Tax Letters: Overcoming our behavioural biases for a better financial futureDate: June, 2013
We all can hopefully admit that we do not always act logically when it comes to managing our own finances.
Behavioural economics challenges the traditional view of economics, which generally states that humans are rational beings who calculate the costs and benefits of every decision we make in our daily lives. The premise of behavioural economics, on the other hand, is that our decisions are heavily influenced by internal and external biases. As it turns out, many of our decisions are, in fact, irrational. We all can hopefully admit that we do not always act logically when it comes to managing our own finances. Here we present a few suggestions that you may implement to overcome your decision-making biases and improve the likelihood of achieving your financial goals.
1) Set up an automatic savings plan
Human nature has a tendency to defer decisions to the future – particularly when it means forgoing current benefits for the sake of our intangible future selves. That being said, one way to mitigate your predisposition to procrastinate is to direct a certain percentage of your earnings towards your investment portfolio on a regular basis. Any major bank can assist you in setting up an automatic savings plan, such as a Registered Retirement Savings Plan (RRSP), which will facilitate you in making pre-authorized investment purchases at fixed intervals.
One of the key benefits of an automatic savings plan is Dollar-Cost Averaging (DCA). DCA is an investment technique that lessens the risk of investing a large amount in a single investment at the wrong time (e.g. avoiding the risk of attempting to “time” the market and watch your investments decline the next day). Just about any investor will tell you at one time or another they looked back at a financial decision and said, “How could I have been so stupid?” Far too often, this phrase is recited when one has failed at attempting to “time” the market. However, by saving for your future in this pre-programmed manner, you will develop financial discipline, which is a move in the right direction to overcoming the inherent challenges we struggle with when it comes to investing and saving for the future.
Furthermore, from a tax perspective, if you have the funds deposited into your RRSP, not only will you receive a tax deduction to reduce your current year’s tax bill, but you will also benefit by having your investments grow and compound on a tax-deferred basis. The term “RRSP season” is ironic, as it suggests that saving for retirement is something that only occurs once a year. However, saving for your future should be an automatic behavior. By implementing an automatic savings plan, you will put your investment portfolio on “auto-pilot” mode and will thus mitigate the inherent biases of our irrational selves to procrastinate and ignore our financial futures.
2) Pay down and/or consider restructuring your debt(s)
The human brain is hard-wired to buy and consume in the moment. This is one reason why most of us are unpleasantly surprised when we open our credit card statements in January to find that we have racked up unexpectedly high bills following the holidays. In order to prevent your debt from spiraling out of control, you must take an active role in properly managing it. Specifically, it is crucial that you limit discretionary spending wherever possible and pay off high-interest debt(s) (e.g. credit cards) as soon as possible. Moreover, if you hold multiple debts, it may also make sense to consider pursuing a consolidated loan to benefit from a lower overall effective interest rate.
If you hold personal debt (e.g. a mortgage on your home) and own investments, you should consider if your debt holdings are optimized from a tax and cash flow perspective. Specifically, you may benefit from a strategy whereby you can convert non-deductible debt into tax-deductible debt and thus improve your overall after-tax cash flow.
A common example is where an individual has a mortgage for $100k and an investment portfolio for $100k. The interest on the mortgage is non-deductible as it is for personal living purposes. However, if the individual liquidates their investments, uses the funds to pay off their mortgage, and then takes out an investment loan for $100k to acquire the same securities, then the interest charges on the new investment loan would generally be considered tax deductible as the interest is incurred for the purpose of earning investment income. Implementing such a debt restructuring strategy could improve your cash flow significantly over the long-term by decreasing your after-tax cost of borrowing. It is important to consult with a tax advisor to discuss the tips and traps in implementing such a strategy with respect to your personal circumstances and in ensuring that the net result is consistent with your overall financial and tax objectives.
3) Prepare a comprehensive financial plan
The importance of having a comprehensive financial plan cannot be overstated. As the old adage goes, “If you fail to plan, you can plan to fail.” It is important to take an active role in setting your financial goals and objectives, executing your goals, and monitoring your progress towards achieving your stated targets.
A comprehensive financial plan should consist of realistic, measurable, and quantifiable goals that you can genuinely achieve. Be sure to sit down with your investment and tax advisor to receive their input and ensure that your financial plans incorporate their advice. And remember that from a tax perspective, the goal should not be income tax minimization, but rather after-tax maximization of your wealth.
Furthermore, your comprehensive financial plan should not only address simply evaluating if your investments are producing their expected returns. A well-drafted plan should also consider estate planning, insurance needs, tax planning, etc. For example, do you have a Will, and if so, is it up-to-date? Does your existing life insurance provide adequate coverage to provide for your loved ones? Etc. Regardless of your age or income level, there is no time like the present to plan for your future.
A professional advisor can be of great value in guiding you through the process of creating your own personalized financial plan. Moreover, your advisor can help you stay on track in achieving your stated goals over the long-term. By utilizing the services of your advisor to aid you in achieving your financial future, you will be implementing effective safeguards to prevent yourself from succumbing to your brain’s behavioural biases in making poor planning decisions.
Scientists have made stunning discoveries about the ways our brains evaluate rewards, size up risks, and calculate probabilities. Generally speaking, they have come to learn that our “fight or flight” hard-wired brains make us terrible in the realm of saving for our futures and planning for the long-term. Notwithstanding this fact, we can implement certain strategies, such as those outlined above, to improve our chances at achieving long-term financial success, and to help us in regaining control over the battlefield between reason and emotion. Hopefully when you put these strategies into practice you will achieve the financial future you foresee for yourself.
This article was originally prepared by Henry Korenblum.
This article has been prepared for the general information of our clients. Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article.