Economics isn’t named the dismal science for no good reason. In terms of the accuracy of its predictions, it has more in common with Astrology than Physics or Chemistry. Seriously, if you had based your investment decisions on their predictions on when the economy would turn, I wouldn’t be surprised to find you living in the streets today.
The problem is, these economic models are based on the BIG assumption that human beings are rational. But are we really that rational? (Nope? Especially when I see those big diamond rings and their price tags.)
Seems not, especially if you have been following the latest research and findings from Behavioral Finance/Economics. These stuff (as compared to the latest macro models) have grown increasingly popular and have even entered the mainstream consciousness (you know it when you find books like Nudge and Thinking, Fast And Slow appearing at Popular bookstores).
For example, I might have identified a stock with a share price of $1.00. But because of the anchoring bias, it’s hard for me to buy more after it climbed to $1.50 in a month, even if I “know” that its business prospects have improved by leaps and bounds and $1.50 remains a big discount off its intrinsic value.
It also appears that we like to fool ourselves. We find it easy to imagine saving money next month. But when the next month arrives, we realise it’s easier to spend than save. And the cycle continues.
We spend so much time studying and finding out these built-in weaknesses of humans. But then instead of not acting on these impulses or biases, we are taught to learn to accept them and then device strategies around them.
If we have a spending problem, financial experts advice us to freeze our credit cards. Unable to save? Navigate around your weakness by paying yourself first at the start of the month. It seems to follow that we should just tie up our stomachs if we have a weight issue. (FYI, this procedure is real and out there.)
These gurus definitely hold a dim view of humanity just like Hobbes. But no one is complaining since these methods work, right? ‘It doesn’t matter whether it is a white cat or a black cat, a cat that catches mice is a good cat”.
The thing is, many of these behavioural-psychological strategies do produce some negative side effects. I have illustrated some examples below:
1. Debt Snowball Tactic
This so-called financial guru Dave Ramsey advocates a tactic called the “debt snowball,” through which you pay debts in the order of the smallest balance to the largest balance, regardless of interest rate. This is based on the view that people tend to give up on arduous projects if there’s no tangible benefits at the start. Those low-lying fruits are necessary to keep the engine going. “Hurray! One debt down after just one month!”
But this doesn’t make any mathematical sense. In fact, one is likely to be worse off practicing this. The debt with the higher interest rate would definitely snowball faster and should be tackled immediately instead. The saving grace of this strategy is that most of the time, the debts with the lowest balance (credit cards) tend to be of higher interest than those with higher balances (mortgage) as shown in this previous post.
2. No debts! But no matter what?
How about loans with no interest then.
“You must be joking?! How would these stuff exist in this world?”
Then you probably haven’t heard of the tertiary loans provided by our three local banks for Polytechnic and University education. These loans are actually interest-free during the course of study, which means a period of between 3-5 years!
However, many well-to-do parents have a neurotic aversion to letting their children be in debt for their education. Reasons like “It’s better to pay it first. Who knows, the market might tank when Boy Boy graduates and he will be saddled with debts. He needs a headstart in life!” cut no ice with me.
If you’re that risk averse, just place all those monies in fixed deposits. Even with meagre interests on the deposits, one will at least be a few hundred dollars better off 4 years down the road.
3. Use ILP/Whole-Life Insurance/Endowment as a savings plan
“Most people do not have the discipline to save for their financial goals. Therefore, you should pay me to get you into this Investment-Linked Policy/Whole Life Insurance/Endowment. As you will be penalised HEAVILY, it will ensure that you will have cash in 20/30 or 99 years when you need it to buy a car or for retirement. These products are great pre-commtiment devices!” – Most Insurance Agents
The above is really bringing Benartzi’s findings (watch it at TED) to a whole new level. Paying high commissions and potentially high penalties (when you really really need the money) to start a saving plan is definitely detrimental to a person’s financial well-being! To be honest, I still can’t grasp the idea of liquidity being regarded as a negative thing.
If you understand that the “I will be saving next month” promise to yourself does not work, then isn’t the simplest solution staring at you in the face? Just learn to ignore this little devil within you and start saving today!
It’s a really depressing situation if you are your own’s worst enemy.