Friday, March 21, 2014
Throughout hundreds of articles, lessons, resources, and tutorials, you’ve learned aboutfinancial statement analysis, discounted cash flows, accounting conventions, basic tax strategies, real estate, mutual funds, stocks, bonds, and more. All this knowledge is pointless, however, without the one key trait that has the power to save you from immense financial and psychological pain. That silver bullet is summed up in a single word: rationality.
What is rationality? For the purpose of this article, we’ll define it as “the ability to make intelligent decisions based upon objective observation of your own psychology, the facts surrounding a particular investment, and the specifics of your financial situation”. It can mean the difference between retiring to your vacation home in Palm Beach and spending your days working multiple low-paying jobs into your golden years. Perhaps more importantly, it can mean the difference between a peaceful night’s sleep and agonizing hours of tossing and turning as a result of worrying about your pocketbook.
Rationality Key 1: Know Thyself (Understand Your Own Psychology)
In each and every life decision there are ordinarily two distinctive choices: the one that makes the most sense in terms of financial or physical well-being, and the one that lets you sleep at night.
Imagine, for example, that you have $500K in adiversified portfolio. Your banker approaches you and offers to loan you $300K in a long-term, fixed rate personal loan with semi-annual payments that you estimate can easily be made based upon your expected rate of return. This additional leverage will magnify your return on equity, causing you to generate far more profit for each dollar of your own you have invested. Should you take the deal?
From a practical standpoint, it makes sense to accept the terms of the agreement and borrow the funds. Your investments are conservative, you are not moved by market fluctuations, and you don’t have any need for the capital already in your account. Over the next twenty years, the incremental return that is generated by the borrowed money will result in many times thewealth you would otherwise have owned.
On the other hand, your personality may simply lean toward a desire to be debt-free. Regardless of the additional profit you could earn by utilizing the bank’s resources, you are already financially independent and have no desire to introduce any repayment risk whatsoever. You are going to sleep easier knowing that everything you possess is legally yours with no claims against it. If the Stock Exchange closes for years due some horrific accident or natural disaster, you won’t be affected because there is no need to make payments or sell assets.
Which course of action would rationality seem to dictate? If an objective observation of your own personality reveals that you are likely to fret about owing money – regardless of it is makes good financial sense to do so – it is probably unintelligent for you to take the cash. In other words, as odd as it seems, one of the most rational things you can do is accept your irrationalities that are unlikely to change and compensate for them accordingly.
Rationality Key 2: Remember that Money is a Means, not an End unto Itself
Money exists solely to serve a purpose. All of the effort you put into selecting stocks and bonds is simply so you can have a better life for yourself and your family. There are other factors at work that supercede the time value of money. There is nothing wrong with a 25-year-old spending $400 on a cashmere sweater as long as she is fully aware that the decision not to invest cost her approximately $37,220 by the time she retires. Is a single item of luxury apparel worth such a hefty price tag? Only she can decide – but rationality dictates that the decision must be done with eyes wide open and even then, only if the decision won’t be second-guessed and regretted.Rationality Key 3: Be Realistic
The ability to confront cold, hard reality is perhaps one of the most valuable traits an investor can possess. Figure out what you want, what you need to do to get there, and then develop a system that will take you to your goal. A case in point: A very close friend of mine is in her mid-sixties. She has consistently made poor financial decisions yet lamented that she is unable to own a home, even now. What’s worse, she resents those who are financially well off, despite the fact that many of those people worked their entire lives to save, invest, and build a nest egg.
As far as we know, there are no known cases of manna raining down from heaven in recent centuries. Isaac Newton’s observation of cause and effect is just as real in the world of investing as it is in physics. If you don’t do what is necessary to achieve your goals, you will never have the things you desire. It is that simple. The good news is, you can change course regardless of age or circumstance.
Rationality Key 4: Don’t Be Moved By Emotion
As you were reminded in Stick to the Basics: Simple Reminders for Profitable Investing, movements in the quoted price of your investments are meaningless except in that they allow you to add to your holdings at attractive, lower valuations and sell your holdings at rich, higher valuations. As Graham said in The Intelligent Investor, to allow yourself to become perplexed by these movements is to become emotionally tormented by mistakes in other peoples’ judgment!
Once you and a financial advisor have put together a structured portfolio that reflects your time frame, resources, and investment goals, why should it matter if your holdings decline twenty-five percent in a year? As long as your approach is sound and you avoid overpaying for securities, these occurrences can be valuable opportunities to add to your existing assetson the cheap.
Rationality Key 5: Bolster Your Knowledge with Authoritative Sources
It’s much easier to remain impartial and unemotional when you are convinced you are correct and the market is wrong. Such self confidence can only be acquired by studying the basics of finance; check out Top 10 Investing Books for some recommended reads.Conclusion
Financial decisions should be impartial, cold, and rational. Whether you are deciding betweenpaying off debt and investing, or analyzing an income statement, optimism and “irrational exuberance” should not be allowed to affect your decision making abilities. Think critically, logically, and do what makes the most sense for your bottom line within the confines of your personal psychology.