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7 steps to get your finances back on track

By Cybele Weisser, senior editorApril 9, 2010: 2:07 PM ET

(Money Magazine) -- Finally, the Great Recession seems to be fading into the distance. The economy grew at a robust 5.9% in the last quarter of 2009. The stock market, while no longer on a tear, is still up about 70% over the past year. And the Fed recently raised its short-term lending rate to banks, a signal that Ben Bernanke & Co. think the financial system is on the mend.

But if you're feeling like your own fiscal recovery is still pretty far off, you're not alone. In February consumer confidence took a tumble: By one gauge, consumers' assessment of current conditions, it was at its lowest level since 1983.

Meanwhile, a recent poll by Harris Interactive found that half of Americans don't expect their financial situation to improve in the next six months, and 30% expect it to worsen -- about the same number who felt that way a full year ago.

"People are still very spooked," says Columbus, Ohio, financial planner Jill Gianola.

Granted, you've got reason to remain rattled by the events of the past few years. Your job may still feel anything but secure; your home equity isn't the financial cushion it used to be; and your 401(k) statements, while less painful to open, show balances far lower than where you thought you'd be at this point.

But the way your brain is hard-wired is compounding the problem. That's because, as numerous studies by behavioral finance experts show, you are naturally programmed to view things as worse than they really are -- and that perspective can prevent you from taking the actions needed to get your finances back on track.

To take control of your money in these still tough times, you have to figure out how to conquer the emotions that hinder you from making the smartest decisions and devise a concrete action plan to help you achieve your goals. Below are seven ways to do just that.

1. Get in touch with a better reality

The worry: The broad consensus among economists is that the recession ended in the middle of 2009. Yet in a February survey by Gallup, about half of Americans said they thought the economy was getting worse, only slightly less than the number who felt that way six months earlier.

Why the disconnect? Put part of the blame on a psychological phenomenon finance experts call "recency bias" -- the tendency to believe that what happens in the future will look a lot like what happened in the recent past. Today two straight years of bad economic news is coloring your take on the economy, leading you to gloss over positive news and focus on the gloomier headlines you see.

Plus, because of the complex way our brains comprehend risk, it takes far more good news to build our confidence than it takes bad news to destroy it, notes University of Oregon professor Paul Slovic.

In one study on risk perception, Slovic showed people fake headlines, some reassuring and some dire, about a nuclear power plant near their home. The good headlines only raised the subjects' trust in the power plant slightly, but the bad headlines had a huge negative impact. "In the past few years we've seen a lot of things that caused us to lose faith in institutions that we'd like to be able to trust," Slovic says. "These feelings tend to override our ability to analyze things in a logical way."

The fix: Don't fret about what the economy will do next; it's a loser's game. Instead, calm your anxiety by making sure you're covered if bad stuff does happen.

Boost your emergency fund.

Already got three to six months of living expenses in the bank? With long-term unemployment at a record high, many planners now suggest setting aside a year's worth of income, especially if you work in a troubled industry like autos or real estate.

Tap the power of a Roth.

What if you're hard-pressed to come up with the extra cash? Redirect a portion of the money you're saving for retirement. Put only enough in your 401(k) to get the full company match; put the rest into a short-term bond fund in a Roth IRA. Unlike a 401(k), contributions to a Roth can be tapped without penalty in an emergency because you've already paid taxes on that money. But earnings withdrawn from a Roth before age 59½ will typically be taxed and hit with a 10% penalty.

Cut out big-ticket money drains.

Like many families these days, you've probably already reined in spending. But the cutbacks people tend to make -- eating out a little less, say, or vacationing closer to home -- probably wouldn't make that big a difference to your financial stability if you were to lose your job.

So identify major expenses you could cut if your income were to take a big dip -- Do you need that second car? Is private school really necessary? -- since many laid-off workers who have found a new job lately have had to take drastic pay cuts (as have staffers at some downtrodden companies).

"Some of my clients are doing the same work for 15% less than a couple of years ago," notes Atlanta financial planner Mary Claire Allvine.

What if you go to all these measures and nothing bad happens? Hey, having some extra savings never hurt.

