01 Apr 2021 How to Make Prudent Financial Decisions

Lately I’ve found myself discussing a good number of questions requiring an answer beyond a simple yes or no. Questions like, should I pay off my mortgage? I have a chunk of cash I want to invest, how and when should I put it to work? Should I take my pension as a lifetime payout or rollover the balance to my IRA?

Answers to such questions often begin with “it depends,” but my actual answers to each of these real life questions were to pay off the mortgage, invest the cash immediately as a lump sum and take the lifetime payout. I believe my advice was the best course of action in each case but it strikes me as interesting that I have given the exact opposite advice to different people, at different times with different circumstances. Is it ok for a professional advisor to offer different answers to the same question?

I think so.  It’s perfectly fine, maybe even ideal, for different people to reach different conclusions about answers to financial questions that don’t have a “right” answer. In each case, I offered advice to my client based on their unique set of circumstances as we collaborated to make a prudent financial decision. After all, I believe that’s part of what good financial planning is all about: Making prudent financial decisions again and again over a long period of time while avoiding the one big decision that blows everything up. Make enough good financial decisions over a long enough period of time and you’ll end up dramatically improving your financial well being.

That all seems simple enough, but the challenge is that we make our financial decisions within a complex system (investments, taxes, financial rules) and in the face of an unknown future. And, to boot, we humans suffer from all kinds of cognitive biases and heuristics that make objective decision making difficult. That’s why it’s so important that we develop a good framework for making important financial decisions. We need to figure out a way to give ourselves the best chance of making as many good financial decisions as possible.

With that in mind, my humble submission for such a framework begins by answering this list of questions about the financial opportunity or choice we’re considering…

– What are facts? What do the studies show? What are the probabilities?

– What is the expected return? Financially or otherwise? What does it look like if this goes right?

– What are the risks? What does it look like if this goes wrong?

– What impact does it have on our financial plan?

– How does it make us feel?

– How does it make our spouse feel?

– Is it outside the norm of conventional financial wisdom? That may be ok, but we should probably describe why that’s the case?

– Have I sought outside perspective? What does outside counsel say? What are their own biases?

– How does it fit within the context of our other financial decisions? I plan to elaborate on this one in a few weeks!

I often find that a prudent answer becomes clear as I walk through this list of questions. A high risk decision with negligible positive impact on our financial plan that causes Crystal and me to lose sleep at night is off the table, regardless of its expected return. However, it’s possible to get through all 9 questions and still not have a clear answer. Especially when the decision involves more than one person. That’s when the real art of this framework begins.

The next step (if needed) involves figuring out how we prioritize or how much value we place on the answers to the above questions? I find that crafting a second set of questions derived from the first can be helpful. These questions are oriented around maximizing our highest priorities by “borrowing from” the things we value a bit less.  For example…

– Would we be willing to give up 1% in expected investment return if it meant that we could sleep better at night and still retire on time?

– Is it worth taking more risk in our portfolio if it raises the probability of being able to retire two years earlier?

– Should we take money out of our IRA early (outside financial norms) if it means we can start the business we’ve always dreamed of that offers a high expected return?

If a clear answer didn’t present itself after the first set of questions I find that the second set usually does the trick. In the unlikely case that you still find yourself hamstrung, I might suggest turning to your trusty Magic 8-Ball as a method of last resort.

I hope you’ll find this framework helpful next time you’re faced with an important financial decision. And by the way, a good financial advisor can not only provide you with the outside perspective I mentioned but should also be skilled at walking you through the first set of questions and helping you craft the second. As always, please let us know how we can help.