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Decision-making is not for the faint-hearted

Decision-making is not for the faint-hearted

03 August 2019

If I assume that basic opportunities (like education, family circumstances, access to health services) for all people are the same to start with then I would argue that by far the most significant factor that determines where people end up in their lives is the quality of the decisions they make. Good or bad luck plays a smaller role than you might think.

If this statement can be expressed as a formula it will look as follows:

Success = Quality of decisions + / – Good or Bad luck

The importance of your ability to make good or bad decisions cannot be emphasized enough. The good news is that making good decisions is within everybody’s reach. The human being is unfortunately an irrational specie. But like any skill, good decision making can (and should) be practiced. Note that having a high IQ does not make you immune to irrationality – even the greatest minds are susceptible to it.

One of the most influential books written about the subject is a book by Daniel Kahneman, entitled Thinking fast and slow. The book delves into human decision making and how we can avoid the tendency to make bad and/or irrational decisions. There are many pitfalls, but you need to be aware of them to be able to avoid them.

One of the best tools that you can apply to improve your decisions is to make an effort to understand the long-term implication of a decision. You might have to take care to unpack the problem to gain a different perspective. Consider for example the short- and long-term implications of smoking or a high sugar diet.

The following cases are good examples that we have come across in client interactions that illustrate the point. The names are fictitious, the cases are not.

Example 1

According to our calculations, Dr Frankenstein (age 45) is over insured regarding his disability cover. He is currently paying R 12 000 pm towards his cover. If he brings his cover in line with his needs, he will save “only” R 600 pm.  Is it worthwhile reducing his cover to save R 600 pm?

Example 2

Sara starts her career at age 23. She prepares her budget and decides to save R 1 000 pm, escalating at 5% per year, towards her planned retirement at the age of 65. She has to decide between two portfolios – a balanced allocation that will probably yield a return of 10% per year (average) or a more aggressive allocation that has the potential to generate an average return of 12% over the investment period. How important is the decision to forfeit a mere 2% per year over the lifespan of her investment?

What is the long-term impact?

The best way to approach these types of problems is to AVOID making intuitive decisions. Rather calculate the long-term implications and then discount it to a value in today’s terms. This value is the cost or value of the choice/advice.

In Dr. Frankenstein case, a saving of R 600 pm until the age of 65 (assume we increase the contribution by 8% per year and the investment generates a return of 10.5% per year) will add R 816 000 to his retirement fund, or approximately R 254 000 in today’s terms. If we assume that this amount is left to grow for the next 20 years (without any further contributions) he can bequeath a legacy of around R 6 million to his heirs. In today’s terms the value of the decision to decrease his disability cover is around R 585 000. What seemed like a trivial decision ended up making a material difference to his retirement planning.

In Sara’s case, during the first year, her decision would have made only a R 120 difference in her fund value. But compound that up to age 65 and it becomes a R 11.9 million difference (about R1.85 million in today’s terms). Not a decision to be taken lightly, is it?

There are too many other instances of irrational decisions made to mention, but the examples below are mistakes that we often come across:

  • Disregarding the effect of high fees/costs on compulsory savings products (normally with insurers).
  • Paying for life/risk cover after retirement, while ignoring the threat that premium increases pose to retirement capital.
  • The impact of investments that are TOO conservative is often ignored.
  • The use of tax-inefficient investment products and structures is not considered.
  • The impact of aggressive premium growth patterns on risk policies over the long term is overlooked.
  • The impact of over-insurance over the long term (often when group cover is ignored) is not properly assessed.
  • Practice of insuring unnecessary items on your short-term policy (instead of building your own risk fund) is not considered.

Every decision to light a single cigarette feels insignificant but can be deadly in the long run. In the same way, we make countless more “minor” bad choices which if compounded over time, cause much harm to our long-term (often financial) well-being.

Make a clear distinction between 1st tier decisions (what to wear, what movie to see, whether to play golf or not, etc.) versus 2nd tier decisions (choosing a life partner, selecting investment products, drinking and driving, buying a house etc.).  Low quality 2nd tier decisions can often haunt you for the rest of your life.

Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth & Risk Management is an authorised financial service provider with FSP no. 5966.

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