistakes and setbacks can be reversed. If a little old lady runs a stop light and totals your car, there’s no undoing the damage. Make the best of your situation. Focusing on your long-term goals, make a list the of options available to you. Don’t make a rash decision. Be smart.
Don’t let it get you down. When you make a mistake or suffer a setback, it can be tempting to ease the pain by spending more money. We buy things to make ourselves feel better, but the spending actually has the opposite effect. We feel guilty about what we’ve purchased, and this guilt makes us want to go out and spend more. Fight that feeling. Don’t let one problem snowball into two or three.
Learn from your mistakes. Figure out where you went wrong. How did that traveling salesman sell you those over-priced steak knives? What can you do in the future to prevent yourself from doing the same thing again? It’s a fine line to walk: you don’t want to beat yourself up, but you don’t want to keep making the same stupid mistakes, either.
Don’t fall victim to the sunk-cost fallacy. When I play poker with my buddies, we always try to goad each other to betting more than we should. If I’ve bet $1 on a pair of jacks and there’s an ace on the board, the guys will try to convince me to put in another buck. “You’re pot-committed,” they say. This is the sunk-cost fallacy. Just because you’ve spent $200 on a gym membership already doesn’t mean you need to keep spending money on it. Cut your losses. Get out as soon as possible.

Although I make fewer mistakes than I used to, I still do stupid things from time-to-time. Last fall I was talking to a friend who worked at the corporate offices of The Sharper Image, a company that makes and sells technological gadgets. He was telling me that the stock price had fallen, but that management was certain they could turn things around. It was just a passing conversation, but it made me think. The next day, I went out and bought $3,500 worth of Sharper Image stock at $3.14 per share. This was a bulk of my Roth IRA money for 2007.

This was dumb. I didn’t research the stock. All I was doing was gambling, plain and simple. And I lost. As you may have heard, The Sharper Image declared bankruptcy recently, cutting the value of my investment from $3,500 to $350. There’s a chance this will drop all the way to zero.

I could let this get me down — and believe me, I think my choice was plenty stupid — but I’ve tried to put a positive spin on it instead. I view this as a costly learning experience. I believe that the average investor should steer clear of stock-picking and focus on indexed mutual funds (that’s where 95% of my money is). This experience has only strengthened my conviction. I do hope to invest in individual stocks sometime in the future, but for now I’m going to concentrate on becoming better prepared and better educated so that I don’t make a mistake like this again!

Posted March 5, 2008 under Miscellaneous

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COMMENTS: Leave yours...

7million7years March 5th, 2008

Great advice!

Although, I would LOVE to play poker with you ... you have JJ and an Ace comes and you don't bet? I have a game this Thursday at my house ;) ...

J.D. Roth March 5th, 2008

Heh. I don't know much about poker. That's why they invite me to the game. :)

Actually, I was going to check my poker example to be sure it made sense before I submitted this to Ramit, but I forgot to do so. But I hope the point is clear: sometimes when playing poker, you want to chase a hand that you know is a statistical loser just because you've already bet a lot of money. This is dumb. It shouldn't matter how much you've already bet. What matters is your current expectations of winning.

JT March 5th, 2008

I'm a huge fan of your blog, J.D.....

But after all of the personal finance books that you've read, which I'm sure beat to death the idea of buying low-cost index funds, what exactly was going through your head when you decided to put your entire Roth contribution in 1 stock?

To me, (if you REALLY did that and aren't just making up the story for effect) that can't be a matter of becoming more educated and prepared - even the most financially irresponsible know better than to do something as compulsive as that.

Unfortunately, it's a major sign of a gambling addiction.... obviously I know nothing about your personality and no clue about whether or not you've had gambling troubles in the past, but I think it's at least worth it to get evaluated... http://www.addictionrecov.org/addicgam.htm

Davosian March 5th, 2008: I just came across a fun story that shows another way to fix mistakes. Enjoy: Master Card Weedidng

Tyler March 5th, 2008

It shouldn't matter how much you've already bet. What matters is your current expectations of winning.

Actually only partially true. What matters is your current expectation of winning the hand, AND the amount of money currently in the pot (ignoring for the moment metagame concerns like table image). What's really meant by "pot-committed" is that the amount of money in the pot is large enough compared to the remaining amount in your stack that you must continue the hand with any reasonable chance of winning.

Cap March 5th, 2008

Ouch. The Sharper Image buy is definitely a tough one. Reminds me what Ramit said about one of his first dabble in buying individual stocks.

I have to admit that I've done the same thing too, buying into some company that I expect to turn around (only to later receive the bankruptcy court papers in my mail box)... even though I've read many many books, and have heard many advice about the fallacy of purchasing individual stocks w/o due diligences.

