Financial Planning In A World Of Uncertainty
This article appeared in the February 2017 edition of Forbes magazine. Click here to view the original article.
Author: Josh Sherrard
The year 2016 was a great one for surprising, disruptive developments and information. The election of Donald Trump, Brexit, new conversations on immigration, climate change, robotics, artificial intelligence… One could argue that there’s never been a period of time of such rapid, widespread change, and with it, such a high level of volatility, uncertainty, complexity and ambiguity (VUCA).
While many of the business owners we work with are optimistic about a change in Washington, some of our clients in the dairy industry expressed great concern. With the election of Donald Trump and his promises to alter the trade arrangements with China, many industries are guessing about how this will impact them since these farmers currently send roughly 25% of their products to China.
For financial advisors and wealth managers, this subtle but pervasive emotional undercurrent can lead to indecisiveness, impulsiveness, and emotional decision-making on the part of clients, colleagues and staff. How might we combat these self-defeating tendencies? How might we help our constituents make wise decisions, despite VUCA circumstances?
Loss Aversion And The Sunk Cost Fallacy
Nobel prize-winning psychologists Daniel Kahneman and Amos Tversky, in their pioneering work in behavioral economics, made it clear that we as humans have cognitive biases that affect our thinking and decision-making, especially under the kinds of stress that are common in today’s world.
For example, I believe fear of disappointing our clients and constituents can lead us to exaggerate the truth, avoid healthy confrontation, and prevent us from pushing to new levels of knowledge and ingenuity. One of the business owners we work with has been afraid to launch out on a new endeavor for fear of failing. The risk is in a large real estate venture that could increase sales and create additional revenue for the client. Understanding “loss aversion” and the “sunk cost fallacy” are two cognitive biases can help us and our clients navigate difficult decisions.
Loss aversion and sunk costs are related concepts. Kahneman and Tversky observed that human beings are more concerned with potential losses than they are excited by potential gains. This loss aversion tendency manifests itself in the way we deal with sunk costs—money, time, or effort that’s already been invested or spent and can’t be recovered.
As Dave McRaney, author of You Are Not So Smart, says, “Sunk costs drive wars, push up prices in auctions and keep failed political policies alive. The fallacy makes you finish the meal when you are already full. It fills your home with things you no longer want or use. Every garage sale is a funeral for someone’s sunk costs.”
Recently a colleague of mine came to the realization of the impact of sunk costs and loss aversion. After several years of pouring money, time and emotional capital into an international private equity endeavor, he came to realize that his efforts to prevent loss were costing him profit in his primary business. This significant cognitive change has propelled him into a profitable fourth quarter and a promising 2017.
A Good Advisor In The Age Of Uncertainty
If a client is continuing to invest in a venture that bears no fruit and feels they cannot abandon the project for fear of losing all they have invested, a good advisor steps in to help them analyze their true loss and potential upside.
I find clients come to me with questions ranging from “Should I buy this property?” to “How should my partnership be structured?” As a business family coach, part of my job is to help them look at the big picture and measure the costs relative to that. One major factor is to know what you can safely risk without jeopardizing your core business and main sources of revenue. Remember our assets go far beyond just cash. Time, money, emotional capital, intellectual capital and overall effort all need to be measured. Allow the facts to help chart your course more than the VUCA world we live in.
In a VUCA world, it’s important to have a strong, rational mindset to combat the thoughts and especially the feelings that can arise from media-driven events and circumstances. In turn, I’ve found that such a mindset is the result of a consistent practice of self-awareness, self-knowledge, and the thoughtful development of routines and habits that support deeply held personal values. Engaging in rational conversations about our human shortcomings and tendencies with trusted advisors is one way to build and sustain the kind of mindset that serves clients, their families, their businesses, and their communities.
It is important to not only surround yourself with trustworthy individuals who can engage you in rational conversations but also to be that trustworthy individual for clients, colleagues, family and friends. These are certainly interesting times we live in.