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Approximately Right vs. Precisely Wrong

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Photo Credit: ThinkStock

Photo Credit: ThinkStock

The second president of the United States, John Adams, made a prediction years ago in a letter to his wife:

“The second day of July, 1776, will be the most memorable epoch in the history of America. I am apt to believe that it will be celebrated by succeeding generations as the great anniversary festival…It ought to be solemnized with pomp and parade, with shows, games, sports, guns, bonfires and illuminations, from one end of this continent to the other, from this time forward forever more.”

Make no mistake about it, John Adams painted an incredibly accurate picture of what was to come! This coming month, a mere 237 years later, our nation will celebrate its great anniversary festival by hosting parties, parades and fireworks with our neighbors, family and friends.

But focusing too heavily on the details, however, one could also argue that John Adams was wrong. After all, we celebrate our nation’s independence on the fourth of July, not the second!

In hindsight, it seems ridiculous to claim that Adams was incorrect. In the moment, however, it is easy to get distracted by minutia that has little relevance to our financial well-being. We easily become critical of ourselves and envious of others, resulting in us completely missing the big picture.

People frequently confuse precision with accuracy in their financial lives. It is often believed that the more precise you get with calculations and assumptions, the more details you can uncover.  But as the saying goes, every time you “assume” something, you stand to make as “ass” out of “u” and “me.” We must be careful where we apply precision, as it is often misplaced.

As Michael Edesess states, “Economics pretends to be mathematics, but it is not mathematics. There is a major difference. No mathematician uses a term in a formula, or a statement of a theorem, unless that term has first been defined with excruciating precision. Hence, there is no question of what the term means, let alone any debate that is carried on only because two disputants have different concepts of the meaning of their terms. As a result, a very simple proof of something will invariably persuade the other side. The cost of this, however, is that mathematics is strictly limited in what it can define and prove.”

In our personal financial lives, this dynamic manifests itself in a wide variety of ways, but is typically a function of focusing too much on short-term results. Your neighbor got a 3.0% rate on their mortgage while you refinanced at 3.25%. Your brother-in-law bought Google’s IPO as you maintained a balanced portfolio. And your friend saved 15% on her car insurance.

On the surface, it may seem like you are doing something wrong, missing out, or getting bad advice. The big picture may paint a very different picture. Your neighbor is planning on staying in their home forever and was willing to incur higher closing costs to obtain that rate, while you are planning on moving within 5 years. Your brother-in-law also bought a handful of other IPO’s that didn’t fare so well (and neglects to mention that when bragging about Google). And your friend elected to reduce her liability limits to obtain the lower rate.

Proper financial planning revolves around all areas of your financial life working in tandem to support the life you want to live. Every financial decision has butterfly effects. If you take on additional risk (whether it is in your portfolio, borrowing more money, or the result of reducing liability limits) as a byproduct of focusing too heavily on the short-term, you jeopardize all of the things you have accomplished to date.

This phenomenon is particularly troubling to the mathematically inclined, which happens to be the lion’s share of the financial services industry. Finance is often discussed as if it is a series of linear calculations. In some respects, it is.

However, when assessing the purchase of a bigger home or second home, there is far more to consider than whether you can afford a bigger payment. The obvious changes are mortgage payments, real estate taxes, utilities, maintenance and home insurance. However, all of these increased cash flow commitments means that the level of support required in the event of a lost income increases, whether that is temporary due to job loss, or permanent as a result of death or disability. A new neighborhood means new friends and neighbors, new social networks and structure, new school systems and a wide range of social pressures that may result in meaningful changes to our financial commitments.

In the investment realm, we argue over active and passive investment strategies, when simply (1) having a solid strategy and (2) actually following it are  far more important in the context of our financial well being. Investment behavior is a far greater determinant of financial success than investment strategy. The allure of interesting research, charts, graphs and mathematics often causes us to lose sight of this.

We use excruciating precision when discussing things like safe withdrawal rates from a retirement portfolio, the best time to start taking Social Security benefits, or how much to save in order to reach a 20-year retirement goal, despite the reality that none of us live the static life we use to model these scenarios. Cash flows ebb and flow, life and career opportunities ebb and flow. The value of flexibility in a financial plan can’t be modeled in a monte carlo analysis.

At the end of the day, all of these analyses are laced with assumptions that are ultimately going to change. Those changes may be a function of life events, tax policy changes, or things we can’t even fathom at this point in time. When those changes occur, we have a tendency to apply a laser focus to the areas directly impacted rather than how it will impact the whole picture. While each of these changes are going to impact the individual components of a plan, they likely impact the total picture less than we think, particularly if we have made all our decisions with the big picture in mind.

This does not mean these analyses aren’t warranted, however, we ought to consider that our assumptions – no matter how well researched and developed – may turn out incorrect. In her book, Willful Blindness: Why We Ignore the Obvious at Our Own Peril, author Margaret Heffernan explains that “we turn a blind eye in order to feel safe, to avoid conflict, to reduce anxiety, and to protect prestige.” In other words, we project images we want to see play out in our lives and then cling to them, subconsciously converting all the assumptions and variables used to build those images into unwavering facts. Heffernan suggests we ought to constantly be asking ourselves, “what if I am wrong about this?” We must apply a margin of safety to protect us against ourselves and our inability to predict the future.

The difficulty in applying this, however, is that the margin of safety cuts both ways. A great deal of advice given in financial services is really driven by being overly conservative with our assumptions. This bias is a function of the great fear most people have about running out of money, and the reality that financial professionals know that markets, cash flows and lives can be quite volatile. A few ill-timed decisions can derail even the best laid plan, so a safety margin is built in.

However, being overly conservative robs people of living a richer life, perhaps traveling more when they still have their health, sharing some of their wealth with children and grandchildren while they are around to enjoy it with them, or simply not having to make major decisions like downsizing a home prematurely. There is great risk in relying too heavily on linear mathematics to make abstract decisions. And though we are discussing financial decisions, that risk is not quantified by money.

Understanding the mathematics of personal finance is critically important to frame your decision-making process. However, once there, you are far better off maintaining a focus on being approximately right, than relying too heavily on quantitative measures and risking that you could be precisely wrong.

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1 Comment

  1. Russ Thornton says:

    Fantastic article. Well written and very true . . . nice job, Joe

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