Foundations of Decision Making

Decision making principles for successful wealth management

Smart decisions rely on solid foundations

We apply a number of decision “principles” to help guide our clients’ wealth management success.

Many are based on research from the fields of economics, psychology and decision making analysis. Others, however, reflect how we look at things, driven by both our values and experience. While these principles are focused on wealth management issues, most of them have much broader application.

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Some key principles that we think will help you make better decisions are discussed below under the following headings:

1. Understand opportunity cost

Opportunity cost is an important concept in economics. It says that the cost of any action is not the direct cost incurred in taking that action but the highest value alternative action you choose (perhaps, unknowingly) to forego. The decision rule that applies is that you should only choose actions that have benefits in excess of their opportunity cost.

Let’s make that a little more concrete with an example.

Assume a surgeon wishes to have a brick wall built at his residence. A bricklayer, costing $50/hour, could build the wall in one hundred hours for $5,000.

However, the surgeon is a capable bricklayer – he could do the work in one hundred and fifty hours. So he takes three weeks off work, builds the wall and saves himself $5,000. But has he really?

In his medical practice, the surgeon can earn a net $300 per hour or, say, a total of $45,000 over three weeks. The surgeon’s opportunity cost is therefore $40,000 in excess of the benefit of building the wall himself. He should choose to hire the bricklayer, rather than give up his day job!

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Application of this principle implies that it does not usually make economic sense for most people to become amateur financial planners or wealth managers. This does not mean that you abrogate responsibility for your financial affairs but rather that you should focus on what you are best at to increase the likelihood you will achieve what is really important to you in life.

“... from the standpoint of building wealth, free time is better spent sharpening one’s professional skills rather than studying investing.”
Warren Buffett

The opportunity cost concept is also relevant to effectively using leisure time. Too many people notionally undervalue their leisure time, resulting in them choosing to do things they would be better off paying someone else to do.

For example, consider the situation of a self employed lawyer who could work 80 hours a week, earning a net $250 an hour, but chooses to work 50 hours a week to have more leisure time. We can therefore say that his leisure time is worth at least $250 an hour, as that is what he is prepared to give up (i.e. it is his opportunity cost).

However, each weekend he spends 7-8 hours and his wife a further 4-5 hours doing chores - gardening, washing cars, completing various maintenance jobs, washing, ironing and tidying up the house. All these jobs could be done by third parties at no more than $50 an hour.

Unless our lawyer and his wife get such intrinsic satisfaction out of doing these “chores”, he would be better off working a couple more hours a week as a lawyer and hiring the necessary domestic help. He and his wife would then be able to enjoy (and, perhaps, find) things that are far better uses of their leisure time.

Whenever you find yourself queuing, chasing the “best price”, doing things that you don’t enjoy, you need to ask yourself whether you have properly taken account of the value of your leisure time. Although the monetary value you require to commit your time may vary depending on what you are giving it up for (e.g. helping a charitable cause versus working additional hours), if you don’t think of it as a valuable resource you can end up doing some things that are counterproductive to what’s really important to you.

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2. Focus on what you can control

Good decision makers don’t waste effort on or aren’t distracted by things they cannot control or effectively influence. They focus on the inputs that drive outcomes, rather than the outcomes themselves.

“Happy people plan actions, they don’t plan results”
- Dennis Wholey

In a wealth management or financial planning context, we encourage clients to focus on costs (both personal and investment), risk (both personal and investment) and taxes as these are aspects of their financial affairs they can do something about. We do not directly focus on investment market returns as these are out of our control.

How often do we hear champion athletes respond to interview questions like “Did you ever think you could win tonight?” with responses like “Aw, gee mate, I just thought about doing everything we practised and practised at training”. The focus is on the inputs – other than luck, that is the only way you have any chance of achieving desired outcomes.

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3. It’s about ends, not means

As in all walks of life, when it comes to their financial affairs people often confuse means with ends. For example, they want to reduce tax, they want higher investment returns, they want less risk, they want a holiday house, they want income earning investments so they have cash to live off etc. etc.

The list is long – you could say endless. But the question is, is that what they really want? Are any of these things ultimate aims or are they only potential means to what may not be well considered or well articulated goals. When challenged, most people admit their aim is not to pay zero tax or to maximise their wealth but to achieve their version of a good life.

The problem is that a focus on the means for their own sake rather than on their contribution to achieving the desired ends could do you more harm than good. Often there needs to be compromises made between the means in order to give you the best chance of getting where you really want to go. 

