The attitude toward Money varies in different cultures. There is a mixture of love and hate. Some see it as the source of all problems in life, and some see it as of core importance. None of these are quite right. I think in order to view money in the right perspective, firstly, we need to understand the fundamental of what money really is; Perhaps by gaining a better understanding of what money truly represents, we can adopt a more appropriate attitude towards money.
Money is merely a measurement of an important commodity in our society, RISK. There are no prejudices held against the word “Risk”. It is a very important driver of biological evolution including our own one. Like all other animals, we evolve to better adapt to the changing environment and ultimately, to reduce the risk of survival.
In our dealings with risks, humans started to do one thing that no other animals have done. We knew how to reduce our own risk by exchanging risk with one another. So came the era of bartering. All goods are a product of a different set of risks it has taken on in order to produce. As bartering became more advanced it would start to involve more parties. For example, one day the Grower Mary urgently wanted to exchange her crops which couldn’t be delivered for another 3 weeks for Hunter John’s meat to feed her offspring. Congratulation, debt was born. That repented a risk that Grower Mary has just passed to Hunter John. Now John wanted to exchange the undelivered crops for Tool Maker Adam’s hunting tools. They need something to quantify and standardize risks so this more complicated exchanging of risks can be made possible. Currency was born. Money as we know it today was just a natural progression along this line.
As our society progressed, risk became more complicated. Human’s ability to assess risks had not evolved as quickly as our social evolution. Today, most people are still very primitive when it comes to risks assessment. Using intuition or the heuristic approach, which is can be referred to as the “rule of thumb”. Since money is the measurement of risk, the accumulation of money is an indication of how well someone assesses risk. Risk is not the enemy of money creation, it’s the mother of it.
Kids should be enabled with a solid understanding of risks and how the world works (namely common sense) in order to prepare themselves for the greater community. In my opinion, a child who has a right attitude towards risk will naturally grow to have a right attitude towards money and also joe best to manage it.
Following on from my previous comments regarding money attitude, the lessons I have learnt, is that, each investment is met with risk is on the other side. It is the main driving force for all investment returns. You take on risks, you should be rewarded with corresponding expected returns. And of course, it depended on whether the risks are correctly priced.
When we are presented with an investment option, we will do two things. First of all, we need to know what the risk is for the investment and are we comfortable to take on these risks? For example, equity (stocks) will have inflation risk, economic risk, interest rate risk and sectoral cyclical risk etc pegged to it. Secondly, we evaluate if this investment is correctly priced given its inherent risks. If a security is correctly priced, you will be rewarded with expected return. If the investment is overpriced, that means you will take on unrewarded risks.
This can be likened to the nutrition label on food packaging. By analyzing this, you can see all the different components such as protein, sugars and fats. Is it the nutrient that you need for your diet? Then you finally check the price of the food item and make comparisons.
Budgeting and saving are crucial in managing your wealth as well as achieving financial goals.
In traditional finance, life-cycle model is used to map out the saving and consumption plan. People are assumed to exercise near perfect self-control to balance the short-term spending and the long term financial goals. In reality, this assumption is far from the truth. Behavioural biases make people deviate from the rational (traditional) path.
Knowing that reality is different to the theoretical world, researches have sought answers from behavioural finance. It’s a science that attempts to answer questions such as “How do emotions affect judgement and decision making? How do people perceive uncertainty? How does risk affect decision making?”.
It turns out that we can use our understanding of how people actually behave when it come to making financial decisions to help us save and control spending. The two behavioural biases that we can utilise to our advantage are; mental accounting bias and framing bias.
Mental account bias is about how people have different attitude towards risk depending on how they mentally categorized money. Typical example would be people see the money they won in casino as “house money” that can be used to irrationally take on excessive risks.
Framing bias explains how people have different responses to questions dependent on how the question is asked (framed). For example, in choosing Portfolio A or Portfolio B for investment. Portfolio A offers 70% chance of attaining financial goals and Portfolio B offers 30% chance of falling short of one’s financial goals. People are more likely to choose Portfolio A because of the positive way that the question is framed.
