14 Mar Emotion and Fact in Financial Decision-Making, author unknown

First of all, the title implies that there is a correct answer, which, of course, there is not. In the absence of the entire range of data and facts of any given situation, the appropriate answer must always be, “it depends.”

At a deeper level, this and every financial question involves two core issues. One is financial, which I will not discuss here, and the other is emotional, the “comfort” or “peace-of-mind” issue.

 

Let us here explore the emotional side of the question.

Peace-of-mind is a relative emotion. Generally, people feel secure when their actions or circumstances are in alignment with their preconceived notions of what they assume to be smart or safe. The problem with peace-of-mind, as Charles Darwin so eloquently stated, is that, “Ignorance more frequently begets confidence than does knowledge.”

 

Emotions are manipulated by sales hype, sensationalism, and social pressure.

 

When people say they are “comfortable” or “satisfied” with their financial decisions, are they making decisions that solely align with their assumptions and preconceived ideas of what they deem accurate?

 

The ability to recognize this weakness is what will separate those who prosper economically from those who fail to reach their potential.

 

Economic prosperity is never measured by a number on a piece of paper, but rather by the test of actual results compared to potential results. To me, the following question addresses the heart of the matter:

 

Based upon your values, are your resources translating into the maximum quality of life, with the least amount of risk and the highest degree of certainty?

The issue is efficiency.

 

Because most people lack the time or means to adequately verify their choices beforehand, they resort to a “trusted opinion” of a friend or supposed expert. Unfortunately, trust of this kind often leads to lost wealth and shattered dreams, because the trusted advisor’s opinions have usually been formed based on tradition, popularity, and unverified assumptions of their own. To paraphrase Robert Kiyosaki, author of Rich Dad, Poor Dad,

 

“The difference between the wealthy and everyone else is the ability to distinguish fact from opinion.”

 

The path of least resistance is to blindly follow the unverified advice of others, and do what most people do. You may not be right, but you will not be alone either. The more difficult option is to expend effort to find the truth.

 

It is admittedly a little scary when you start testing assumptions, but the question to ask yourself is this:

When the truth is available, when do I want it?

 

You should be warned that to commit to finding and following truth will sentence you to a lifetime of swimming upstream.  Most are unwilling to question assumptions because of fear, arrogance, or both. If you derive your security or confidence from doing what everyone else does, beware. The truth offers its own rewards, but social proof is not one of them. Most people will think you are nuts. On the positive side, though, ask yourself this question:

How often is the path of least resistance the most rewarding?

 

What I am saying may not be popular. As philosopher and author Truman G. Madsen once said, “You will never find a want-ad for a philosopher.”  Yet, long-term sound decisions are always the result of applied sound philosophy. I read a quote from a very successful businessman regarding finances who said, “When the masses walk one way, I walk the other.”

 

So back to the issue of financial decision making based on emotions:

Is your confidence and peace-of-mind the result of independent verification of your decisions, or is it simply derived from the fact that you are doing what you believe you are supposed to do based on the opinions of others?

 

Model economists say that the primary source of error in financial decision-making is failure to understand long-term consequences and secondary effects of choices.

 

Because so many variables are involved, it is impossible to accurately anticipate consequences of choices over the long-run. This is why economists build and use models to aid in the process of understanding the possible results of various circumstances and decisions. Models are not capable of predicting outcomes, for the reasons stated earlier, but they are very useful in identifying principles that govern outcomes through a variety of tests, simulations, and observations.

 

The primary objective of financial analysis should be to understand the principles which govern the results of any economic choice, not to know what to do in a particular situation, such as whether to pay off the house or invest in a 401(k).

 

A good litmus test for financial strategies is to answer these questions:

What has to go right in order for this to work?

What could go wrong that would cause my plan to fail?

A partial list of variables to consider could be:

Unemployment; market crash; inflation;

significantly higher taxes; other changes to tax laws;

interest rate changes; lawsuit; disability; premature death or unusual longevity;

property loss; health changes; fear, uncertainty, or other human nature factors;

divorce; remarriage; fraud or misinformation.

 

Strategies that are not fully resilient to every risk listed above are therefore less than ideal, and leave room for scrutiny and improvement.

Perfection should still be the goal.

Emotions can often cloud facts in the decision-making process.  By modelling the facts, emotions are tempered by the truth of the situation.  Financial success is the result of sound financial decision-making.