Business Forum: Can't speak financial? Cheer up

  • Article by: ROSS LEVIN
  • Updated: April 9, 2005 - 11:00 PM

My family just returned from our out-of-the-country spring break trip. My wife speaks pretty good Spanish, and my daughters understand passable Spanish. I, on the other hand, found myself just adding "o" to a few crucial words I needed to transmit -- "taxi-o,"coffee-o." Fortunately, many of the natives spoke reasonable English, so I could generally communicate.

But this got me thinking about how financial planning concepts, with which I am so comfortable, might sound unintelligible to those who don't speak the language.

Behavioral finance

Financial planners often bring up the concepts of behavioral finance when we look at how smart people can make seemingly foolish money decisions. Behavioral finance issues come in many forms and can seem incredibly complicated. Here is just one of those concepts, sunk costs, described in a manner to which you can easily relate.

We had paid in advance to go on a tour that, once we arrived, we realized we had no desire to take. And yet I almost found myself forcing my family to go ahead with the tour because I had incurred the "sunk cost." Since I had paid for it, I'd better get my money's worth! How stupid. We decided against going on the tour, taking instead a wonderful family hike where we saw a tree full of toucans. Had I rigidly adhered to the sunk-cost principal, I would have missed a great experience.

Think about how you do this in your daily life. Maybe you go to a play that you are too tired to enjoy because you bought the tickets. Or maybe you are afraid to move because you feel you can't get enough of the value out of your house. Don't punish yourself because of those sunk costs. Do what is truly right for you, whether you have borne some costs or not.

Investments

When planners talk with you about investments, we tend to overwhelm you with jargon. I know that I do it with my clients with the concept of "mean reversion." Here is what mean reversion really is.

We saw some children laughing uproariously at the pool as they ran and played together. At night, we saw those children come crashing down at dinner. They either had a huge fit or fell asleep at their tables. With kids, what goes up must come down.

What happens with kids happens with investment classes -- and this is mean reversion. For example, according to Callan Associates, from 1995 to 1998, the Standard & Poor's Barra 500 Growth area (large-cap growth stocks) was the best-performing out of eight asset classes; from 2000 to 2004, it was the second-worst-performing asset class.

This is a universal truth in investing. Over long periods of time, stock investment classes -- large, small, international, growth, value -- will perform similarly. Since this is the case, the best performers for one period will inevitably have compromised returns down the road. Even this year, while many U.S. stocks are floundering, international investments have yielded positive year-to-date returns.

And think about areas that performed poorly last year as potential bounce candidates. Before your eyes glaze over the next time an expert talks of mean reversion, just think of the laughing and sobbing child you see at the supermarket.

How about the investment that we all know is completely golden -- real estate. I was talking to a developer I met on our trip who said that what he likes about real estate is that "He makes money while he sleeps." I told him that this might be true, but the problem is that when the market turns against you, you are so nervous that you can't sleep.

In fact, in some countries after currency devaluation, property has dropped by two-thirds! When you think that you can just close your eyes and count dollar signs, this is about more than mean reversion -- it's about greed. Decide what returns you need based on your goals and choose to take only as much risk as necessary to achieve them.

General planning decisions

You might have heard economists talk about "marginal utility." Here is a real-life example of this concept in action.

Many of the places we stayed included an all-you-can-eat breakfast buffet. I used to pile my plate high with everything from pancakes to eggs to bacon to yogurt. I realized pretty quickly that my enjoyment of the breakfast waned somewhere between my fourth forkful and my 40th. My hunger had been sated early enough so those last few bites did not create equal satisfaction as my first few bites. The marginal utility of my last bite was far less than my first.

Rather than pile stuff on my plate that I really didn't want, I decided to think about what I really wanted before I headed to the buffet line. This helped me make more reasonable choices. Just because you can have something doesn't mean that you should. When you are looking at the resources you have, take time in advance to think about what the most important things are and dedicate your time and energy to those. And deliberately choose to not buy or do some things.

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