DR 089: 12 Keys to Making Smart Financial Decisions (#7 is a Doozy)

We face countless personal finance decisions every day. They range from the seemingly trivial (should we go out for dinner) to the more impactful (how much should we spend on a home). Yet each of these decisions works together over a lifetime to define our finances.

Over the course of running this blog since 2007 and the podcast since last year, readers have emailed me thousands of questions. These questions have covered topics as diverse as investing, credit scores, annuities, and taxes. The launch of the podcast last year has accelerated the email I receive. Now readers send in countless emails every week (and I respond to every last one of them).

While the questions are diverse, the principles underlying my approach to personal finance and investing are more unified. So today I'm going to walk through the 12 key principles I consider when making personal finance decisions. I hope it helps you make better decisions, too.

Podcast of this Article

1. Think Long Term: In a world that prizes ease and speed (think get rich quick scams), thinking long term as we make financial decisions is critical for building lasting wealth. It puts into perspective everything from the $4 latte at Starbucks (I’m drinking one now) to whether we should invest in our employer’s 401k to how much we should pay for a home.

For example, thinking long term helps us realize that--

• A daily $4 latte ads up to $21,056 over 10 years using the Rule of 752 (hat tip to Mr. Money Mustache)
• Investing $1,000 a month beginning at 25 instead of 35 yields $1.75 million more when we retire at 65
• Paying the minimum payment on a $5,000 credit card debt charging us 15% will take us 27.5 years to pay off at a total cost of $12,517.52

2. Finance Your Lifestyle with Cash not Credit: Credit card debt sucks the life force out of your very being. Don’t finance a lifestyle on credit. That means paying cash for everything from groceries to vacations to cars. Make the sacrifices you need to make to pay cash. If a decision you are considering might require you to finance your lifestyle, think again.

Note, it's fine to charge expenses to a rewards credit card, so long as you pay it off in full each month.

3. Save a Dime of Every Dollar: It’s as simple as it is powerful. Make it a habit, starting right now, to save at least 10% of your gross pay. Or become a super saver by saving 20% or more. If you doubt the power of this simple step, reach The Richest Man in Babylon.

And reconsider any decision that might put this goal in jeopardy.

4. Always be Honest (particularly with yourself): It's amazing how we can talk ourselves into some really bad financial decisions. Whether it's borrowing from our 401k because we will be paying ourselves the interest or buying furniture we don't need because of zero interest financing, we can deceive ourselves into financial trouble. Be brutally honest with yourself and the motivations behind your decisions. If necessary, get a second opinion from a friend or family member who you know is good with money.

5. Keep Fees Low: Whether the fees are for investments, banking, credit cards, are other financial products, lower cost options generally outperform more expensive options. Keeping fees low is absolutely critical when it comes to investing. That’s one of the reasons the core of my portfolio is in low-cost index mutual funds and ETFs. But fees also matter on all financial products. That’s one of the reasons I maintain pages on this site for free checking accounts, free or low cost prepaid cards, and discount online brokers.

6. Keep it Simple: The more complex a "solution," the less likely it is to be the best option. In most situations, term life insurance is better than complicated permanent life insurance products. Index funds generally are preferred to more complicated actively managed funds. Simply investing in funds or ETFs is most often preferred to complicated insurance products that include an investment component. All other things being equal, simple is usually best.

7. Embrace Uncertainty: This one may surprise you. We are built to shun uncertainty. It's the fear of the unknown that keeps a lot of people out of the stock market. Uncertainty fuels the insurance industry, particularly when it comes to cash value life insurance and annuities. The problem is that it costs us a lot of money to protect against all of these uncertainties. While some of this protection is unavoidable (think car insurance or term life insurance), we should think twice before spending a lot of money in return for guarantees.

This concept is particularly important when evaluating annuities. While annuities have their place in some financial plans, the come at a high cost. In addition to the fees associated with these products, they also limit our upside. Yes, we get a guaranteed stream of payments, but at a high cost. The key is to think twice before spending a lot to avoid uncertainty. Embracing the unknown has its rewards.

8. Don't Be Greedy: You know the feeling. A friend has a hot stock tip that can't lose. Yet in the back of your mind a concern arises that perhaps this is just too good to be true. It usually is. We need to understand and monitor our own emotions when it comes to money. If we are often tempted by the get rich quick mentality, we should think twice before acting. These deals often end badly.

9. Embrace the Power of Compounding: Whether is the compounding of investment returns or the snowball of high interest debt, we need to understand the power of compounding. Once understood, we can then evaluate financial decisions to determine if they take advantage of or ignore compounding. That is to say, we need to be investing today and paying off debt (starting with high interest debt).

10. Think Outside the Box: So often we view financial decisions in black and white. Whether it's the view that an emergency fund must always be in cash at an FDIC-insured bank or that we should always pay off all non-mortgage debt before investing, these dogmatic approaches to personal finance are often not in our best interest. Before making a financial decision, consider all of the options and weigh the pros and cons of each.

11. Do Important Things First: From how you spend each day to making big financial decisions, don't put off the important tasks. Each day understand what you want to accomplish and get the important stuff down first. When it comes to finances, don't put off critical action items such as having life insurance, preparing a will, or investing for retirement. Do the important things first, and the rest will fall into place.

12. Take Responsibility: In the past few years, we have been bombarded by politicians who want to convince us we are victims. Whether they tell us the “system” is rigged or point the finger at Wall Street and corporate America, the result is the same--we feel helpless. It’s all nonsense designed more to score political points than to move the country forward. Don’t play the victim.

Take responsibility for your decisions and your situation. Of course, things happen that are out of our control. But what is never out of our control is how we respond to them. Taking responsibility builds perseverance and creativity, and it puts us in the right frame of mind to succeed.