How to Avoid Making Dumb Money Mistakes: A Five-Step Plan

Even smart people can be dumb about money. Here's how to avoid making money mistakes.
Even smart people can be dumb about money. Here's how to avoid making money mistakes.

It's not hard to find financial illiterates, even among those with college educations. Many people find themselves buying fashionable goodies they don't really need on credit -- and forgetting to save for retirement. How can people avoid these dumb money mistakes?

Financial adviser Bill Losey, who is based in suburban Wilton, N.Y., has a five-point plan for dealing with them. He learned it the hard way: He made many of the same mistakes himself. After he had dug himself out of a hole, he realized that he might be able to use his newfound knowledge to help others.

Here are the five things Losey says you need to do to break those tragic bad-money habits.

1. Make a budget: Most people, even rich people, live without a budget. But don't fret: You don't need a ledger or spreadsheet program to create a budget that works. Simply draw a line down a sheet of paper. On the left side, write down all the money that comes in; on the right, all the money that goes out. "It will show you how much money you are spending on essential items and how much of your income you are actually assigning to frivolous expenses," Losey says. Many of his clients find that they're frittering away between $200 and $800 a month on stuff they don't really need. Once you have found the miscreant bucks, you can use them to pay down debt, pay off your mortgage or save for retirement.

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2. Distinguish between needs and desires: Do you really need that iPad 2 or do you just want it? "Do you understand that by borrowing money, you are actually spending away your future earnings?" Losey asks. These decisions can be difficult because emotions get in the way, fed by slick advertising.

3. Understand the difference between good and bad debt: Bad debt is debt incurred on goods that are going to depreciate in value. It's a debt on something that has no potential to make money. Good debts, on the other hand, are debts that can potentially create value, such as a mortgage, a business loan or a student loan. Of course, just because a mortgage is a good debt doesn't mean that you should take out the largest possible loan -- that also can get you in trouble. But this rule does mean that just about everything you buy on your credit card is a bad debt. Use your plastic for the miles and rewards, but pay off the balance due every month.

4. Educate yourself financially: Many people are convinced they are never going to be able to build wealth, and the root cause of this conviction is a lack of education, Losey says. "We live in a society of financially illiterate people," he says. "You have to educate yourself, because in school nobody teaches you how to manage your money." Losey's not talking about taking a course. Instead, he recommends immersing yourself in financial books and magazines. And you can't just read one book, no matter how good Suze Orman is. Things are changing so fast that you have to keep up with the latest developments. Pop quiz: Do you know the difference between an ETF and an ETN?

5. Set financial goals and take them seriously: When people educate themselves about money, they start to see how the financial world really works and they start to explore their own financial potential. Have a conversation with your spouse or a financial advisor to figure out how much money to save and what to do with it. Should you save to buy a house or put money aside for retirement? What about your children's college expenses? Losey receommends the 1% rule: Save 1% of your salary and take one third of any raises and add that to the pot. He says its best to save for multiple goals, but if you're forced to make a choice, save for retirement before a college education. "You can always finance a college degree but you can't finance retirement," Losey says.