Financial Thinking

We human beings are more than just rational logic machines. Economics, the study of decisions that affect the financial well-being of individuals and societies, describes how people make choices under conditions of scarcity. But observing the way our minds work has lead academics to modify traditional economics by adding principles that define exceptions to the otherwise logical rules that we supposedly use when making choices. The field of behavioral economics is becoming an increasingly popular way to reconcile economics to actual human decision making.

In that vein, I question the effectiveness of “client appreciation” as a form of marketing. This seems particularly notable in situations where a business person, who is an expert in their field, is also responsible for their own marketing. As an example, think of real estate agents. I pay a real estate agent to present my house for sale and find buyers. I expect most agents are not expert in marketing. When I first moved to Calgary, we bought a house with a real estate agent and we’ve been on his marketing list since then. Each year, he sends us market updates and a small gift, such as a first aid kit, a cooler bag and a backpack.

This struck me as a little incongruous, but I could never put my finger on the disconnect. Then I read an article that described two different modes of decision making. One is financial, the other is social. Like mental accounting, in behavioral economics, we maintain separate “accounts” in our mind for social functions and for financial functions. To use the example of the real estate agent, he worked for me not as a favour for a friend, but because I hired him to perform his professional function. Therefore, the market updates make sense, in relation to his professional work. The gifts, on the other hand, cross the divide between financial (work-related) thinking and social (favour-based) thinking.

Marketers talk about the “powerful force of reciprocation.” But it still must respect the boundaries of social and financial thinking. For example, if my dentist asks me to floss, I’ll take it under advisement. If he gives me a new roll of dental floss, I feel like I should reciprocate by using the floss. This works, because he’s not asking a favour, he’s giving his professional advice and the gift fits in with his professional duty. On the other hand, mutual fund sales reps will sometimes phone and send a small gift to say thank you for a significant order. I always chuckle and think to myself, “I didn’t place the order to be your friend. I placed it because I felt it was most suitable for my client’s needs.”

Last week, we held a barbeque at our office. We invited all our clients and everyone had a very enjoyable time. However, fewer than a quarter of our clients attended. It occurs to me that the people who came are mostly the ones who we also see socially. Further, we had investment managers in attendance. Investors who wanted to talk with them about their method got some financial value from the event. Those clients would probably not have attended otherwise.

The only time I have given client appreciation gifts is at Christmas. It’s common for us to receive gift baskets from companies that we support, not to mention that it’s always a pleasure to receive chocolate. However, I felt awkward giving gifts to my best clients. Now that I reflect on it, I realise that those gifts are unrelated to our professional relationship and cross into social territory. The best thing I can do for my clients is to professionally discharge my responsibilities, and that’s the true basis for our continuing relationship.

Everyone has both social and financial sides of their thinking. When I meet with clients, it’s important to be interested in them as people, and understand the social influences that affect their financial needs. However, I am not a close friend of the people I serve professionally, so I choose not to engage them with social gift-giving. Instead, I do everything I can to competently serve them in a professional manner. If they ever have to choose between working with me or another advisor, I expect they’ll make their decision based on who is more professionally competent, not who gives better gifts.

What is your experience with receiving gifts from people you hire? How does your company give gifts? Does this separation hold when offering money to a friend?

Learning to invest takes time and experience. When I started investing in stocks, I felt like a kid in a candy shop. Actually, for that analogy to work, it would have to be a candy shop where some of the candy is spicy, some is sour, some explodes and only about half is any good. I was faced with thousands of stocks I could buy, but how to decide? So I chose a strategy at random (momentum), mis-applied it, and had mixed success. As I read about and practised investing, I realised that there are many strategies that can all be successful. How could I choose one, or could I combine various strategies?

There was still one element missing. Underlying my choice of strategy lay my purpose for investing. Early on, I had very little idea of my purpose. I am a financial advisor, and that’s what we do: we invest. Obviously, I wanted gains, but results were hit-and-miss as I varied my approach and invested only haphazardly. When I determined that I was investing for early retirement, in order to leave my job and become a teacher in Hong Kong, my purpose became clear and the most effective strategy for my situation became obvious. Having and keeping in mind a purpose made me a much more successful investor.

Saving and investing has never felt like a sacrifice to me. I’ve never had to give up buying something I wanted so that I could invest. The purpose behind my investments, my goal to retire at age 35, informs each decision. I could go skiing, or I could retire earlier; I could buy a new car, or I could buy a used car and move to Hong Kong sooner; I could buy a flat-screen TV, or I could start teacher training sooner. As Roy Disney, Walt’s brother, said: “When your values are clear, decisions become simple.”