2. Work on your plan b

The worry: In a recent Gallup poll, three out of 10 Americans named unemployment as the biggest problem facing the country, the highest number since 1983. Having a big cash cushion will help tide you over if you're laid off, alleviating one source of anxiety. But you'll still have to find another position, and that feels like an especially tough task lately: The latest consumer confidence survey found that nearly half of all Americans now believe jobs are hard to get.

The fix: Act as if you're already job hunting.

Do a hard-nosed assessment of the danger.

Be brutally honest with yourself: Are fewer high-profile projects coming your way? Has it been a while since your boss asked for your advice? The answers to these questions may reassure you -- or spur you to get your résumé in order and reach out to a few headhunters, ASAP.

Expand your network -- before you need to.

A survey by the job-search site ExecuNet found that 73% of six-figure earners had landed their current position through personal contacts. But, says Herminia Ibarra, a professor of organizational behavior at the international business school INSEAD: "Most people are lousy at networking. They feel like they're trying to manipulate and put on a show."

Building relationships now, not after your job is already shaky, will help get rid of the awkwardness. Notes Ibarra: "Networking is easier if you aren't thinking the whole time, Can this person get me a job?"

Make it a priority to engage in a networking activity once a week. Go to an industry event; join a task force at your company; drop a friendly e-mail to an old colleague who now works for a competitor. And diversify your network, which will help you explore opportunities you may not have considered, says Ibarra. So sign up for that softball league and look for like-minded peers on a social networking site like Ning, which connects people based on common interests.

Plot a career change, just in case.

Most people wildly underestimate how long it takes to make a drastic switch, says Ibarra. Brainstorm now about what your next act might be. Is there a healthier industry in which your job skills and experience would be applicable, a career path you've long fantasized about pursuing? Then try to put together a mental game plan about how you would pursue that second career, if need be -- for example, what course you would take to beef up your skills in a new area, or who you would call for an informational interview.

3. Focus on the first step

The worry: Thinking about all you should do to shore up your finances (make up for lost ground in retirement savings, expand your network, stuff cash into your emergency fund) is dizzying. Watch out -- puting too much on your plate at once is often a recipe for spinning your wheels.

The fix: Break the goal down into smaller tasks, which betters the odds you'll stick to it ("I'll exercise for 15 minutes twice a week" vs. "I want to lose 20 pounds").


"Save more" is a tough goal if you rely on willpower alone. Take the thinking out of the process by arranging to have an extra $100 a month automatically deducted from your checking account or paycheck and funneled into your IRA or savings account.

Pick one expense to cut.

That's more effective than simply vowing to chop your monthly spending by 20%.

Tell a friend.

Research shows you make better progress toward your goals if you feel you're being held accountable. So let family and friends know your plans. Or make a "commitment contract" on Stickk.com, which forces you to cough up cold hard cash if you fail to meet your goal.

4. Don't be guided by fear

The worry: As stocks and home values declined by double digits, investors poured money into cash investments: The amount Americans held in savings accounts and money-market funds increased 18% between October 2007 and March 2009, according to the Leuthold Group.

In fact, fear of losing money is one of the greatest drivers of money decisions, according to behavioral finance experts. Research shows that when faced with choices that involve a certain amount of risk, we overwhelmingly choose small, certain gains over potentially larger but uncertain ones. Adds economist Tyler Cowen: "The idea of any loss at all matters more than the size of the loss."

Right now, the instinct to avert losses may be causing you to select overly conservative investments that can leave you even further behind in your goals.

A recent T. Rowe Price study compared two investors who had $10,000 in stocks at the end of 2006, and added $100 a month to their accounts over the next three years. The first investor avoided the worst of the market crash by selling his equity holdings in September 2008 and moving his portfolio and subsequent contributions into cash. The second investor stuck with stocks throughout the downturn. While he had lost considerably more than Investor No. 1 at the market's low point a year ago, by February of this year Investor No. 2 was in the lead, some $2,000 ahead of his skittish pal.

The fix: Being conservative is okay, but do it smarter.

Ratchet down your equity holdings.

