Have you ever made a bad decision?
Have you ever made a bad financial decision?
I’ll go first. My answer to both questions is a resounding, “Yes.”
In the world of financial commentary, there has been plenty written about bad decisions fueled by emotions, but what about those bad decisions that were made with a perfectly sound mind? I’d like to discuss those types of decisions today.
Essentially, financial planning is just the collection of small decisions, and these small decisions ultimately equate to either positive or negative outcomes; a goal achieved or a failed aspiration. Sure, some decisions carry more weight than others, but ideally, we’d like to get a majority of these small decisions right – we want to hit the mark.
If not our emotions, what other financial-decision-enemies are lurking out there? Today we will specifically discuss two: assumptions and secondary consequences. Then, we will unpack a simple example to show how our assumptions and secondary consequences play out in real life.
Our Assumptions
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Mark Twain
David Bahnsen’s father, Dr. Greg Bahnsen, was a philosopher, theologian, and probably best known for his work in apologetics. Specifically known in the field of apologetics for championing a presuppositional approach. I am personally fond of Dr. Bahnsen’s defense of the faith, and I am partial to this manner of peeling back the onion to clearly see how we land at our conclusions. We peel layer by layer to understand what our presuppositions are, we clearly identify those assumptions, and we challenge them. This same framework can easily be applied to personal finance.
What we are really talking about today is behavioral economics, essentially the study of financial decision-making. A key concept within this field is the study of heuristics: the shortcuts, rules of thumb, and biases we bring to the decision-making table. The problem here is that if we unknowingly land on a bad decision, the compounding nature of the financial world often amplifies the consequences, which is what I’d like to touch on next.
Second Order Effects
“Failing to consider second- and third-order consequences is the cause of a lot of painfully bad decisions, and it is especially deadly when the first inferior option confirms your own biases.” – Ray Dalio
David Bahnsen recently penned an article in World Magazine that highlights the four books that shaped his thinking on economics. Inspired by the article, I decided to purchase Economics in One Lesson by Henry Hazlitt. I’m most of the way through the book, and if you were to only walk away with one thought or concept, Hazlitt would want you to be aware of the second-order effects of financial decisions. Sure, the book focuses on public policy and high-level economic decisions, but the concepts clearly apply to our personal financial decisions.
When we decide to do “X” versus “Y,” this is not only a decision on where to go directionally when we hit a fork in the road, but it also impacts the path and journey going forward. The domino effect of our decisions often includes the unintended consequences that we did not consider initially.
If our assumptions are about looking backwards and asking, “How did we get here?” Then, secondary consequences are about looking forward and asking, “Where will we end up?” Financial decisions are like crossing the road; we must look both ways – forward and backwards – before proceeding.
Where the Rubber Meets the Road
I am always leery about sharing my Thoughts On Money without landing the plane with some simple and practical application. Up to this point, we’ve discussed concepts and theory, but this article would be lacking if we didn’t dive into application. So, let’s take a look at a very simple financial decision and discuss common assumptions and secondary consequences associated with that decision.
“Should I invest in my 401(k) plan at work?”
The heuristic here, or short-cut answer, is, “Of course!”
Let’s unpack this further, though; let’s peel back the onion. What are some potential assumptions here? “Everyone else at work is participating in the 401(k) plan, why wouldn’t I?” or “It’s prudent to save for retirement, right?” Again, these assumptions could lead us to a quick conclusion, but we are best served by first asking what exactly a 401(k) plan is. We want to understand the pros and cons of a 401(k), and we want to understand if there are any potential secondary consequences associated with this decision.
So, what is a 401(k)? A tax-deferred retirement account is defined in Section 401 of the tax code. A participant can fund this account – within annual contribution limits – using pre-tax dollars and defer the taxes to be realized/paid at a later date. Essentially, the account can’t be accessed before 59 ½ without penalty (barring a few exceptions), and the IRS will eventually require distributions starting as early as 73 based on rules around Required Minimum Distributions (RMD).
This small description should raise even more questions:
- Could I potentially be deferring taxes to a later date when I will be in a higher tax bracket?
- If distributions are treated as ordinary income, would it be better to save in a brokerage (taxable) account and pay long-term capital gains rates?
- What if I defer my taxes in a state that has no income tax, but I retire in a state that does?
- Do the liquidity limitations – based on the early withdrawal penalty – create an issue that I haven’t considered?
- Does my employer offer some sort of matching incentive that I would miss out on by not participating?
As you can imagine, the list does go on. A simple financial decision, right? Maybe one we’ve never thought to challenge.
I use this example because I think most approach this as a “no-brainer,” but I have personally seen this small decision have a meaningful impact on someone’s financial plan.
It Depends
One of the most common and frustrating answers in the realm of personal finance is, “It depends.” Whether it is at a family gathering or a sporting event with friends, if you are the token financial advisor in the group, you are bound to get peppered with questions. Your likely answer is, “it depends.” As seen above, even participation in the 401(k) plan at work deserves deeper thought and more follow-up questions.
Behavioral finance uses the word heuristic synonymously with “mental shortcuts” or “rules of thumb.” The dictionary definition references “trial and error.” None of these descriptors is suitable for our financial decisions. We want to be confident in our decisions based on solid research, questioning our assumptions, and grounded conclusions.
What’s right for your financial plan, very well might not be right for mine. My preferences, background, resources, etc., make the need for advice and a plan that is tailored to me individually. Why? Because just like toothpaste out of the tube, many financial decisions don’t allow for take-backsies, you are simply left with the consequences.
So, always look both ways. Look backwards to understand your assumptions, and look forward to understand the potential consequences. Financial planning, the sum of many small decisions.
