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Financial Decision Rules
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In this article, The Skilled Investor summarizes some of the significant problems faced by ordinary individuals, when they attempt to plan their family finances. This is the first in a series of articles that will provide scientifically grounded decision rules that address these problems.
In general, individuals will benefit greatly and get more enjoyment out of their financial affairs, if they decide ONLY to follow financial and investment strategies that are: a) scientifically grounded, b) completely passive, c) thoroughly diversified, d) savings focused, e) risk adjusted, f) cost effective, and g) tax efficient.
A previous article in this category, "The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient," suggested that individuals are much better off with a well-considered financial viewpoint. A stable set of financial beliefs can help you to keep focused and on track throughout your life. This follow-up article discusses the need for these beliefs to be based upon financial practices that have been established scientifically.
How much you earn, spend, budget, and save are by far the most dominant determinants of your long-term financial well-being. Self-control in your financial decision-making regarding budgeting and consumption is far more important than clever investing. Expenditure control and budgeting works, while attempts to be clever about investing usually are counter-productive.
Investments with low risk and high returns are just fantasies. No "risk-free" investment money is consistently and reliably available to individuals. Luck dominates skill in the securities markets. Clever investment selection is vastly over-hyped, and only the promoters tend to benefit. On average over long periods, investors get paid risk premiums, because they put their money at risk. If they control their costs, they get to keep most of these risk premiums.
You may be just as nervous as the next person is about investment risk. However, the coverage of your future expenses by your accumulated assets will determine whether you can actually manage, when risk really happens.
Complete diversification is always a better idea. On average, the securities markets will not pay you to hold any skewed subset of the overall market. Doing so is just a gamble that may or may not pay off. You should not expect to be paid any more for the added risk and anxiety.
Owning individual securities is just a big waste of your time and money. Individual investors tend to be terrible investment portfolio managers. Almost everyone can hire an index fund manager to do a much better job for far less time, money, risk, and consternation.
Your time is valuable. Do not ignore its value, when you assess how you are doing. If you use poor financial planning and investing strategies, you shot yourself in one foot. When you spend a lot of time on these bad strategies, you shoot yourself in both feet.
Passive, index-oriented investment strategies tend to be superior, because they narrow the range of outcomes, and thus, they reduce the total investment risk associated with your portfolio. While the relative costs of active and passive strategies are very important, the higher risk and higher uncertainties of active strategies are just as important.
This article discusses the reasons why selecting mutual funds and ETFs based on the characteristics of fund managers is a waste of your valuable time and money. You cannot reliably identify beforehand professional investment managers who will deliver superior performance at a reasonable price in the future. You cannot hire them at a price that is lower than their potential value-added.
Superior past mutual fund and ETF performance does NOT predict superior future performance. Only very poor past performance tends to be a slight predictor of more poor performance in the future, and excessive investment costs are the likely culprit.
Whether good or bad, financial advisors are expensive. If you need a financial advisor's help and you carefully select a good financial advisor, the value of the personal finance and investment advice that you receive might easily repay the advisor cost. However, bad financial advisors can cost you dearly, though both high financial expenses and poor investment strategies.
If you realize that you need help with your personal financial planning, get a good financial advisor. However, be very, very careful with your financial advisor selection process. A good financial advisor could make things much better. A poor one could make things much worse.
A personal financial plan is not complete without needed insurance. As you use your favorite personal finance software to develop a workable lifetime financial plan, you should also consider where you might be vulnerable to other risks that would disrupt your planning. Insurance may provide cost-effective risk pooling benefits in some circumstances. However, in other situations, the net present value of insurance premiums may be too high to warrant carrying the insurance, despite the risks.
Your investment portfolio and other property could become your estate at any time. As you proceed through life and become more successful financially, you need to monitor the size and trajectory of your potential estate assets. In particular, if you have responsibilities to others, you need to prepare appropriately for the day when your valuable assets become your estate. Prepare for your demise in advance. For the sake of your family, find a good estate lawyer sooner rather than when it is too late.
The future is fundamentally unpredictable. The future of personal financial planning and investing is similarly unpredictable. Anyone claiming or implying that they can predict what will happen to investment returns in the securities markets in the future is just blowing smoke. If their predictive smoke claims to benefit you, then you should be suspicious. If you have to pay a lot of money to buy their predictions or financial advisor services, then you should be far more suspicious.
Too often, financial services companies give individuals advice about financial planning and investing that includes some razzle-dazzle about their supposedly superior analytic model, system, or tool. The general theme is usually the same: pay us and we will help you to beat the market using our unique insight developed from our special tool, model, system, etc. Unfortunately, these marvels are just more sophisticated forms of blowing marketing smoke -- this time aided by technological mirrors.
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