After recognising that people tend to focus on short-term satisfaction to the detriment of long term goals, we can use mental accounting and framing as a partial response to the issue of self control. Our recommendation is that you classify your sources of wealth into three mental accounts: 1) current income; 2) currently owned assets; 3) the present value of future income. People tend to spend firstly, based on current income and finally, spend based on future income.
The propensity to consume has different implications. For example, high proportion of bonus will be saved because people treat it as current asset rather than current income and thus have a lower propensity to consume it. If people allocate portion of current income into mortgage offset account, which is classified as a current asset rather than current income, than it will less likely be consumed for short term gratification.
Another implication is that, if people classify home equity as current asset instead of future retirement asset or future income, people are more prone to take out loans against it to fund short term spending. Individuals will spend for most of their current income on current consumption, a varying portion of their currently owned assets and very little based on their expectation of future income.
So in order to help with self control, use mental accounting wisely to trick your own brain into looking at money differently. It is not going to achieve the theoretically optimal short term and long term consumption plan. But this knowledge of behavioural finance can help us be closer to the optimal solution.
I’ll talk a bit about the pitfalls we see people make in managing their Self Managed Super Fund. Individuals set up SMSF for the control of capital. This control comes at a premium. Two issues we see in managing an SMSF are high concentration of investments and excessive trading.
Investment returns are driven by risks, with risks moving through different cycles. Highly concentrated or inadequately diversified portfolio means it has less resilience to sectoral or market cyclical risks. If an SMFS is highly concentrated on say, property or Australian stocks, this means its performance is highly correlated with the Australian economy or interest rate risk. An optimally diversified portfolio is one that can deliver long term returns via all its growth assets and also enjoys less short term volatility thanks to the low correlation amongst its asset classes.
Most people are aware of diversification, however, they tend to adopt “naive diversification”, which is equally distributing funds among their short listed funds. If there are 5 funds a investor is considering, she will be inclined to invest ⅕ of fund in each fund. A research study has asked two groups of people to allocate 100% to two portfolios. Group one was offered: A is a stock fund, B is a bond fund. The average outcome is 50/50 allocation. Group two was offered: A, a stock fund, B, a 50-stock/50-bond balanced fund. The average outcome is still 50/50. It is clear that group B’s outcome clearly has an overweight on stocks. The covariance or the correlation between assets are ignore by most investors. The overweight investment in stocks is unintentional and is due to behavioural bias.
Excessive trading came from behavioural bias of overconfidence, illusion of control and fear of regret. Scientific research has shown that excessive trading is detrimental to investment performance. Individuals try to time the market by trading in and out of a fund or an investment. This behaviour causes investors to underperform buy-hold strategy by as much as 6% annually compounded. An individual who begins full time employment at 21 and retires at 67, every 1% increase in annual compound return is equivalent to $200K at retirement. You can do the maths.
Separately Managed Accounts (SMA) can be a very tax efficient vehicle of investment when compared to traditional managed funds. You receive the same benefits of engaging professional investment experts without the tax inefficiency of pooled funds. Ask your advisor about this service and consult your tax advisor on its implication.
From a behavioural finance perspective, we recognise that the reason for having an SMSF is due to the fact, investors want control and seek higher market engagement. This why we suggest adopting a Core-Satellite approach to portfolio construction. This is where a core portfolio is combined with other satellite investments. It is important to build a robust and diversified strategic core as the building block. The composition of the core is depended on your individual circumstance and financial goals. It should be optimally diversified across different asset classes and different risk factors. This core would serve the purpose of providing a strong foundation to achieve long term financial goal.
Additionally, investors can trade or invest in high conviction investments with the satellite portion of the portfolio. This Core-Satellite approach will give investors more confidence as they remain engaged with the market with a better overall wealth creation experience.