I’ve spent a long time reading blogs, articles, books, and magazines about finance. Over the years I’ve watched movies, YouTube clips, and more about how to get your finances under control. I’ve seen countless instances where financial pundits spend their precious words describing what everyone should be doing differently with their money. They talk about budgeting, paying off debt, and saving for retirement. Or they discuss saving for your child’s future education and planning to minimize taxes.
And yet, these problems still seem to persist. Canadians are more indebted now than at any time in history (Canadian Household Debt- Globe and Mail). As a whole, North Americans have minuscule amounts saved for their impending retirements. We know that we SHOULD be maximizing our contributions up to the matching limit in our company retirement plans.
Those of us who are parents know that we SHOULD be saving for our children’s education. We know that getting a 20% return on our investment from the government match is a great deal.
Many people know that it is best to put the tax refund from their RRSP contributions towards their retirement savings. We know that saving in a TFSA, and not paying any taxes when you withdraw the money, makes perfect sense.
We all know that we SHOULD be watching our money, and not spending frivolously on things we don’t really need. And yet for many of us, there seems to be some invisible force which keeps us stuck in a rut. Like the earth’s gravity sucking us towards its surface, this force prevents us from breaking free of our harmful habits and behaviours.
Enter the relatively new field of Behavioural Economics. Behavioural Economics is the study of the effects of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions (Wikipedia). It looks at the WHY behind our behaviours with money. And it has recently gained widespread publicity. One of its main proponents is Economist Richard Thaler. He just won the Nobel Prize in Economics for 2017 by combining past psychological insights with economic theory.
There’s a sub-field of behavioural economics called behavioural finance. It deals with the question of why people we assume are highly rational, make irrational financial decisions. And why do they act this way in spite of widespread, common knowledge to the contrary? It looks at things like overreactions to market fluctuations, and the irrational causes of market bubbles and crashes.
This relatively new field marries psychology with finance. And it would seem to provide some interesting answers to the question, “what are those invisible forces that keep us from changing our knowingly poor financial behaviours”? In order to explain, let’s looks at a model.
Historical View of Personal Finance
This is how personal finance and money management have been approached in the past. Pundits, financial experts, newspapers, magazines, and the like, have spent an inordinate amount of time, effort and ink exploring the nuts and bolts of personal finance down to the most minute detail. A quick Google search of “financial strategy” returns over 748,000,000 results. If you search Behavioural Personal Finance, you get 750,000.
Now I know this little Google search experiment isn’t exactly hard science, but it clearly makes a point. The financial world heavily emphasizes the details of money. And these details are important. They can most definitely help us in our quest to reach financial freedom.
But while the majority spend most of their time focusing on the details, we spend very little time on the behaviours that put those details into practice. And we spend even less, a minuscule, almost non-existent amount of time, on the psychology that drives those behaviours. Financial authors, advisors, and talking heads may occasionally mention that what is driving your behaviours is your thinking, but they spend most of their time talking about financial products (stocks, bonds, portfolio allocations, robo-advisors, RRSP’s and TFSA’s, etc.).
Why is this? Behavioural Economics gives us a clue.
The Curious Incident of the Candy Bars in the Office
The Harvard Business Review (HBR) recently detailed an interesting observation that came about in the early stages of the smash business success, Yelp’s, development. At the time there were 15 employees working out of a small office. In an effort to help the employees power through long afternoons, the office manager would stock the office kitchen with a variety of chocolate bars. There was everything, a smorgasbord of chocolate delights, enough to wet the proverbial whistle of everyone in the office.
Predictably, everyone loved the idea and was grateful for the extra “help” in making it through the day. It was awesome to be able to get a little pick me up without having to leave the office.
But something sinister soon began to happen. People became alarmed at their increased chocolate bar consumption rates. Individuals with no previous sweet tooth grew concerned. Even those who didn’t really like chocolate bars were eating them. Everyone in the office became disturbed at their candy bar a day intake levels.
According to the HBR, “in a world of rational economic decision making, more – and more choice – is always better”. If you choose to do SOMETHING, that is better than ignoring the choice and doing NOTHING. It’s called revealed preference. It states that whatever choice you make, it must be the best one given the information, incentives, and options you have. In an office full of different chocolate bars, choosing any chocolate bar amongst all the choices was better than the alternative, not choosing one at all.
In the world of finance, this means when we spend our time looking at the myriad of financial products and strategies, our brains deceive us and tell us that picking from a larger selection must be better than ignoring all the options and going with a simple solution.