As I hinted earlier, decisions about potential investments are almost limitless. Not only are there thousands of common stocks, there are also preferred shares, bonds, real estate and others. Given that I want to replace my earned income with passive income, any investment that doesn’t produce cash flow is unsuitable for my situation. That filters out a majority of the options and simplifies my decisions greatly. I don’t need to know everything about every type of investment, and I don’t need to be informed about the prospects of every sector of the economy. I can focus my time and attention on a couple dozen companies at a time, looking to invest in the most promising, while ignoring everything else.

Autumn 2008 was a shock to me. I had never experienced a market crash before, and I was shaken by it. I was fortunate to have someone older and wiser, my father, to put things in perspective and show me the benefit of remaining optimistic. I realised that, despite the drop in market value of my shares, the dividends continued to be paid. Because I was so focused on my goal of accumulating dividend income, I didn’t panic. I found opportunities (high yields due to irrationally low share prices) to take advantage of difficult time. In hindsight, I still can’t tell if I was smart or lucky, but I was able to act because of the grounding provided by my purpose.

Having a clear goal keeps me motivated, focused and disciplined. The purpose behind my investment strategy increases my likelihood of success, just as straying from it has usually been a mistake. When you invest, what purpose are you working toward?

Accountability is sometimes confused with financial incentives. After all, financial incentives require a certain level of accountability. Before any punishment or reward can be doled out, measurement and reporting are required. It seems, however, that when some people talk about accountability, they actually mean punishments and rewards.

The term “accountability” is bandied about a lot in politics and in management. President Obama wants to hold BP “accountable” for the Gulf of Mexico oil spill. What does that mean? In a word: sanctions. Politicians want to hold the public education system accountable for outcomes. What does that mean? Pay for performance, or financial incentives. CEOs are accountable for corporate success, which usually translates into huge bonuses. In each of these cases, “accountability” is practically a synonym of financial incentive.

So where is the problem? In the Gulf of Mexico, the problem is that the ban on offshore drilling doesn’t address the actions of BP. It addresses the fear and anger, and is an effort to punish an entire industry for their “sins.” In public education, the problem lies in the lack of control teachers have over the outcomes for which they are held accountable. Multiple studies have shown that socio-economic factors explain more of the variance in grades than does excellent teaching. The problem in the office of CEOs is that short-term incentives reward short-term behavior, sometimes to the detriment of the long-term viability of the company. Lehman Brothers is an example.

Each of the above examples have one thing in common. The problem lies with tying accountability to outcomes. If we stop to reflect, outcomes are almost always unpredictable. Buying a portfolio of real estate loans may work well for decades, then suddenly crumble. The chief executive of Lehmans can’t be expected to predict the sudden reversal of the economic environment. Everyday choices pose the same problem. As an example, a couple planning a dinner party is an exercise in uncertainty. It remains unknown which guests will attend, even if they RSVP, what the conversation will revolve around, and whether or not everyone will have an enjoyable evening.

If outcomes are always unpredictable, how should accountability work? There are four steps, and I will use the dinner party as an illustration. First, as is already common, we set expectations. We must outline our goals, or the outcomes we would like to achieve. This is already understood. In our example, a couple wants a dinner party to provide an enjoyable evening for a group of friends. Second, we must focus on choices made, not on outcomes. Even if the outcomes are disappointing, it may have been unforeseeable to the agent. Suppose that, at the dinner, one of the guests becomes drunk and boorish, offending other guests. Are the hosts accountable for the outcome? In my opinion, assuming they didn’t desire this outcome, we can only review their choices. Was it reasonable to invite this guest, or did he have a history of offending others? Was it reasonable to serve alcohol, or did they know their guests had a low tolerance? The third step is review. This is a chance for the agent to describe their choices. After the dinner party, the hosts will review the evening. If they made reasonable choices, the outcome can only be accepted as unfortunate, but unavoidable. Energy should be spent on fixing the situation, not wasted on recrimination. The final step is reviewing how well their choices translated into reality. Because we all hold a biased world view in our minds, it is helpful to measure our perceptions and decisions against reality. This might cause the agent to reassess previously held assumptions or to refine their perspective. The hosts of our hypothetical dinner gathering may reassess their opinion of the boorish guest or their attitude toward alcohol.

Accountability is important, but it is so often wrongly applied. It is important to review people’s choices and reflect on whether or not results are satisfactory. Done properly, this can be a learning experience. Part of why financial incentives seem to work is because they include measuring and reporting, aspects of accountability. However, incentives ignore the agent’s motivations, which are more telling than the outcome.