All of these financial “sound bites” may be excellent advice in specific situations. But, do we try to apply these money rules without considering the entire situation? Are we too busy to get all of the facts?

Using financial sound bites to influence our financial decisions is a two-edge sword: one, you use the sound bite when it is not applicable to your situation; and, two, you reject good advice, because it is inconsistent with a sound bite. Remember, almost every sound bite is a reminder of good advice in certain circumstances. How do you know if the circumstances are right? There is never a substitute for research, knowledge, and experience. All of these take time.

In financial decisions there can be no substitute for reviewing all of your facts and goals, and then applying various “what if” scenarios to see what is best for you. You can use a “what if” scenario based on a sound bite to evaluate how it would work for your circumstances. Using established methods and proven financial practices, offer the best chance of making the right decisions.

PlanLab®  is a collection of financial tools designed to assist in determining how various options will work in specific circumstances. Knowing that the purpose of any financial analysis is to help someone make a financial decision, all of the PlanLab tools use principles from Neil Rackham’s SPIN® Selling.

A brief and simplified explanation of SPIN is that people make major decisions based on getting answers to four types of questions: (1) What is the Situation? (2) What is the Problem of this situation? (3) What is the Implication of the problem? And, (4) what is the Need-payoff for this implication? If a person has the answers to these questions, then the decision is simple: does the cost of the solution have more benefits than the costs of doing nothing? People tend to make the right decisions, when given all of the facts in this manner.

PlanLab provides these decision-making facts. The modeling of monthly cash flow for each “what if” scenario, provides answers for every situation. Users of PlanLab often comment that they are surprised at the various outcomes – for some situations the outcomes do not follow the “sound bites.”

SPIN® is a registered trademark of Huthwaite, Inc. European SPIN® trademarks are held by Huthwaite, Ltd. SPIN® Selling, by Neil Rackham, published by McGraw-Hill, Inc., New York, NY.

The answers must consider individual situations, but a few basic concepts should always be considered before making decisions to each question.

Should I take my money out of my 401K Plan?

If you take your money out of your plan, it is subject to income taxes. Paying taxes on the decreased values will increase your losses. If you are under 59 ½ you may pay an additional 10% penalty tax. You can avoid the taxation by rolling over to an IRA, but that generally provides no advantage to leaving it in the 401K. Unless the money is immediately needed for another reason, you should not take it out of the plan.

Should I change investments in my 401K?

If you are close to retirement, say within five years, you definitely want to reexamine your asset allocation to be sure you are not too heavily invested in stocks. If you are already retired, you want to be sure that the portion, from which you are taking your retirement income, is in very conservative investments. In most cases, if your investments are diversified, you should consider leaving them as they are. If you move them to a low risk investment now, they will not be able to recover. The more time you have between now and retirement, the longer you can wait for the values to recover.

Should I continue to make contributions to my 401K?

Yes. First, you always want to take advantage of any employer match—it is free money. For example, if the employer matches $.50 for each dollar you contribute, that’s like earning 50% after taxes for each matched dollar. Regardless of economic conditions, you should always contribute up to the amount that the employer will match.

The other reason that you want to contribute is called dollar-cost-averaging. This principle always works to your advantage, but it is especially advantageous when the market is down— like it is now! Here’s how dollar-cost-averaging works. My making monthly contributions, you purchase shares based on their value each month. If the price per share goes up, you get a few less shares that month. If the price goes down, you get a few more shares. Proportionately, you get more additional shares when the price goes down than you give up when the price goes up. Consider the example in the chart below.

$100 is contributed each month. The first month the price per share is $5, so 20 shares are purchased. The price goes up the next month to $6 per share. The $100 buys 16.667 shares. The third month, the price is back to $5 and 20 shares are purchased. The next month the price drops to $4 per share, so you receive 25 shares. If the price returns to $5 the next month, 20 more shares are purchased. You now have a total of 101.667 shares worth $5 per share for a total of $508.33. It is easy to see that the average price paid per share was $5. Had all $500 invested been invested at the average price, you would only have had 100 shares worth $500. Systematic purchasing with varying prices allows you to do better than the average.

Let’s continue the prior example, but this time let the prices go really low. This time, the price continues to decline to $1 per share. It would be easy to get discouraged when the price has fallen so low and values so low, but continuing to contribute each month until the market has reversed, provides substantial gains. In this example, dollar-cost-averaging has produced 30% more value than would have been earned buying the stock each month at the average price.

If we had lost our nerve when the price reached $1 and quit making monthly purchases, we would have only had $1,325 when the market had recovered.

For someone who is a number of years from retirement and has time to let the market recover, dollar-cost-averaging can make this economic crisis a “blessing in disguise.”

Photo credit: m kasahara

For example, a retirement calculator prompts for desired retirement income, years until retirement, and the amount of retirement savings. After adjusting for inflation and anticipated earnings, it determines that additional monthly savings of $1,000 are needed from now until retirement. This is a one-sided solution: if everything else remains the same, then this solution works. BUT, in real life, where does the $1,000 month come from?  Will other expenses or savings have to be reduced to save an additional $1,000 a month? In reality, expenses and/or discretionary spending must be reduced by $1,000 per month in order to save an additional $1,000 a month – that is the other side of the calculations.

A cash flow analysis considers not only the benefits of the solution, but also the costs of the solution. For the above example, a cash flow analysis would determine that the same $1,000 of additional savings is necessary, but it would also show the impact on other expenses and help determine which expenses needed to be cut, or other assets used to make the solution work. If assets that would have been used for retirement are now used for the additional savings, then it is not a solution. It would be the same as moving money from one pocket to the other with no net benefit.

Simple illustrations and calculators are great for providing pieces of the puzzle. This can be very useful in setting expectations of a solution. Only with a cash flow analysis can you show both the benefits of a solution and its impact on other financial items. Only with a cash flow analysis can you show the other side of the solution.