The recent Christmas/New Year period again provided time to meet less regularly seen family, friends and acquaintances and catch-up on what they have been doing. Inevitably, given what I do, the subject of personal finance often arose in some shape or form.
And it’s not usually raised by me. Invariably, the initiator is looking for my endorsement of whatever financial action/decision they have already taken or are committed to taking. They really aren’t particularly interested in hearing the almost inevitable reservations I may have.
Sheltering behind my ongoing obligation to “know the client”, I avoid getting involved in what experience has told me is likely to be a frustrating and fruitless conversation by simply saying I don’t have enough information to provide a worthwhile opinion.
But such situations leave me feeling a little hollow. It’s hard to passively standby while people you care about do what I think are often “dumb” things with and around money. I console myself with the knowledge that even “dumb” decisions often have good outcomes. Unfortunately, such positive results often encourage further “dumb” decisions.
Poor risk assessment and overconfidence are a dangerous combination
The examples below provide a flavour for the types of conversations that came up:
- A retired, sixty something ex-banking colleague explains that he has borrowed heavily to purchase only positively geared Sydney investment properties and is living well off the net income. He argues that he has little risk, as the positive gearing will provide protection against any potential interest rate rises. I wonder (to myself) how his strategy will fare if the Sydney apartment building boom leads to falling rentals and/or difficulties in attracting tenants;
- A couple in their mid-fifties, with little personal financial knowledge, say they are starting to save money now the kids have left home and the mortgage is paid. They are beginning to “dabble” in the share market to learn about investing. I only offer the suggestion that the share market can be a very expensive teacher;
- I extol the benefits of reducing investment risk through diversification (i.e. spreading your investment bets as broadly as you cost effectively can) to a young adult relative and he enthusiastically agrees. In the next breath, he says he would like to buy an investment property;
- A friend in his mid-60’s suggests he is looking for more “low risk, high returning” investments like the partly debt financed housing development in outer Adelaide he has just committed over 25% of his potentially already inadequate retirement wealth to. What could go wrong, I think to myself; and
- A late-50’s professional friend explains how he had helped his daughter with the deposit on an apartment and went guarantor for her loan, so she could “get into the Sydney property market”. While appreciating his generosity, the phrase “rope to hang herself” goes through my head. I also wonder what financial and life lessons the daughter took from this behaviour.
The common theme that runs through all the above conversations is an inadequate appreciation of investment risk. While optimism is a desirable human trait, a failure to ask “what can go wrong?” and “how will I cope if it does?” can, and often does, lead to poor investment decisions and, sometimes, disastrous consequences that are easily avoidable.
There is also a tendency to consider each investment decision in isolation, with the expectation that every decision will be “a winner”. The notion that “risk and reward are related” is either ignored or not accepted or understood, with the behavioural flaw of overconfidence overriding a more objective assessment.
Investing and making money are seen as ends in themselves. This contrasts with our view that investment is always only a means to the end, with that end being to secure your desired future lifestyle with minimum required risk.
None of the actual or intended financial decisions discussed above would be contemplated with our financial planning approach. Although I am not privy to the desired future lifestyle for each person discussed above, if the sizeable downside risk inherent in all of the actual/intended financial decisions did crystallise it would force significant negative adjustments in lifestyle expectations.
Investment research shows there is a better way
The chances of any of the friends and family referred to in the conversations discussed above reading this article are close to zero. They already believe they know (or can teach themselves) all they need to know about investment and personal financial planning.
It would give me no pleasure to see their hubris and ignorance punished. But it is frustrating that they, like most others, are not open to the rigorous research that suggests there is a better way to take investment risk and maximise the chances they will be able to finance the lifestyle they choose.
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