For example, it is unrealistic to expect higher investment returns and at the same time demand lower risk. Or, while considered in isolation a holiday house may sit well with your idea of “a good life”, it may involve unacceptable sacrifices or trade-offs in other areas of your life.

Smart decisions require a clear understanding of what is of most importance to you and where you want to go. Without an understanding of these primary objectives, decisions made regarding the pursuit of any secondary objectives (i.e. means) are likely to be less than optimal and, often, counterproductive.

4. It’s about goals, not obligations

David Henderson and Charles Hooper in “Making Great Decisions in Business and Life” warn of what they call the “I must” trap as a hindrance to clear thinking and sound decision making. The reality is that there is very little you must or are obligated to do. Nearly everything we do by choice, because we “want” to do it.

Some of these choices may not be that palatable. You may not be overjoyed to work all next weekend to finish that already overdue report. But the alternative is possibly less palatable to you - you will not be able to buy that new car, you will not be able to go on the holiday you were planning etc.

It is often helpful to remind yourself that when you choose goals for yourself, you also choose to do things necessary to achieve those goals. They are not obligations, but a consequence of your goals. If you find yourself burdened with apparent obligations, it is a good time to review the goals you are trying to achieve in meeting those obligations. You may find they are no longer of importance to you, if they ever were.

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5. Don’t make mountains out of molehills

Not all decisions are of equal importance and, remember, your time is valuable.

If a decision is unlikely to have significant financial consequences or can be easily reversed, it is not worth giving significant time to. Even for a major decision, if, after having gone through a robust decision making process you cannot choose between two alternatives because they appear as good as each other do not continue to agonise. Adopt some simple, time efficient process to make a choice – flip a coin if necessary.

Henderson and Hooper advise that the amount of effort applied to a problem should be proportional to the importance of the problem. As to how much effort to apply to the problem, they suggest “The One-Percent Rule”:

“You should spend approximately one percent of the value of a decision analyzing the decision”.

This should not be taken too literally, but used to provide some sense of the relationship between the effort in making the decision and the expected value of the outcome (in terms of dollars, hours or some other relevant measure).

6. Create alternatives

“There is more than one way to skin a cat.”
- Unknown

You are always able to make better decisions. With more time and more information, better solutions usually reveal themselves. But the reality is that perfection costs too much – you would never make any decisions.

However, except for very minor decisions, the other extreme of accepting the first solution that offers the prospect of improving on the current situation is almost certain to short change you. Too often people want to “move away” from where they are now and jump to the next thing that comes along, rather than “move towards” potentially better, well considered futures.

Good decision making looks at all the obvious alternatives and, where the importance of the decision warrants it, seeks to create new ones as well. The more alternatives, the more likely you are to make a better decision.

When it comes to how you want to live the rest of your life, it seems to us that you should “open your eyes” as wide as possible to the alternatives available. With the help of a robust framework to compare and evaluate them, you are in a position to make smart decisions, confident that they will move you toward a better future rather than just away from where you are now.

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7. Value versus cost, investment versus expense

“What is a cynic? A man who knows the price of everything but the value of nothing.”
- Oscar Wilde

In making decisions, many people focus too heavily on what they are going to have to outlay in terms of money or time to provide them with the potential to achieve their desired outcome. However, what they should be looking at is the expected return of that outlay. If the expected return is greater than the outlay then it makes sense to proceed, regardless of the size of the outlay.

If becoming a Wealth Foundations’ client is expected to improve your expected lifetime financial position by $2 million (in today’s dollars), it is not a smart decision to reject the service because it may cost you $200,000 (in today’s dollars) over your lifetime. In fact, you should not care if it cost you $1.9 million – unless, of course, there was a cheaper alternative available offering a higher net benefit.

In a similar vein, a lack of patience or a short term focus results in confusing the notion of investment and expense. For example, seeing regular servicing of your car as an easily avoided expense rather than essential maintenance of a valuable asset could ultimately cost you dearly, perhaps your life, if there is a resulting major mechanical failure.

Often during economic downturns, short sighted businesses abandon an objective for long term profits and see all outlays as expenses rather than investments in the future. Skilled employees are retrenched, research is abandoned, and training budgets are slashed to achieve instant bottom line gratification. When the recovery comes, such firms are poorly placed to take advantage of the upturn.

Similar short sightedness is often revealed in the area of personal wealth management. To reduce a current tax expense people may enter into dubious “structured” or “tax-advantaged” investments that are unlikely to be consistent with their long term lifestyle objectives. Short term gain for long term pain.

Smart decision making aims to make expected positive returns on outlays. While the amount of the outlay is an input to a decision, it should not drive it.

