"Heuristic" is a fancy word used by behavioral finance experts to describe "rules of thumb" that people use to simplify financial decisions. In other words, "mental shortcuts," perceptions, pre-conceived notions, or biases that influence the way we handle money. Because there is so much financial information available today and so little time available to process it, everybody is looking for easy ways to make decisions. Unfortunately, heuristics can sometimes lead to poor results or cause people to overlook attractive investment opportunities. Below are six common examples:
"All Investments Are Expensive"--Many people use this statement as an excuse not to invest. It is simply not true. You do not need a last name like "Gates" or "Buffet" in order to start investing. Many investments can be purchased for $500 or less. The best place to start is with an employer savings plan (e.g., 401(k) plan or credit union). Your deposit comes right out of your paycheck and the minimum required investment is generally low (e.g., 1% of pay or $10 per pay period). Another low-cost investment is mutual funds. Some fund families require an initial deposit of only $250. Even if investment firms require more, minimum deposits are often reduced for retirement accounts.
"Stocks Are Too Risky"--Many people must believe this heuristic because only half of U.S. households invest in stocks, either directly or through mutual funds and retirement plans. An investor's real risk is NOT having any stock exposure. This is because history tells us that in time periods of ten years or longer, stocks outperform all other asset classes. On the other hand, if you keep all of your money in cash, say a CD earning 4.5%, you will actually lose purchasing power after taxes and inflation (e.g., 4.5% minus 1.3% in the 28% tax bracket minus 3.2% inflation).
"All Banks Charge High Fees"--Many people believe this one also because research indicates that between 15 to 20% of U.S. households do not have a bank account. Yes, it is true that bank fees (e.g., stop payment, insufficient funds) have risen sharply in the last two decades. And, yes, practices like clearing the largest of a batch of checks first so that more checks will bounce at $25 or $29 a pop have become more commonplace also. What many people don't realize, however, is that there are different bank accounts for people with different needs. An example is the New Jersey consumer checking account. Required by law, these accounts are available at all banks. Eight checks can be written per month, with a cost of 50 cents for each additional check. Consumer checking costs $3 monthly and allows balances to drop as low as $1.
"U.S. Savings Bonds Are A Poor Investment"--There was a time, in the 1980s, when this statement was probably true. Then the U.S. government overhauled its savings bond program. Series EE bonds, which require only $25 to purchase, earn 90% of the average 5-year Treasury note yield for the preceding six months. The current rate in effect through October 2001 is 4.50%. Series I bonds, which are inflation-adjusted, currently pay 5.92% through October and require a minimum of $50.
"Buying a Home is Always Better than Renting"--Not necessarily. If an individual or family's future plans are uncertain, or their job stability is questionable, renting may be a better option. Another time when renting is a good strategy is when you are retiring to a new location. You might want to live there a while and really check it out first before committing to purchase a home.
"Credit Cards Are Bad"--Again, not necessarily. "Good debt" is borrowing for things you need but can't afford out-of-pocket or to improve your income (e.g., college) or net worth (e.g., home improvements). "Bad debt" is paying finance charges for consumption and depreciating items (e.g., vacations, clothing, meals). Credit cards with "perks" (e.g., frequent flyer miles, discounts) can be especially attractive if you pay your bill in full each month. On the other hand, if you carry a balance and pay interest, the costs often exceed the benefits.