Done right, this approach may not reduce your long-term returns much. A portfolio invested 70% in large U.S. stocks and 30% in bonds and one invested 60/40 have both averaged gains of 11.1% a year over the past 30 years, says Ibbotson Associates; but the 60/40 mix had far fewer dramatic losses in the down years. The key to keeping returns relatively robust is to put the nonequity portion of your holdings mostly in bonds rather than cash.

Get income you can rely on.

For older investors, creating a steady income stream is the key to staying calm during tough times, says Houston financial planner Tom Jackson. Research has shown that retirees who have a reliable income source (such as a pension) are happier than those who don't, even if the amount of money they have to live on is the same. No pension? An immediate annuity can serve the same function.

5. Put down the mouse (and the remote)

The worry: When the stock market was on a tear last year, checking your 401(k) balance every week (or day) seemed like a harmless pastime. Trouble is, the inevitable fear of losing money that results from watching the constant ups and downs of the market can lead you to make some less-than-ideal moves with your money.

Economist Richard Thaler, along with psychologists Amos Tversky, Daniel Kahneman, and Alan Schwartz, studied the behavior of a group of investors who looked at a hypothetical portfolio monthly vs. those who checked just once a year. At the end of the experiment, the investors were asked to make a final permanent portfolio allocation. The monthly checkers moved a large portion of their money into low-risk fixed-income funds; those who didn't watch the market regularly were far more likely to stick with stocks.

The fix: Set limits on monitoring your portfolio.

Do quarterly checkups.

That, along with an annual re-balancing of your portfolio, is all you need, says planner Allvine. Checking more often just amps up your anxiety.

Force yourself to take a breather.

Check your portfolio after the markets have closed for the day and tell yourself you'll reconsider in the morning, suggests planner Gianola. Or erase the saved passwords to your brokerage accounts on your computer and put those passwords in a separate room in the house from your office area. You'll be far less tempted to switch up your investment mix frequently if it takes some effort to actually make the move.

6. Stop keeping score

The worry: One reason you may be feeling so lousy about your money these days is that you're measuring your progress against a goal you created when the financial markets were at the peak of the last boom, says behavioral finance expert George Loewenstein.

It's a common phenomenon known as "anchoring," in which we create a standard against an arbitrary number. If, say, your 401(k) balance was $250,000 two years ago, you may have in your head that the "right" number for your 401(k) today should be higher, and feel disappointed that you don't have more even if the investments in your plan returned 30% last year.

The fix: Learn creative mental accounting.

Rethink the buckets that you put money in.

Behavioral economists have found that we tend to think of money differently depending on its origin or our intention for its use. Most of us tend to place "found" money, such as a tax return or a bonus, in a separate category from our regular income and see it as cash that can be frittered away.

Conversely, we're less likely to spend money that must be pulled from a savings account, even one with no withdrawal penalties. So if you get a $5,000 tax return, tell yourself it's your annual raise, not a windfall -- and then use the money to bump up your Roth contributions.

Similarly, before you drop a few hundred on a fancy new espresso maker, ask yourself: If I had to withdraw this money from my son's college fund, would I still spend the dough?

7. Simplify your financial life

The worry: If you feel like it's tougher than ever to manage your finances, well, that's because it is. "People are expected to take more responsibility for their finances, and they're increasingly complicated," says Davenport, Iowa, financial planner Eric Kies.

But research shows that trying to stay on top of too many details can impair your ability to make sound financial decisions. In one University of Minnesota experiment, two groups of students were told to write an essay on any topic; one group was also instructed not to think about a white bear. Afterward, each student got $10 and was told he could take it home or spend it at a nearby store. The students who were trying not to think about the white bear far outspent those given the less mentally taxing task.

The fix: Get rid of financial overlap.

Pare down on plastic.

You don't need 14 credit cards -- two to four will do. Holding fewer cards also reduces the chances you'll miss a payment and get hit with a hefty late fee.

Consolidate your accounts.

Roll old 401(k)s into a single IRA, and keep your investment accounts with a single brokerage. Getting one statement will make it easier to keep track of your assets and get a snapshot of your financial life. Maybe you'll find out you're doing better than you think.