There are several often repeated misunderstandings I see when it comes to managing your finances. Below are the top five, in no particular order:
Money misunderstanding number one: Miscalculation of tax rates
This is far more common than it should be. If someone is in the 30% tax bracket for example, they often think that all their income is taxed at 30%.
But New Zealand has gradual tax rates where the percentage you get taxed increases as your income increases. For example, if you earn $65,000, then your income is taxed as follows:
0-$14,000 @ 10.5% = $1,470
Over $14,000 to $48,000 @ 17.5% = $5,950
Over $48,000 to $70,000 @ 30% = $5,100
Total tax of $12,520, or 19.3%, in this example. Nowhere near the commonly misunderstood amount of 30%.
Another situation I see tax calculations misused is when someone has a second job. A lot of people believe there is a special tax rate (higher than normal rates) for second jobs. Again, this is not the case.
All that matters is your total income. For example, if you are paid $50,000 from your day job and $15,000 from your second job, you will be taxed exactly the same as someone who earns $65,000.
Money misunderstanding number two: Renting is dead money
Rent expense pays for a roof over your head. Much like a mortgage does. The only part of home ownership that doesn’t cost is the mortgage principal, which is very little in the early stages of a mortgage by the way. Outside of principal, there are many costs to home ownership too, which if you are considering rent as dead money, you should also consider as dead money as part of home ownership. These costs include, but are not limited to:
Mortgage interest
Home insurance
Rates
Repairs and maintenance
Purchase costs
Sales costs
Opportunity cost of not being able to use your house deposit money elsewhere
Furnishings
Using my first apartment as an example, all housing costs (not including mortgage principal) over 10 years of ownership costing $293,000.
Mortgage interest $171,000
Furnishings $20,000
Body corp fees $30,000
Rates $16,000
Repairs and maintenance $20,000
Cost of not using $60,000 deposit in savings $20,000
Sales costs $16,000
Total 10 year cost of home ownership $293,000
These are costs that added no value to the property. They are the costs for the privilege of owning the apartment.
If I rented over that same 10 year period I would have spent about $104,000. Almost $190,000 less renting.
This shows a huge reliance on capital gains of home ownership. It’s been great for the last 20 years, but I have serious doubts it will continue.
As long as you can be disciplined with the extra money you may have renting, then it is not as bad an option as many make out. Home ownership is ideal for most looking for a place to settle for 15 years plus, as the costs of home ownership have had more time to be spread, but renting is far from dead money. In fact, it can often be the smart choice.
Money misunderstanding number three: Income equals wealth
High income does not equal wealth.
Income doesn’t matter if you spend it all. What you do with your income matters.
Someone earning $200,000 a year with annual expenses of $180,000 is worse off than someone earning $60,000 a year with expenses of $40,000, even though they are both saving $20,000. Person A has a savings rate of 10%, whereas person B has a savings rate of 33%.
Savings rate has a huge significance on our ability to attain financial freedom. The higher the percentage, the quicker we can reach financial independence.
Sure, a higher income helps. But only if you don’t increase your expenses with your newly found income. It is not uncommon for us to increase our spending as we earn more. We buy nicer houses. We travel more. We generally splash out more. This is referred to as lifestyle inflation.
Just because you don’t earn as much as someone else, it doesn’t mean you can’t be wealthy. It just means you have to try and stop looking rich, and start acting rich.
Money misunderstanding number four: Index fund returns are only average
The argument I often hear from active fund supporters are that “index funds are just average”. “If you want to be better than average you need to pick stocks within the index”. “Index funds are boring”.
It sounds great on the surface. I mean, who doesn’t want to be better than average? Here’s the kicker though – index funds are better than average. Yes, they may be the average of all companies in the index, BUT the results of the index are generally better than that of individual stock pickers over the long term. Countless studies have shown this.
In any given year, plenty of people can pick companies that will outperform the market. Over two years, fewer people will be able to outperform the index. Five years, and even fewer people can outperform the index. Extend this out to 20 years plus, and most people who pick individual stocks have performed worse than the index. Each year that passes, more and more people get overtaken by the index.
Sure, there will be a small percentage of people that do better than the index over the long term. No offence, but the chances of you being one of those people is slim to none. Maybe over the short term, but not 20 plus years.
Low cost index investing could not be easier, so if you are scared to enter the market this is a great start. Some active investors may try to make you feel bad by saying things like “index investing is only for beginners”, or “index investing are only average returns”. The fact is, index investing is not just for beginners and the returns are clearly better than average. Even many active managers now use index investing, so be careful you are not paying a professional to do something that you can easily do yourself at a much lower cost.
It appears the pros have decided, if you can’t beat ‘em, join ‘em.
Money misunderstancing number five: Investment returns are hugely important
I often see new investors chasing returns from their investments, either taking on more risk than they are comfortable with, or not getting good returns for the level of risk they are taking on.
I think there is too much focus on returns.
How much someone ends up with in their investment accounts is a combination of two things:
1/. Investment returns
2/. How much money you invest
If you are starting off, then far and away the most important thing is how much you invest. Not the returns.
In the grand scheme of things, returns don’t matter as much until your account balances grow much higher or as you are approaching retirement.
Let’s illustrate with an example.
Helen is 25 years old. She is investing $500 a month into a well-diversified portfolio and is earning returns of 4% (after fees and tax).
4% investment returns over 10 years
After 10 years of investing she has contributed $60,000 of her own money, and received $14,918 in investment returns. 80% has come from Helen’s own pocket.
Let’s increase the returns to 5% and see what happens:
5% investment returns over 10 years
$19,241 in investment returns now. But still, 76% has come from Helen despite a 1% better return! Doesn’t seem like much.
In fact, the extra $4,323 in returns received over the 10 year period could have just as easily been achieved by investing an extra $29 per month.
So instead of chasing an extra 1% return, could it be easier to find an extra $29 a month? One less coffee a week? Two less lunches out a month? Shop around for a cheaper internet or phone deal?
The point is, I find there is far too much focus on returns at the wrong end of the investment timeline.
Returns are extremely important when your investment balance grows.
The best thing you can do as a new investor is to focus on ways to increase your own contributions, and not rely on returns, nor be scared of poor returns.
If you have a bad year in the markets, then it is just a tiny blip in the scheme of things. Make it up by cutting back some costs and investing more.
You will make a far greater impact on your portfolio by increasing your input, than you will by trying to get a slightly better return.
Or even better, do both.
***** Any common misunderstandings that you have experienced or heard? *****
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here