Is Automating My Finances a Good Idea?

Dear Two Cents,
Money experts are really into automating their finances. But is this always a smart? For example, I'd like to start investing, but I'm a little overwhelmed and don't know much about it. The "set it and forget it" method is often suggested for beginners like me. This sounds great, and it would give me time to focus on other things. But is it the best way to get a return on my money?

Thanks,

Financial Fledgling

Dear FF,

Yes, many experts are fans of automating not only your investments, but your finances in general. We'll explain why, but first, let's talk about what exactly automating means.

What It Means to "Automate" Your Money

Automating your finances is setting up your finances so they require little management. Here are some examples:

• Setting up a regular automatic deposit into your savings account
• Signing up for contributions to your 401(k), to be automatically deducted from your paycheck
• Using the auto-pay option to pay your bills

With automation, your budget manages itself. You tell your money what to do and where to go, and it passively works for you.

"Set It and Forget It" Investing

It takes knowledge and skill to actively invest—build a portfolio stock-by-stock and check in on your assets regularly. Which means it probably takes a lot of time, too. That's why the "set it and forget it" method you mention is the favorite of many personal finance experts and investors.

Investing guru Warren Buffett has helped to popularize this method. He talks about index funds a lot. Index funds offer a rate of return that mirrors the stock market, and they're very low-maintenance. So you can invest in them without worrying about their daily valuations. Buffett said:

Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors…

The idea is that most people can't beat the market. Index funds are made up of a handful companies, and they're designed to earn the same return the market does. So, if you're not a skilled, savvy investor (and many times even the savvy investors can't beat the market), index funds are the way to go.

To summarize, here's how you'd set up your investments in a "set it and forget it" strategy:

• Open a brokerage/retirement account.
• Pick your index funds.
• Know that your funds will grow over time, without you having to worry about their daily valuations.
• Periodically make sure your portfolio is balanced.

The Advantages of Automating

One big advantage of automating your finances is that you develop good financial habits without too much effort. You make a smart decision once, and it pays off continually, without you giving it much thought. For example, let's say you vow to save 10% of each paycheck, and you set up an automatic deduction for each pay period. Every time you get paid, your savings have already been deducted, so you don't have to worry about being tempted to skimp and save only eight or five percent.

As you mention, another big draw is time. You have more time to focus on other things. Financial author Ramit Sethi would agree. In a post on automating your finances, he writes:

By setting up a bulletproof personal finance system, you can start to dominate your finances by having your system passively do the right thing for you. It will help you automatically manage your money, guilt-free, for years to come. Bills, payments, and even investments will be automated, leaving you to focus on the things that really matter.

Sethi is a big proponent of automating your finances in order to focus your time and energy on ways to increase your income. For example, not worrying about investing frees up time that you could spend honing your job skills.

The Disadvantages of Automating

But there are some solid reasons to be active, too. J. Money of financial blog Budgets are Sexy tells us that he's generally a fan of automating, but it's also smart to stay active sometimes:

It's super easy to miss mistakes and overpay on things if you never pay attention, which is the main downside to automating - other than bouncing checks or payments because of mis-managing of funds, which you also have to be careful of. Also - sometimes it's good to feel the "sting" of paying your bills manually - makes you appreciate money more and double-think the items you're about to send money to.

We've written about this before. Financial writer Carl Richards recommended the slow-tech approach to finances. The idea is: when you have to manually crunch the numbers, you reconnect with your financial situation and might be able to save more and improve your spending habits.

The Disadvantages of "Set It and Forget It" Investing

Index funds are pretty popular, but not everyone is a fan. To help you in making your decision, it's worth noting the drawbacks of maintenance-free investing. Investopedia's Wayne Pinsent offers five reasons to avoid index funds:

1. Lack of Downside Protection: If the stock market hits a bump, so will your funds. With passive investing, there's no protection against this.
2. Lack of Reactive Ability: Pinsent explains that, sometimes companies are under- or over-valued on the market. An active investor can take advantage of this and buy or sell accordingly.
3. No Control Over Holdings: Investing in an index fund gives you no control over the individual holdings in the fund—they're pre-picked for you.
4. Limited Exposure to Different Strategies: Pinsent says an active investor can try different strategies and get better risk-adjusted returns.
5. Dampened Personal Satisfaction: The stock market can be stressful, but investing in index funds doesn't guarantee you won't check your stocks and worry about the economy.

Of course, there are valid counter-arguments for each of these points. Most of the actions in these points require a lot of time and a deeper knowledge of investing.

Ultimately, you have to consider both sides, and do what works for you. But, obviously, we're generally fans of efficiency and productivity. And that's what "set it and forget it" investing is all about. You get the same rate of return as most everyone else, and you don't have to worry about being in over your head. You can focus your time and energy in other areas. You might focus it on other ways to invest in your future—making yourself an indispensable worker, for example. Sethi calls it the bigger picture.

There's one caveat, though: it's still important to periodically check in on your finances, even when you automate them. You want to make sure you haven't miscalculated your budget. You want to make sure your portfolio is balanced.

Automating is great, but you should get hands-on every now and then, too.

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Two Cents is a new blog from Lifehacker all about personal finance. Follow us on Twitter here.