How do physicians measure the cost of a financial road not taken or a decision not made? One series of studies offers insight.
Over the years, I have come to appreciate the value a good financial advisor offers through proactive planning and a steady hand in advising clients. Many times this is more important that any tangible returns or advice. I am fascinated by behavioral finance and what makes each of us tick. What makes one person invest more when markets are down and one desire to run for the hills? What makes one person invest in that great-sounding real estate deal and the other one step back and approach it with a high degree of caution? Why does one person keep $200,000 in cash and the other $25,000? There are many decisions that are made throughout our lifetimes that are made casually without the appropriate discussion and thought. The problem though, is how do you measure the cost of a road not taken or a decision not made?
There are many studies on these behavioral traps, with an ongoing study from financial services market research firm DALBAR being the one cited most often. The DALBAR study is updated annually, going on for 20+ years now and they note: "After decades of analyzing investor behavior in good times and bad times, and after enormous efforts by thousands of industry experts to educate millions of investors, imprudent action continues to be widespread. It is clear that improvements through investor education have only produced marginal benefits. Investor behavior is not simply buying and selling at the wrong time, it is the psychological traps, triggers, and misconceptions that cause investors to act irrationally. That irrationality leads to buying and selling at the wrong time which leads to underperformance." DALBAR has quantified the impact of these behavioral biases by looking at flows into and out of investments. Below are their latest findings showing the average investors performance since 1995.
One of the traits that good investors possess is a focus on goals and designing an investment strategy to achieve those goals. The DALBAR studies show the opportunity cost of poor decision making. It is not only poor decision making though that is a key behavioral flaw; many times it is the inability of making a decision, many times because of fear, lack of information, or poor inputs/facts about the decision. One of the nine behavioral flaws DALBAR found is that people treat errors of commission more seriously than errors of omission. The Cambridge Dictionary defines error of omission as a mistake that consists of not doing something you should have done or not including something such as an amount or fact that should be included.
A common example today of an error of omission that causes many individuals to enjoy lower living standards in retirement than they should is poor cash management. We have a chart we show clients that graphs the return of $100,000 over 20 years at three different growth rates: One at 1% (current cash rates), one at 3% (possible long-term inflation rate), and one at 6%. At 1%, $100,000 turns into $122,130, at 3% it turns into $182,075, and at 6% it turns into $331,020. Looking at the 1% and 3% comparison, in this example, you would lose about $59,945 in purchasing power over 20 years with a return of 2% below inflation. Comparing the 1% and 6% returns, this is a loss of $208,890 over the 20 year time frame.
There are many other areas where errors of omission come in - not making the decision to have adequate disability and life insurance for a family, not being proactive with our time management, not having guardians named for young kids, not taking that family vacation, or not taking steps to have a budget reflect your priorities in life are a few examples. Think about errors of omission and if this is one of the traits you may struggle with. While it is difficult to measure, seemingly casual decisions we make can have real costs over time.
Bill Cleveland, MBA, CPA, CFP, is a partner and senior advisor for Preston & Cleveland Wealth Management, LLC, with offices in the Southern U.S. Cleveland is a fee-only CFP and a member of the National Association of Personal Financial Advisors (NAPFA), providing comprehensive financial planning and investment management services to individuals and retirement plans across the country. He can be contacted at firstname.lastname@example.org.