Financial Foolishness

Good article in a recent edition of the Journal.

Seven Wonders of Financial Foolishness
November 12, 2006

We may not agree on what investors should do. But I think we can agree on what they shouldn't do.

Take a look below, where I have listed seven common financial gaffes, some big, some small. No doubt a few insurance agents, credit-card executives and Wall Street brokers will quibble with my list. But I think the rest of us can agree that these are seven truly foolish mistakes.

1 Missing the match

Vanguard Group, the Malvern, Pa., mutual-fund company, recently released a report analyzing the 401(k) and other "defined contribution" plans it oversees. One finding: 36% of eligible employees haven't signed up.

That is a horrifying statistic. It isn't simply that these folks may not be saving any money for retirement and they are missing out on both a tax deduction and tax-deferred growth.

To make matters worse, these employees are likely passing up free money. Many 401(k)s match employee contributions at a rate of, say, 50 cents on the $1. If you don't put in your $1, you don't get the free 50 cents from your employer.

2 Rolling the dice

Even if you participate in your employer's retirement plan, you could still mess up royally, by making bad investment choices.

Indeed, many employees make the most elementary mistake, which is failing to diversify. Vanguard found that 13% of 401(k) participants have everything in bonds and money-market funds and another 19% have everything in stocks.

Moreover, in plans that currently offer company stock as an investment option, an astonishing 15% of employees invest more than 80% of their account in their company's shares. Betting that much on a single company is absurdly risky, especially so when you're relying on the same company for a paycheck.

3 Paying the penalty

With retirement accounts, there's a third crucial mistake: Cashing out the account before age 59½. That not only takes a big chunk out of your nest egg, but also it triggers income taxes and usually a tax penalty as well.

Yet many folks make this error when they leave their employer. Vanguard calculates that, at that juncture, 29% of 401(k) plan participants take part or all of their account balance as a lump sum, rather than leaving the money in their old employer's plan or rolling it over to another tax-deferred account.

To be sure, some people taking the lump sum may end up investing the money. But the odds are, the money gets spent, a heap of taxes gets paid -- and their retirement is suddenly much further away.

4 Taxing yourself

Paying unnecessary taxes is bad news. But you also don't want to end up paying no taxes at all.

Suppose you're out of work for a long spell or you just retired at age 60, and you are living off money in your savings account. Because you don't have a paycheck coming in, it's entirely possible that you will owe little or nothing in taxes.

That might sound appealing. But in truth, it isn't smart money management, especially if you figure you will be in a higher tax bracket once you start working again or once you begin drawing down your retirement accounts and collecting Social Security.

Let's say you are married and you file a joint tax return. If you take the standard deduction and one personal exemption each, you could have $16,900 in income and pay no federal taxes. The next $15,100 of income, which would bring your total income to $32,000, would be taxed at just 10%. In fact, you could have total income of $78,200 and still be in the 15% income-tax bracket.

My advice: If you expect to be in the 25% or higher tax bracket once you return to work or once you start tapping your retirement accounts, you might want to take advantage of your low tax bracket today by, say, selling stocks with capital gains or by converting part of your individual retirement account to a Roth IRA.

5 Insuring the affordable

Prudent folks purchase insurance to cover disasters so potentially devastating that they couldn't possibly afford the financial hit without major hardship.

What if people aren't so prudent? Consider trip-cancellation insurance and extended warranties. Sure, if you have to bag the trip to Europe or if your television goes into meltdown, it will cost you some money and it won't be pleasant. But it is hardly a financial disaster.

Similarly, there is no point in having low deductibles on your auto and homeowner's policies. If you put a $700 ding in your car, you can probably cover the cost fairly easily out of your own pocket, so there really isn't much point in paying an insurer to shoulder this risk.

The same thinking applies to insurance on your children's lives. The principal reason for buying life insurance is to ensure your family isn't left financially destitute when one member dies.

Yes, if a child dies, it is a terrible loss. But it isn't a terrible financial loss, so there's no reason to have insurance on a child's life.

6 Carrying a balance

According to the Federal Reserve, the average interest rate levied on credit-card accounts is closing in on 15%. That's a steep price to pay, particularly given that credit-card interest isn't tax-deductible.

Conceivably, you might carry a credit-card balance if paying down your cards meant you wouldn't have the money to fund a 401(k) with an employer match. But otherwise, carrying a credit-card balance is financial lunacy, and you should do everything possible to get your cards paid off.

7 Locking yourself in

If you and your spouse are age 65, there is a decent chance that one of you will live until age 90. That means you need to think like long-term investors, including continuing to keep a healthy portion of your portfolio in stocks.

But that doesn't mean you should buy investments with long surrender charges, which is often the case with tax-deferred variable annuities, mutual-fund B shares and equity-indexed annuities. After all, you are tapping your portfolio for income and you need the flexibility to sell at any time without paying hefty commissions.

Got a salesman trying to sell you a product with a back-end sales charge? Just say no.