Investing 101

What's the big difference?

What is going to make a difference in the way you invest 2011? It could be in the mix of investments you choose, or it could come down to your own behavior - in saving a bit more, making wise consumer choices and using financial advice. In that spirit, here are three “big difference” ideas for 2011.

The simple genius of “pay yourself first”

In 1989, David Chilton made it the key piece of advice in his bestseller, The Wealthy Barber: Pay yourself first. He pointed out that most people don’t have the time or patience to budget in order to save. They are far more likely to succeed if they have money flow from their bank account directly into their investment accounts or RRSPs – sight unseen. If you don’t think about it, you don’t miss it, he reasoned. And your spending habits adjust accordingly.

Before that time and since, advisors have been putting this advice into practice, helping millions of Canadians to grow their savings. While “pay yourself first” rarely makes the headlines, it is probably the single biggest factor in helping people save.

The role of financial advisors in helping establish good habits has been under-recognized, but this is changing. According to recent IFIC research, Canadians who use financial advisors have substantially more investment assets than those who don’t, and this persists across all income levels.

For example, advised households with income levels greater than $100,000 averaged $214,587 in investable assets; for non-advised households, the amount was 35% lower, at $138,358. At the $35,000 to $54,999 income level, investable assets averaged $123,348 for advised households and $27,104 for non-advised households.

And, these more prolific savers are being smarter about investing when they have advisors. Among advised households, 69% have RRSPs, versus 29% among non-advised households. Investors under the age of 45 were three times as likely to have started an RESP if they had an advisor. Through pre-authorized savings, as well as through greater use of tax-effective investments, advisors are helping Canadians do the right things.

Cars, lunch, cable and errors of prospection

Since the advent of better cave-drawing implements, suits of armour, Peugeot pepper grinders and titanium drivers, human beings have been on a quest for better stuff. According to Harvard psychology professor Daniel Gilbert, we generally buy things because we have fabricated some vision of the future in which the purchase makes us happier. This act of imagination is termed “prospection” (as opposed to retrospection).

In his book, Stumbling on Happiness, Gilbert points out that humans are hopelessly inaccurate when making predictions about future happiness states. We overestimate the intensity and the duration of our emotional reactions. For example, we may imagine that the purchase of a certain car will make our life perfect. In fact, it almost certainly will be less exciting than we anticipated; nor will it excite us for as long as predicted. Why? Because we adapt. Life with the new thing becomes “normal.” Yet, we seem unable to predict that we will adapt. When we find the pleasure derived from a thing diminishing, we move on to the next thing and almost certainly make another error of prospection.

Gilbert believes there’s a bit of useful programming in this dissatisfaction: we are constantly driven to get up in the morning and seek out the next great thing. From a personal savings perspective, however, it can be harmful. By creating awareness of these errors of prospection, and being even-handed about the balance of saving and consumption, advisors can create opportunities for savings success.

Here is a financial example everyone can identify with: the difference between very good and great television service. What if you forego a $100 programming package and settle for the $65 package?

Over 10 years, this small sacrifice can grow to $5,714 (see chart) – greater than the $5,138 cost of one year’s tuition at an average Canadian university. And, if the saver uses an RESP, the 20% Canada Education Savings grant kicks in and the education fund gets an additional $1,107, for a total of $6,821.

If you invest the $35 you’ve saved each month for 10 years, with a 6% rate of return, your savings would grow to $5,714.
Total Deposits $4,200
Growth $1,514
Source: Mackenzie Investment and Regular Deposit Calculator at mackenziefinancial.com

Diversification and the unwitting tacticians

There are two challenges created by the past 10 years’ worth of equity market volatility:  the challenge of the markets themselves and the challenge of investor behaviour. When market dips are deeper, it becomes more tempting to become an unwitting tactician, either by selling low or by adjusting future purchases to become more conservative (and missing potential recoveries).

Recent research into investor behavior suggests that too much choice can actually harm investment returns, and that sensible default settings make tremendous sense in managing investor behaviour. That’s the opinion of economics professor David Laibson, who we interviewed two years ago in the Professional. He cited research from a living laboratory: Sweden’s social security system. In the fall of 2000, Sweden added a self-directed “premium pension” which was financed by a 2.5% payroll tax.

Participants were automatically enrolled in a balanced fund, but at a certain point, Sweden mounted a public education campaign encouraging enrollees to choose for themselves from a list of 465 mutual funds. The 70% of Swedes who made their own decisions generally did a poor job, compared to the 30% who didn’t. Once the government’s promotion campaign ended, over time the fraction of the Swedish population adopting the national default allocation rose to 90%, with good results.

This default setting turns out to be a solid strategy:

• Built-in diversification through a balanced fund
• “Pay yourself first” through a payroll deduction
• Sticking with a core strategy regardless of what’s going on in the markets