People evaluate information through social interaction with others.
There’s an old saying that you can be judged by the friends you keep. But do your friends also affect your wealth?
Ever notice how a group of people who spend time together, whether in a social group or work environment, tend to develop similar tastes, interests, and lifestyles? The reason is that people evaluate information through social interaction with others. This is especially true for topics you may consider to be difficult. Many people consider financial decision-making to be hard. Should I contribute to my retirement plan at work? How much should I contribute? What should I invest in?
The answers to these questions should depend on your own situation. Your age, level of wealth, income, and aversion to taking risks are important characteristics to consider when making financial decisions. Yet we often abandon these characteristics in favor of doing what our friends and colleagues are doing. That is, our beliefs about the importance of contributing to a pension plan, owning stocks, or buying a house are often more influenced by the beliefs and choices of others, and less by our own needs.
There are several basic rules about your financial decisions that will enhance your long-term wealth. Financial advisors, experts, and academics alike advocate these ideas. Anyone who has some interest in financial matters has probably read about them. Yet many people do not follow these simple rules and set themselves up for great disappointment. Consider these important rules:
Contribute to your 401(k) plan. Indeed, contribute the most money that is allowed by law. If you cannot afford to maximize your contribution now, then slowly increase your contributions each time you receive a raise. Even though this advice has been given for two decades, one third of the people eligible to contribute do not. Most of those who do contribute do so at very minimum levels.
Diversify your investments. Do not put all your eggs into one basket. Your portfolio should consist of a mix of stocks, bonds, and cash. If your retirement plan has choices for real estate or commodities (such as gold), then own some of them too. Many people are not well diversified. About º of 401(k) participants hold no stock investments. Another º hold more than 80 percent of their portfolio in stock investments. That makes half of these employees under-diversified. Consider the sad effect of under-diversification on Enron employees. Even though their 401(k) plan offered 18 different choices, 62 percent of the assets were invested in the companyís stock. When Enronís stock price fell 99 percent in a matter of months, employees lost more than one billion dollars in retirement funds.
Invest for the long-term. It is better to have a long-term focus in your investing. This does not mean that you should never sell an investment. It is good to periodically monitor and update your portfolio. The most important long-term decision is how to allocate your assets among stocks, bonds, and cash. In the long run, your overall return is driven more by how much money you put in stocks, not by which stocks you buy. Many investors spend too much time on stock selection and not enough on asset allocation.
Do you follow these basic financial rules? A common reason for not following through on these rules has to do with the beliefs of your friends. What they believe about these topics influences your beliefs and decisions. Make financial decisions based on what is best for you. At stake are your retirement income and your wealth. You are the one who is affected by your decisionsómake sure they are good ones. In fact, it may even be time to start influencing your social groupís beliefs. After all, thatís what friends are for!
John Nofsinger is a Washington
State University finance professor and author of Infectious Greed
(Financial Times/Prentice Hall 2003). You can reach him at