contributed by John E. Rice, CFA, CFP®
We all make financial decisions every day. Some of the most daunting financial decisions have huge consequences on our well being. Two significant factors make financial decisions difficult – uncertainty and biases.
One of the most difficult financial decisions is how you invest your savings among various choices in the financial markets. One characteristic that makes capital allocation decisions so difficult is that most of the choices do not offer a fixed rate of return. And even fixed rate investments come with risks.
Several factors should be part of your allocation decision. Whether you choose to do it yourself, or delegate to a financial advisor, these factors are important in the framework.
First off, anyone faced with decisions regarding how to allocate their capital would do well to put this in perspective by first considering how fortunate they are to be in a position where they have capital to allocate! The majority of people in the world do not have these difficult decisions to make because they are living at a subsistence level and do not have any savings to invest.
With this frame of reference, we should go about making decisions that will be most beneficial for us, while considering the trade-offs inherent in any decision where the outcome is both important and uncertain.
When considering the allocation of capital, a three part framework can be used to arrive at an optimal capital allocation among the choices for your portfolio. The three parts are:
- Your Financial Objectives
- Your Financial Risk Profile
- Your Outlook for Financial Markets
Your Financial Objectives
First, determine how soon you will need your money. Is this money that will be spent in the next 1-2 years? Or is it for a longer-term goal like retirement many years in the future? With money that will be spent in the next 1-2 years, you will most likely want to invest in a fixed income investment like a CD or money market. Short term fluctuations in most growth investments are difficult to predict with any degree of certainty and you will increase the likelihood of having to sell in a down market if you invest short-term savings in growth investments.
If the money is designated for a longer term expenses, then it might make sense to invest in something with growth potential, such as the equity markets. You increase your odds of growing your savings by investing for growth, but you also increase your risk of loss. This is one of the trade-offs that make financial decisions troublesome for many people!
Your Financial Risk Profile
No financial decision should be made without considering your risk preferences. If you allocate money to growth investments like the stock market, and then you bail out when the markets drop, you increase the probability that you may not achieve your financial goals. Nobody likes to lose money. But it is crucial that you do not allocate too much of your portfolio to markets when you don’t have the stomach to stay in for the long term, because your distate for risk is likely to manifest exactly when markets are at their lowest levels.
Your Outlook for Financial Markets
The outlook for financial markets is the third part of the framework and the one that causes the most angst for many when making investment decisions. Will the stock market go up or down after you invest? You can always find someone with an opinion on where markets are going. A review of the track record on forecasting markets over short periods of time show these forecasters have dismal track records at predicting market moves.
Even though forecasting financial markets is fraught with inaccuracy, you (or your advisor) will need to make judgment calls on financial markets. This is required in order to assess how much to allocate to each asset class. This process needs to have feedback loops that can adapt to an ever changing world, although frequent changes may be detrimental to your financial health.
Integration of these three parts: financial objectives, risk profile, and outlook for financial markets, provides a solid framework for making decisions on where to allocate your portfolio.
No discussion of financial decisions would be complete without considering biases we bring into our financial decision making process.
Two biases I frequently encounter are scripting and mental roadblocks.
Scripting – All of us have certain biases about how the world works and how we should respond to it. In most cases these biases were imprinted on us very early in life. They often influence us in very subtle ways that impact our financial decisions. Many times we are not even aware of the scripts that we face.
Mental Roadblocks – A mental roadblocks is a self-created impairment to getting past a mental challenge, For example, many of us know people that say they are not good at math. What is the first thing they think of when asked to do a math problem? They think they are not good at math! They have just created an additional roadblock to the problem.
Many people have these “mental roadblocks” regarding finances. On top of this financial decisions are charged with emotion since the outcomes of financial decisions can have a significant impact on your quality of life.
Given all of these factors it is small wonder that financial decision making is difficult. You have to make choices in the face of uncertainty, have a framework for continuous monitoring of your progress, and do this all while being battered around by behavioral biases that you may not even know are influencing you!
So next time you are making a financial decision, remember to use the framework and be mindful of the biases you bring to bear on it. Armed with these tools you should make better financial decisions in your life.