More Choice Isn’t Always Better
From my experience, we feel good when we analyze a host of possible solutions to a financial question (which Mutual Fund should I invest in). And after we’ve looked at all the options, weighed the pros and cons, and made a decision, there is a level of extreme satisfaction. We feel like we’ve got a leg up on our fellow investors, like we have some secret, hard-won knowledge very few others have. It can lead to us being overconfident and smug.
And, it takes a long time to do all the research. We end up spending hours coming to an answer, an answer that research tells us is flawed (more on that in future posts). The better choice is for the average investor to buy a low cost, cross-section of businesses, that as a whole, will do well. Buying a low cost index fund would achieve this.
Warren Buffett states that,
“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
In fact, Mr. Buffett put his money where his mouth was in 2007. Both he and an investment banker each wagered $500,000 that over 10 years their financial product would produce superior returns. Buffett’s was a lowly S&P Index fund. The investment banker invested in a high priced hedge fund. At the end of the bet, the total return for the Index fund was around $850,000. And for the high priced hedge fund? $220,000.
When Dumb Money Is Smart
Why is it so hard for people to admit that easy and simple with their money is actually better than difficult and complicated? Again, it may go back to the chocolate bar example and brain research.
The human brain is wired to look at more options as a good thing. We assume that if something is difficult (in this case, investing and getting high returns) then it must be complicated. And we assume that if it’s complicated, we need an expert to help us with it. We need someone with more knowledge of the topic than us. And so, we look to the financial “expert”.
The research, however, tells us that these so-called “experts” are terrible at picking successful investments. In fact, a contest was held by the Wall Street Journal which pitted stocks chosen by throwing darts at a stock table against stocks chosen by professional experts. After 100 contests, the pros won 61 and the darts 39. Yikes! Even less impressive for the experts, when compared with the Dow Jones Industrial Average (the stock index), the pros won 51 and the Index 49. It was basically an even split. In fact, the only real difference was the ridiculous fees you’d pay to the expert as opposed to the comparatively microscopic fees on an index fund.
An Unstable Financial Predicament
When people spend an inordinate amount of time on the details, they have very little time to study their behaviours. In addition, they have almost no time to analyze the psychology behind their money. Because of this, their financial pyramid ends up looking like this in reality:
I taught grade 7 Science. One of our units was Structures and Forces. We talked about what makes a stable structure. Two things my students could tell you? Structures with a wide base and low center of gravity are the most stable. The pyramid above? It would definitely get an F.
A New Way to Think About Money: The Pyramid of Personal Financial Success
So where does this all leave us? Well, we know that left to ourselves, very few of us have developed the behaviours to overcome our own stupidity. We spend far too much time and effort looking at the specific details of our money problems and worries. And, we spend far too little time looking at what got us into our messes in the first place; the psychology behind our behaviours which drive us to the specific details we spend most of our time on.
In order to truly master our money, we must become masters first of the psychology behind our money; namely, our mindsets and emotions about money. The pyramid of personal financial success should look like this:
Once we understand the psychology behind our money, we can work to change it. And as it evolves, we’ll see changes in behaviour. We’ll realize that to have successful behaviours, we may actually have to remove psychology from the equation altogether (More to come in a future post). The best way to do this is to put automated features in place to save us from our stupid selves (more on this in my Master your Money class).
As we see changes in our behaviour, we have to spend relatively little time on the specifics of our financial situations. Because of the solid foundation on which we’ve built, we can have confidence when we encounter turbulent times.
A Solid Financial Foundation: A Beautiful Thing
The beautiful thing about building a solid foundation at the bottom of the pyramid is that these things are timeless principles that will not change. Successful people with money have been using them since money was invented. Details on the other hand, they change faster than we can keep up with. Today it’s Bitcoin and Ethereum. A few years ago it was mortgage-backed securities or flash trading. Before that, it was the .com boom and bust. Who can keep up? And who can predict how it will all play out? But with our psychology and behaviours rooted in timeless principles, the details often become very simple and clear.
As Warren Buffett said, ““A low-cost fund (index) is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth.”
Less Time On Money, More Time for Life
Once you’ve got your financial pyramid of success solidified, you won’t be spending countless hours pouring over the financials and research around different funds and investment opportunities. You can spend that new found time doing things that really matter. Things like spending time with family and friends, serving in your community, having fun doing a hobby or recreational activity, or whatever floats your boat.
It’s not sexy. It’s much cooler to brag about how you’ve recently picked a few hot stocks. That you’re crushing the market right now. Bragging that “my psychology of money is better than yours” leaves much to be desired in a pissing contest.
If bravado is what you are after, then go ahead and spend your time and energy on the details. Me, I’d rather get my psychology and behaviours right. That way I don’t have to spend as much time on the nuts and bolts of my money. This frees me up to enjoy the truly priceless things life has to offer.