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Stick with your financial diet

By Carolyn Bigda, Money Magazine

(Money Magazine) -- If there's one thing to thank this miserable recession for, it's that a lot of us are now much more thoughtful about our finances than we used to be. These days, Americans are padding their emergency funds, trimming expenses, and reducing risk in their portfolios.

Just one problem: With the worst of the recession seemingly over, history suggests that many of us will soon revert to boom-time bad habits. People grow overly optimistic about their circumstances in periods of economic growth, says Meir Statman, a behavioral finance expert at Santa Clara University.

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As stock values rise, home values tick upward, and joblessness falls, we feel richer. Therefore we tend to save less, spend more, and invest more impetuously -- a phenomenon known as the wealth effect. So, ironically, a recovery poses real risks to your financial security.

What you need: ways to trick yourself into staying on track. And with the effects of the downturn still palpable, now's the time to implement such strategies.

Risk no. 1: You'll lose saving fervor

Like most U.S. households, yours is probably squirreling away more money now than in, say, 2005. Think you've been scared straight? Unlikely. We tend to forget the bad times once the good times arrive. As evidence, consider that the personal savings rate often falls following recessions.

How to keep socking away: Undermine your optimism bias by making saving automatic: Have a portion of income deposited directly into savings. It may also help to remind yourself why you're saving. So give your accounts names based on when you'll tap them, suggests economist Tim Harford. Call your cash cushion the if-I-lose-my-job fund. Brand your vacation account Alaskan Cruise fund. "We find it easier to visualize consumption than to just save," he says. Plus, you're less likely to spend money designated for a specific use.

Risk no. 2: You'll go spending crazy

Back in the boom, who didn't buy things they later regretted? You've probably been more scrupulous with spending since the credit implosion. But as your money-anxiety wanes, so too might your self-restraint.

How to stay frugal: Imagine that the money you intend to spend is cash in your wallet, says Michael Pompian, author of "Behavioral Finance and Wealth Management." When buying a $20,000 car, shelling out $100 more for splash guards may feel like nothing. But think about how else you could spend that (gas for two weeks?). Then make your decision.

That said, "self control is like a muscle," says Yale finance professor James Choi. "If you exercise it too much, it gets tired." So also allow yourself a set amount of mad money per month to spend at will. Once it's gone, avoid window-shopping.

Risk no. 3: You'll chase performance

Our tendency to interpret recent experience as the norm can also be dangerous from an investing perspective. Before the bust, it seemed like home prices would always rise. (Ha!) Now emerging markets look like a constant. You said you wouldn't get caught up in next big thing, but ...

How to keep a cool head: Let yourself have 5% of your portfolio to indulge in "opportunities." And create a written investment policy for the other 95%. "Think of it as a binding contract between you and your money," says Colorado Springs financial planner Allan Roth.

Spell out goals and your strategy for reaching them, including asset allocation. When feeling wooed by, say, a Chinese yuan ETF, force yourself to rewrite your policy -- in the time it takes, you may regain your senses. After all, says Statman, "you're probably better off following an investment policy than your instincts."  To top of page

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