How to make better financial decisions

And why you should expect that your carefully laid plans could go wrong.

  • By Jason Butler,
  • Financial Times
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Are you generally an optimist or a pessimist? Do you see opportunity where others see problems, or does every silver lining have a dark cloud hanging over it?

The consensus of research in this area seems to be that our genes influence about half of our general disposition and perspective. The balance is affected by what we learn from early childhood and subsequent life experiences. Your disposition has a big influence on how you make financial decisions.

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Some financial decisions are easy while others are really challenging. Deciding how much to spend on lunch is much simpler than deciding how much to save for retirement and where to invest it.

Every day we must decide between spending money for immediate reward, or deferring gratification to a later date. Our primeval brains encourage us to favour the here and now over the dim and distant future. That made a lot of sense thousands of years ago, when we didn’t know where the next meal was coming from and few people lived long into adulthood. But this mindset can play havoc with daily decisions about spending, earning, saving and borrowing when you might live to 100.

Having enough money for when you cannot or no longer wish to work is not an optional financial goal. It is also the most expensive. Yet many people make money choices that do not reflect that reality, because later life is in the future and they don’t want to think about being old.

Some people with much higher levels of financial wellbeing have developed greater self control over their spending, and are prepared to forgo consumption now for higher benefits tomorrow. This enables them to build savings, reduce debt and accumulate productive assets such as equities and property, thereby creating financial resilience and freedom to make choices that improve their life experiences.

Clearly if you are on a low income, or have very high basic living costs, it’s much harder to defer spending and save. But if you can’t cut spending, the only thing you can do to improve your financial position is to increase income. That means investing in yourself through training, qualifications or work experience to improve your income earning and value creation capability.

Tackling a big decision such as “how much to save towards retirement” is difficult. There are many variables and uncertainties. So many people default to making no decision, storing up problems for the future. To make better financial decisions, we need to ask the right questions.

What if...

Questions such as: how long will you live and how much of that will be in good health? How much will you earn? Will you inherit and, if so, how much and when? What will inflation, stock markets and tax rates do in the long term? How much will you spend and how will this change? What personal changes will happen to you and your family? What changes will you want or need to make to your lifestyle?

The answers will depend on things you can control — such as working, spending, investing, borrowing, personal relationships and hobbies — and many other factors that you can’t, such as the economy, investment returns, inflation, your genetics and childhood experiences.

The nature of risk is that things don’t turn out as you hope or expect, and that the outcome is worse than desired. Many people sensibly approach decision making on the basis that they hope for the best, but plan for the worst.

But just because something is possible, it doesn’t necessarily mean it is probable nor that a bad outcome will be at the extreme end of what is possible. Quantifying the possible impact of a bad outcome and the likelihood of it happening is essential to working out what you can live with, and whether you want or need to make changes now.

This throws up yet more questions to ask yourself. What if you died tomorrow, what effect would that have on your dependants? What if you were incapacitated and couldn’t work for some time? What effect would that have on your financial security?

What if your investment portfolio suffered a big fall in the early years of your retirement, and how would that alter the probability of you running out of money during your lifetime?

Left to our own devices, few of us are willing or able to comprehend potential financial scenarios and their probabilities. But an objective financial analysis in the form of modelling various ‘What ifs?’ is essential to counter the subjective biases that influence how most of us make complex financial decisions.

For example recent research by the Institute for Fiscal Studies found that on average, individuals in their 50s and 60s substantially underestimated their chance of survival through their 70s and 80s.

This subjective bias could cause people to undervalue the benefit of buying a guaranteed income, in the form of a lifetime annuity, when it might be the best approach — at least to meet their core lifestyle spending — when their main concern is running out of money in their lifetime. Separate research from Legal & General even suggests that those who use their pension pot to buy an annuity are generally happier than those who don’t.

The ‘so what?’ question

Having identified what could happen, you then need to question what, if anything, you are prepared to do about it. I call this the “so what?” question.

With complex and abstract things such as financial planning, it’s easier to avoid making a decision, even if it’s not in your best interests. Sometimes we procrastinate and wait until we have more information. But more information might not necessarily mean a different or better decision. Legendary investors Warren Buffett and Charlie Munger made the point at the last Berkshire Hathaway AGM that the second-best financial decision is usually good enough.

Two thousand years ago, Seneca, the Roman stoic philosopher, wrote: “Nothing happens to a wise man against his expectation, nor do all things turn out for him as he wished but as he reckoned, and above all he reckoned that something could block his plans.”

If you create your own personal financial plan, based on sensible guesses about the future, you can make small corrections — in the form of changes to your spending, investment and tax planning — in light of what actually happens.

The discipline of regularly reviewing your financial situation is what maximises financial success, not making big bets or putting your head in the sand and hoping things will somehow turn out OK.

There is a Latin saying: vires aquirit eudo — we gather strength as we go. You can gather strength and prepare for an uncertain future by regularly combining objective analysis with subjective preferences. That way you’ll make better financial decisions, be prepared for any setbacks, and increase your chances of financial success and life satisfaction.

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