Simple rule to improve financial decisions
- Posted by DynamicHedge
- on September 5th, 2015
Why are financial decisions so difficult? Not just the ones related to investing and trading but the ones that spill over into every day life. Obviously, the stakes are high because money is involved. We’ve heard ad nauseum about how behaviorally we’re not wired to make great financial choices. Paradox of choice, and all that. So what do we do about it? Some people concoct complex analytical ways of determining how to optimize outcomes in every situation. That’s fine for some things. You can also get similar results by adopting a simple rule. Don’t fight simplicity.
I have a simple rule that helps lift the cognitive burden of many financial decisions I make. I’ve made a lot of mistakes on the way to this realization. I’ll share my trick with you today, so you don’t have to make the same mistakes. Like all simple rules they’re designed to be easy to follow and flexible enough to adapt.
Here’s the rule: financial service companies do not introduce new products that make less money (why would they?). Therefore, new products will be a bad deal for you. Always default to the older (or oldest) financial products available.
Put another way, if a financial service company releases a new product that purportedly helps the consumer, it means they identified a way to make more money, reduce their risk, or both. You’re the person they’re making money off. You’re the person likely taking on more risk. So, if faced with a decision between a new product and an old one, always choose the old one. Easy right?
A recent example is Energy MLPs (master limited partnerships). MLPs are sold to investors as a bond alternative. The sales pitch states that you get bond-like returns with the upside of participating in the growth of energy infrastructure (without the volatility of global energy prices). Really? Well, MLPs just blew up as a category, and it turns out they were nothing more than a new financial product. If you followed the simple rule, you would have never touched them as an investment. Individuals, pension funds, insurance companies, and lots of other institutional investors have plenty of this paper in their portfolios and it sucks. If you want bond-like returns you should be in bonds. Bonds are nearly as old as the hills.
Let’s say you are trying to choose between leasing a new car or buying a used one. The reason you’re considering a new car is because it seems the dealer you can get you more car for less money. Examining the monthly payments gives the illusion you can spend a similar amount of money and get something newer or nicer. It’s tempting. There’s a laundry list of cognitive blind spots working against you but if you follow the simple rule, you’ll recognize that the modern car lease is a relatively new financial product. Based on the simple rule you can eliminate it as an option. Get something less expensive and finance it traditionally (all else equal) or with cash.
The simple rule also works for mortgages. Does it make sense for you to sign up for some new “innovative” mortgage product that fits your budget now (and resets later) or to save enough money that you can get a regular mortgage? Which one of those ideas has worked out in the past?
This rule does not mean you should shun everything new. As far as I can see, the rule is most effective in the narrow vertical of finance products. Also, what’s good for the micro (you) isn’t necessarily good for the macro (society as a whole). Anyone who can run a spreadsheet will tell you that financial innovation empowers underserved segments of society and is good on a macro level. But, I don’t make my decisions based on the collective good. I do what’s best for me. This rule is designed to keep you away from the big, costly financial mistakes.
I hope this helps to shape some of your decisions and gives you the confidence to say no to things you don’t need in the future.
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DynamicHedge is an equities, futures and derivatives trader based on the West Coast. He runs a long/short opportunistic relative-value strategy within a proprietary trading group. More
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