How do we know if we’re making good financial decisions, or if the choices we’re making are more like financial blunders?
You’d think that just looking at our score card – our bank balance or accountant’s balance sheet, would be enough.
But it’s not quite so simple.
And understanding why it’s not this obvious may be the difference between changing our financial futures, or being stuck in a perpetual state of “where the fuck did my money go?”
We often look back on our decisions (or indecisions) and judge them based on whether or not we like the outcomes – not based on whether we were actually making a good choice at the time.
For example, buying a lottery ticket is a statistically losing decision. The odds against winning are far greater than the payoff – even if that payoff is millions of dollars.
And yet someone wins every time. To that person, buying a lottery ticket appears to be a “good choice” – because they now have a huge pile of cash to play with, even though at the time it was a losing decision.
To get a clearer picture of what’s wrong with this, it’s better to look at a large number of decisions together.
Say we have a mini-lottery game, but instead of picking 6 numbers, all we have to do is to correctly guess the number of a rolled, six-sided die.
Win, and we get $5, and it costs $1 to play.
Is it worth it?
Fairly obviously not. We have only a 1/6 chance of guessing correctly, which that means on average, we will win one time out of every six games. A gain of $5, and a loss of $6.
However, if we win our very first game it feels like we made the right choice to play.
But life isn’t about 1 isolated choice, it’s about the aggregate of all our choices.
So if a person tends to make bad choices because they win some of the time, that doesn’t make the choices any less bad.
To drive this point home, most lottery winners end up right back in the financial situation they were in within 10 years.
Because these are people who, on average, make losing choices when it comes to money.
And even though they won the freakin’ lottery for crying out loud, this isn’t enough to outrun all those bad decisions.
There is some important behind-the-scenes psychology going on here too. It’s been shown in experiments that rewards given at random intervals make individuals much more likely to strive for these rewards.
For instance, a pigeon rewarded with food every time it taps a lever 15 times will work less hard than a pigeon who gets rewarded after a random sequence: 15, 7, 13, 21, 8, 9, 11, 4, 26, 22, 13, and so on.
And in the human world, we see this exact same pattern occurring in casinos all over the globe. The most addictive element is the randomness of the positive outcomes, which create a hedonistic head rush, bubbling emotions, and the desire to play…just one more time.
Why is it important to understand all this?
Because if we want to become wealthier, we have to stack the odds in our favor to make sure that we win most of the time, even if we lose occasionally.
Like a poker player, our job isn’t to have every decision work out in terms of making bank, it’s to make the right decision each time, so that over the course of 100 or 1,000 or 10,000 decisions, the results turn out in our favor.
Most people are afraid to act because they don’t want to be “wrong.” But not acting is intrinsically wrong, because only a large collection of actions that put the odds in our favor can lead us to success.
For example, a professional Texas Hold’Em poker player may have an overwhelmingly better hand than their opponent. Their opponent might need 2 specific cards to come up in order to win, with odds well under 1%. So the poker pro bets big money.
Was it the wrong choice?
No, because if they make the same choice over their entire career, they will win far more times than they lose playing this same hand. It’s absolutely the right choice, and they’re obligated to make it.
What does that mean for us?
It means that we have to start collecting good money decisions:
Pay yourself first: Most people pay themselves last, after all the bills, toys, and entertainment. Savings typically come after all of that. Rich people pay themselves first, putting money into investments, or into savings that are going to be invested later before they pay any expenses. That way, they’re always moving forward.
Investing in assets before liabilities: Most people invest in liabilities, things that take money out of our pockets – often on a monthly basis. Think rent, car payments, insurance, daycare, etc. Rich people invest in assets first – things that provide some sort of monthly cash flow (or tend to go up in value, though this is a much less valuable sort of asset) – and then use their assets to pay for their liabilities
Minimizing Risk: The Warren Buffet special – all financial activities should start from a point of minimizing the potential downside, as a big blow hurts more than a big win helps. Just think, having $100,000 and losing it – becoming broke would be way worse than going from $100,000 to $200,000 would improve our life.
Reinvesting: If an asset is producing an income, one of the most powerful thing we can do is to reinvest that income to either get more assets, or make our existing ones more profitable
Diversification of Assets: Having investments of only 1 type is unstable and dangerous, most definitely not minimizing risk. If all our money is in cash-savings and rapid, massive inflation strikes, those savings could be wiped out practically overnight. By diversifying, we ensure that if any 1 thing changes rapidly, our foundation is so solid that we can react to the setback and carry on building our portfolio, instead of stating over from square one.
Of course, there are professionals in every sphere who don’t play by these rules, and that’s part of a strategy that works for them.
But most of us aren’t top 1% professionals and aren’t going to be. For most of us – certainly for myself – I want a money strategy that I don’t have to be engaged with 24/7.
These principles let us spend just as much time as is necessary to be financially successful, so we can invest our most valuable asset – our time, into living.
Our financial reality is the sum total of all the decisions we make. Now you know how to judge for yourself. The good news is that, wherever you are now, if you start making more good financial choices and fewer blunders, your financial state of affairs can turn around relatively quickly. And you won’t have to win the lottery to make it happen.