I suppose I thought I'll know better, that I can keep on top of things.. but of course I didn't. I quickly forgot about the ~$1,000 investment and broke quite a few sweat when I saw the asset claims papers in the mail (and of course shareholders will get squat).

It was an expensive lesson. I guess I needed the personal experience to really teach me the lesson. Even though my other dart-throwing "investments" balanced out the 90% lost, it still opened my eyes quite a bit. Maybe some of us just need similar experiences to really nail some of the point to the head? *shrug*

J.D. Roth March 5th, 2008

JT, I really did that. As I said, 95% of my portfolio was in index funds already (now 99% thanks to SHRP tanking), so I thought, "Hey, I can play with this money." It was dumb. I know that now. I probably knew it then, but thought I could be smarter than everyone else. It was an expensive mistake, and I'm sorry to have paid so much to learn it. But now I get it. I get it. :(

Tyler, in my circle of friends, "pot committed" is just a term to goad your opponent into making a stupid bet. We're saying, "Look, you already have fifty cents in there, what's another fifty cents going to matter?" They love when I play with them, but I only do it once or twice a year!

aa March 5th, 2008: $500-1000 for emergency fund? No way...

Chris Mancini March 5th, 2008

Helpful read. Sometimes you need something like this to sit back and reanalyze your current spending and financial mistakes. My wife and I just selflessly found our 1.5 yr old puppy a new home just because we couldn't provide him the life and attention he needs right now, because of my full time work commitment and our two daughters (4 and 9 mos).

BTW, before you run and buy a stock, try your luck first at Motley Fool's Caps. I am ranked roughly 700 out of 46000 users. Its a lot of fun and well worth the time in exchange for the education.

Chris

joelmaxwell.com » Recovering From Financial Mistakes March 5th, 2008: [...] from Get Rich Slowly wrote an awesome guest post for Ramit today; check it out here. « [...]

The G March 6th, 2008: You just make my day ! Great advise. Exactly what Im experiencing right now. Still trying to pickup the bits and pieces.

Dan March 6th, 2008

I've always thought the suggestion was to have at least 2 months salary as a 'cash sink' so $500-$1000 seems a little on the low side. I always think that if the worst came to the worst and I lost my job (hopefully this wont happen!) and I found things difficult to get a job in my preferred local area, I'd want to be able to survive at least 4 months on that emergency fund. Obviously belts would be immediately tightened, but would still need to cover rent, food, bills (but not much else!), I think I could easily do that on 2 months salary stashed away.

Anyway great post, I was in a very similar position after my PhD and a couple of not terribly well paid jobs - mountains of debt, credit cards, overdrafts, loans. Debt free over a year now, savings in the bank and it feels good. Not enough cash yet to go near stocks and shares, and that's probably a good thing :)

J.D. Roth March 6th, 2008: Ah, good point, Dan. The $500-$1000 is a *starter* emergency fund. It's good for somebody who's still in school or just beginning to recover from debt. Once you're back on your feet, general consensus is to keep 3-6 months worth of expenses on hand.

Dennis March 6th, 2008: Great post. Starting is the hardest part of being financially smart. But once you get rolling it gets easier and even fun. Keep up the good work J.D.

Maria March 9th, 2008

In general I agree with Tyler.

I do not know much about the sunk-cost fallacy, but I do know something about sunk costs.

And what you should do is the following: If a project or an investment incurred costs that you are not able to get back in any way, these costs have to be regarded as sunk costs when making future decisions about this particular project/investment. That means you have to ignore the costs incurred in the future decisions involved in further actions with regard to this investment. You will have to reevaluate your prospects of gaining (weigh costs and benefits) as if you would start anew with that project, respectively from the point you are at now.

Jonathan March 10th, 2008

"Did you just blow a wad of cash on an Xbox 360 or some new clothes?"

Hey! I just bought a 360, lol. I like it though, and I've been putting off buying it for a half a year or so. I've earned it. :D

How to Recover from Financial Mistakes | Helpmepaymyloans.com -- Resources, statistics, information and news about student loans, general finance management and more March 17th, 2008: [...] get more tips on recovering from financial mistakes, read the I Will Teach You to be Rich article Don’t Panic! Recovering from Financial Mistakes and Setbacks. Bookmark to: Posted under Finance Management Tags: credit cards, financial [...]

Financial Lessons April 11th, 2008: Great advice! I think the most important point is education. The more you know and learn the better you will do financially. If you find good advice from other who have already been in your position and follow their lead then you will be much more successful in life.

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