Behavioural Finance: Some Solutions
More Choice Is Not Always Better
In liberal societies, the usual understanding is that the more choice we have the better. Freedom is about having the ability to choose. Instead, however, what we often find is what is termed “analysis paralysis.” We are given so many choices, we are unable to move forward with any decision at all.
Sometimes, we do better when choices are limited. Within the last year, the Canadian Securities Administrators (CSA) decided to eliminate the Deferred Sales Charge (DSC) fund purchase option. Arguments in favour of retaining it came from the Investment Funds Institute of Canada, saying that it is better to allow for payment choice for its members’ customers. Similarly, the Ontario Ministry of Finance opposed the decision to ban DSC funds citing a concern that it may limit access to advice. Never mind that DSC funds are notoriously opaque with regard to their fees and the theoretical advice one is supposed to receive in exchange for such arrangements is often woefully lacking.
Consider another example of limiting choice. Maybe you are trying to purchase somewhere between one to five mutual funds for your investment portfolio. Do you know that Canadians have over 4,000 mutual funds to choose from? How do you sort the proverbial “wheat from the chaff”? One option is to provide tools that will help to narrow down the available options to an acceptable range. This is one of the great advantages of the rise of index funds, whether mutual funds or Exchange-Trade Funds (ETFs). You no longer need to worry about which mutual fund has the best manager. Instead you focus on other, easily available factors, like cost.
This does require a kind of pre-commitment, however. You have to decide that you will eliminate all but index funds from consideration. You then have to follow through and decide that one of your first criteria for selection is cost. In the world of mutual funds and ETFs, that means the MER, the Management Expense Ratio. There are of course, other criteria that might have priority for you, such as so-called Socially Responsible Investing (SRI), or funds that evaluate potential investments on the basis of Environmental, Social or Governance (ESG) factors. You simply need to decide to make that commitment and follow through.
Opt-Out, Not Opt-In
“If you want people to do something, make it easy” – Richard Thaler
Many employers offer pension plans. In the case of the Defined Contribution type of Registered Pension Plan, participation may be optional for employees. Employers will often sweeten the incentive by matching your contribution. It is in effect, free money to the employee, with the only caveat that you must give up access to that money until you retire. Given that we generally need to save part of our earnings for those days when we may no longer be drawing income from employment, that is actually a very good thing. However, because many of these plans require the employee to “Opt-In,” many simply neglect to do so.
Richard Thaler, who was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to behavioural economics, proposed that companies adopt an “Opt-Out” model. That is, employees are automatically enrolled in their employer’s pension plan requiring them to deliberately choose not to continue enrollment.
Of course, we generally may not have enough influence with our employers to push them toward such a path, but there are some things we can do with our own savings. The key word here is: “automate.” If we automate the investments that are not held within a pension plan, for example in our RRSP or TFSA accounts, we don’t have to do any thinking or decision-making after the initial set-up.
What might an automated investment account look like? First, it will probably be in mutual funds, not ETFs. Generally speaking, with the exception of some of the iShares line of ETFs, you cannot automate the purchase of ETFs. Even when you are able to do so, you can only purchase whole shares, meaning there will always be some uninvested cash left in your account. For illustration purposes, I am going to use one of the model portfolios suggested by the Canadian Couch Potato, in which the investments are divided equally among four different funds. The table below shows the TD e-series mutual funds, lauded by many DIY investors. Their one drawback was that, formerly, they could not be purchased outside of the TD environment. That has now changed, although if you do decide these are right for you, make sure you can purchase them through your discount broker without any fees or commissions.
I should note that the MER should drop by 0.05% based on an announcement TD made about changing the underlying index. The impact should reduce the weighted MER to 0.37% making this sort of portfolio even better, especially considering there are no commissions and no uninvested money is left in your account.
What do you need to do to automate your investments? Usually there are two parts to the process: the transfer of money from your designated bank account to the investment account where the mutual funds are held, and the investment itself. Let’s imagine you have saved up $1,000 to begin your investment journey in your TFSA. After you have opened the account, you deposit the money and make the initial purchases, $250 into each of the four funds. When the account was opened you also arranged for $100 to be automatically withdrawn from your bank account every two weeks, on your payday, and have that money automatically used to purchase $25 worth into each of the four funds. Assuming a 5.2% annual nominal growth rate on this portfolio, in a year you could have over $3,800 in your account. Assuming the annual growth rate and investment pattern continues, this simple automated plan could potentially result in an account worth over $670,000 after 30 years.
Reducing choice, opt-out procedures, automation — these all sound somewhat restrictive. Is this really genuinely good? I argue that it is. We live in an increasingly complex society. So many choices are presented to us that we don’t know what to choose, and that leaves us at the mercy of those who would exploit us, not to mention our own irrational tendencies to act against our own best interest. Some additional things you can do: don’t just automate your investments; automate your bill payments, too, which can include utilities, property tax, and credit cards. You can even automate your clothing choices. Steve Jobs, co-founder of Apple, was famous for wearing a black mock turtleneck shirt and blue jeans. That particular outfit may not work for you but getting clutter out of your life is a good way to allow you to focus on the more important things. I conclude with an invitation for you to give some consideration to the ways you can simplify and automate your financial lives.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax or legal decisions.