Financial Services Blog

theory vs. practice

Common Financial Wisdom: Theory vs. Practice

In the financial world, there are a lot of rules about what you should be doing. In theory, they sound reasonable. But in practice, it may not be easy, or even possible, to follow them. Let’s look at some common financial maxims and why it can be hard to implement them.

Build an emergency fund worth three to six months of living expenses

Wisdom: Set aside at least three to six months worth of living expenses in an emergency savings account so your overall financial health doesn’t take a hit when an unexpected need arises.

Problem: While you’re trying to save, other needs–both emergencies and non-emergencies–come up that may prevent you from adding to your emergency fund and even cause you to dip into it, resulting in an even greater shortfall. Getting back on track might require many months or years of dedicated contributions, leading you to decrease or possibly stop your contributions to other important goals such as college, retirement, or a down payment on a house.

One solution: Don’t put your overall financial life completely on hold trying to hit the high end of the three to six months target. By all means create an emergency fund, but if after a year or two of diligent saving you’ve amassed only two or three months of reserves, consider that a good base and contribute to your long-term financial health instead, adding small amounts to your emergency fund when possible. Of course, it depends on your own situation. For example, if you’re a business owner in a volatile industry, you may need as much as a year’s worth of savings to carry you through uncertain times.

Start saving for retirement in your 20s

Wisdom: Start saving for retirement when you’re young because time is one of the best advantages when it comes to amassing a nest egg. This is the result of compounding, which is when your retirement contributions earn investment returns, and then those returns produce earnings themselves. Over time, the process can snowball.

Problem: How many 20-somethings have the financial wherewithal to save earnestly for retirement? Student debt is at record levels, and young adults typically need to budget for rent, food, transportation, monthly utilities, and cell phone bills, all while trying to contribute to an emergency fund and a down payment fund.

One solution: Track your monthly income and expenses on a regular basis to see where your money is going. Establish a budget and try to live within your means, or better yet below your means. Then focus on putting money aside in your workplace retirement plan. Start by contributing a small percentage of your pay, say 3%, to get into the retirement savings habit. Once you’ve adjusted to a lower take-home amount in your paycheck (you may not even notice the difference!), consider upping your contribution little by little, such as once a year or whenever you get a raise.

Start saving for college as soon as your child is born

Wisdom: Benjamin Franklin famously said there is nothing certain in life except death and taxes. To this, parents might add college costs that increase every year without fail, no matter what the overall economy is doing. As a result, new parents are often advised to start saving for college right away.

Problem: New parents often face many other financial burdens that come with having a baby; for example, increased medical expenses, baby-related costs, day-care costs, and a reduction in household income as a result of one parent possibly cutting back on work or leaving the workforce altogether.

One solution: Open a savings account and set up automatic monthly contributions in a small, manageable amount–for example, $25 or $50 per month–and add to it when you can. When grandparents and extended family ask what they can give your child for birthdays and holidays, you’ll have a suggestion.

Subtract your age from 100 to determine your stock percentage

Wisdom: Subtract your age from 100 to determine the percentage of your portfolio that should be in stocks. For example, a 45-year-old would have 55% of his or her portfolio in stocks, with the remainder in bonds and cash.

Problem: A one-size-fits-all rule may not be appropriate for everyone. On the one hand, today’s longer life expectancies make a case for holding even more stocks in your portfolio for their growth potential, and subtracting your age from, say, 120. On the other hand, considering the risks associated with stocks, some investors may not feel comfortable subtracting their age even from 80 to determine the percentage of stocks.

One solution: Focus on your own tolerance for risk while also being mindful of inflation. Consider looking at the historical performance of different asset classes. Can you sleep at night with the investments you’ve chosen? Your own peace of mind trumps any financial rule.

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