8. Information isn’t knowledge

We are in the “information age”. If you want to know anything about anything, just “Google” it and up will come links to more information than you probably ever need. In the area of personal finance, we probably have information overload.

But the problem is, how do you sort the “wheat from the chaff”. Can you make “smart financial decisions” or any other major decisions if all you have is lots of information? We don’t think so.

“Remember, data isn’t information, information isn’t knowledge and knowledge isn’t wisdom.”
Unknown

Knowledge is the ability to turn information into some sort of order and meaning and provides a base for making decisions. But wisdom goes beyond knowledge and suggests deeper insights that may come from intuition or experience.

The smartest financial decisions are most likely when relevant knowledge and, ideally wisdom, are brought to bear on particular situations. Unfortunately, much of what is served up as financial expertise or advice is simply information, designed to bamboozle and obscure.

However, we also admit that it is difficult for someone initially seeking financial advice to distinguish genuine expertise from claimed expertise. A purpose in providing our “Foundations” on this website is to provide readers with a robust resource (unfortunately, more information!) to help them successfully make that distinction.

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9. Accept reality and take responsibility

This principle really is an attitude that we think goes hand in hand with effective decision making. It is closely related to hindsight bias discussed under Foundations of Behavioural Science and the “It’s about goals, not obligations” principle discussed earlier.

It proposes that a prerequisite for effective decision making is to accept the reality of where you are now. Of course, that does not mean you have to like it. There is learning from the past but no regrets or recriminations.

Also, our observations suggest that wealthy people, in terms of the holistic rather than necessarily the monetary sense of the word “wealthy”, take responsibility for their choices and actions. They do not look for someone or something to blame when outcomes are adverse.

They get on with life recognising there are things they can control and things they can’t. They are comfortable embracing the uncertainty of the latter and concentrating their efforts and acting decisively with respect to the former.

10. Planning is a process not an event

The old adage states that “people don’t plan to fail, they just fail to plan”. For many, their destination in life is wherever they happen to end up. Some may be happy with this approach.

Particularly in a financial planning or wealth management context, others go a little further. They think that planning is a once off event, as a precursor to making some investments. It is like a company doing a strategic plan prior to a major capital raising and never again revisiting the strategy.

Our view is that for those who are serious about articulating and achieving a desired lifestyle on purpose, rather than by accident, planning is an ongoing process.  Circumstances, needs and objectives and the world around us are constantly changing, requiring regular reviews and updates of your plan to keep it relevant. Ideally, plans should be documented detailing intentions and specific actions to achieve those intentions.

Successful wealth management is about “iterating” your way to your desired future, rather than a mad dash to the line. It is not about quick fixes or “get rich schemes”. It is about decisiveness, discipline and commitment to agreed strategies over extended periods. It requires an urgency with respect to decisions and actions and patience with respect to results.

“Plans are nothing, Planning is everything.”
Dwight D Eisenhower

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11. Avoid complexity

We think the best solutions are invariably the simplest solutions. That does not mean they are simple minded, but rather that they are no more complex than needed to solve the problem at hand.

Particularly in the area of personal wealth management, complexity usually reflects either an unstructured mind and/or a purposeful attempt to mystify that is unlikely to be in your best interests. The current financial crisis provides powerful evidence of the wealth destruction capability of complex financial products. However, this is nothing new. It has always been the case and will continue to be so in the future. Although we don’t usually get into forecasting, next time won’t be different.

We recommend that when making personal wealth management decisions you look for solutions that have an inherent logic and consistency, rather than a reliance on “smoke and mirrors”. If anything is too complicated, too difficult to explain or lacks transparency (a “black box”), run away as fast as you can!

“Any intelligent fool can make things bigger and more complex. It takes a genius and a lot of courage to move in the opposite direction.”
Albert Einstein

12. Implementation is critical

Until a decision is acted upon, it is only a good intention. Unless there is commitment to effective implementation the best decision making and planning are a waste of time and effort.

Too many financial plans are thrown into bottom draws, with well conceived and agreed strategies only partially or never implemented. In fact, many individuals and organisations find implementation the hardest part of the decision making process.

Implementation is more likely if:

  • The agreed decision is documented;
  • An action plan to implement the decision is agreed and documented;
  • Someone is given clear accountability for implementing the action plan;
  • A timeline for implementation is agreed and documented; and
  • There is a process to regularly review implementation progress.

Of course, changing circumstances may warrant adjustments to action plans but progress toward your goals will be made. Inaction almost guarantees that your goals will not be achieved.

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We have the knowledge and wisdom to help you apply the principles of smart financial decision making to achieve the financial future you want. Please contact us to discuss further.

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