How to Avoid Type 2 Money Mistakes

Every year, millions of people run marathons. They put themselves through 26.2 miles of running in what is typically over several hours.

It’s a grueling endeavor you can’t just do on a whim (without suffering greatly); you have to train for it.

But people who run marathons love running marathons.

On the Fun Scale, races are an example of Type 2 fun.

The Fun Scale is a great way to think about many things in life. Type 1 fun is something that is fun while you’re doing it. It’s having a beer with your friends at the beach. Snowboarding. A delicious meal.

Type 2 fun is something that may not be fun at the moment, but you look back on it fondly. You enjoy the sense of achievement that comes with doing something difficult. It’s a hike or a marathon.

The idea of Type 1 and Type 2 fun has applications in a variety of areas in our lives.

Today, let’s apply this framework to financial decisions:

The Money Mistakes Scale

Based on the Fun Scale, we know that Type 1 is where the effects are immediate. And Type 2 is where the effects take time to reveal themselves:

• A Type 1 money mistake is one that is clearly bad at the time you make it. Paying for a Netflix subscription but never using it.
• Type 2 mistake is more pernicious. It’s harder to identify because it’s the type of error that hurts you far into the future, long after the decision was made.

Type 1 money mistakes are unfortunate, but they’re limited in scope. OK, you paid for Netflix, it’s no big deal, you can just cancel it. You’re out a few bucks.

Type 2 money mistakes are more dangerous because they’re not obvious at the moment but have the potential to be significant.

It’s not participating in your employer’s retirement plan even though they offer a small contribution match. (This is different than opting out because you have a bad 401(k) plan!)

It’s selecting a mutual fund that charges a 1% fee when you can get the same one charging less than 0.10%. It’s working with a financial advisor that charges you a 1.5% fee on assets under management (and then puts you index funds that you could’ve picked yourself).

It’s also acts of omission. It’s when you let analysis paralysis take control and punt a decision, only never to make it. Or you make it in five years rather than today.

It’s not getting your annual physical because you’re “too busy” and discovering a serious medical condition only after the symptoms make it too difficult to ignore. (You can frame this as a health mistake, but this also impacts your money; it’s all interconnected.)

It’s locking in a mortgage for a house that’s greater than 30% of your take-home pay and assuming you’ll make more money later. If you end up earning more, that’s wonderful! But until you do, you’ll feel the financial pressure impacting everything you do.

How do you avoid type 2 money mistakes?

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Albert Einstein

Type 2 money mistakes are when the powers of compounding are not in your favor (or worse, they’re working against you).

Let’s continue with a simple example of an employer-sponsored defined contribution plan – the 401(K). If your employer offers a contribution match of any kind, it’s usually a good idea to take advantage of it. It’s also a good idea to put it into an index fund that is low-cost.

If you don’t contribute, you’re not getting the free money, and that free money is not compounding for you. If you don’t select a fund, you may not be getting market returns. If you select one with high fees, you are not getting the full return since some of it is being siphoned away by fees.

And if you wait just one year, you’re losing out on a lot of compounding. If you were going to invest that 401(k) for 30 years, then waiting just one year means you’re losing out on 30 years of compounding! The first dollars you put in will be compounding the longest.

In a marathon, it’s like letting everyone else run for ten minutes before you even start. Even if you were to walk or jog a little bit just to warm up, you’re farther ahead than if you waited ten minutes.

Small mistakes can compound into bigger ones

If you’ve ever owned a house, you’ll know that addressing small problems early is the key to avoiding big problems later.

If you have a leak, you’ll want to fix it as soon as possible. If you wait, it can develop mold and require a far more serious remediation. It may cost you money right now, but if you let it fester, it’ll cost far more later.

An ounce of prevention is worth a pound of cure.

Don’t make 30-year decisions based on 5-year assumptions

The first part of the Prime Directive of Personal Finance (I made this up myself) says that you shouldn’t spend tomorrow’s dollars today.

This means that when you enter into debt, you should do so very carefully.

Too many people buy too much house and assume their income will grow to support the mortgage. In an ideal world, that would be optimal.

But then life happens. Maybe you have a child earlier than you expect. Maybe there’s an economic downturn. Or a pandemic. Maybe your car needs to be replaced, or there’s some other financial emergency.

Now you’re in a house that was already a budgetary stretch, and now it’s stretched even more. And a house is relatively illiquid and expensive to get out of. And you’ll still need a place to live afterward.

There’s a reason why the common advice is that you shouldn’t spend more than 30% of your income on housing – it provides enough wiggle room for these fairly common situations.

A lot can happen in five or ten years, let alone thirty.

Ask “future you” for advice today

If those examples were too specific, here’s another way to think about it – Try to imagine what you will be like in 30-40 years.

Now ask that person – “What do you wish I had done about this?”

A few years ago, CNBC suggested that using a face-aging app could help you make long-term decisions. By seeing an older version of yourself, it made it a little easier to think in those terms.

You can practice by looking back 20 years and thinking about what you’d do differently.

I’m in my forties, and I’m thankful that I contributed to a 401(K) when I started working. I was able to get the company match and now, decades later, I have a Rollover IRA with hundreds of thousands of dollars. Most of that balance is from market returns. The only brilliance I can claim is that I elected to participate in a 401(k) in my twenties.

Next, project forward in time.

When I’m in my sixties, I want to make sure I’ve made the right life decisions that go beyond money. With an established financial base, that means focusing on other aspects of my life (fitness, family, etc.) while keeping an eye on the financial ball.

For example, in twenty years, I will want to look back on this time and be thankful that I prioritized fitness in maintaining a strong cardiovascular system and physical strength. I’m not going to run marathons, but I do like running and lifting to stay active. That motivates me to continue to train, even on days I don’t want to. Missing a day won’t hurt me tomorrow, but it might have an impact on where I am in 20 years (much like 401(K) contributions).

You won’t be able to avoid every financial mistake, but if you’re aware that they exist, then you’re less likely to make them.

And knowing is half the battle, that’s what 6-year-old me would tell me. 🤣