Making Financial Decisions

Posted by   admin on    August 7, 2004

How do you make financial decisions? About spending? About investing? About buying insurance? Do you act on your emotions?

Or, do you make decisions by weighing the possibilities so as to increase your chances of achieving a desired result? More often than not, we become overwhelmed by the stress of making financial decisions and go with our gut. Impatience then steers us into making a hasty decision or, sometimes, deciding to take no action at all. When things don't go as planned, our favorite explanation is to ascribe it to luck, good or bad as the case may be.

If everything results from of luck, making financial decisions and managing life's risks would be a meaningless exercise. Invoking luck obscures truth, because it separates an event from its cause. When we say that someone has fallen on bad luck, we relieve that person of any responsibility for what has happened. When we say that someone has had some good luck, we deny that person credit for the effort that might have led to the happy outcome. But how sure can we be? Was it fate or choice that led to the outcome?

Until we can distinguish between an event that is truly random and an event that is the result of cause and effect, we will never know whether what we see is what well get, nor how we got what we got!

As mentioned in our prior newsletters, we strive to provide articles on various aspects of wealth management to assist your understanding of why planning for the present and for your future has importance. Yes, we also promote our services; yet, you will find that we always seek to present thought provoking topics that are relevant to our wide audience.

In this letter we will try to help you develop an understanding that the essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing areas where we have absolutely no control because the relationship of cause and effect is not readily apparent or hidden from us. Lastly, and as always, we will finish with an update on our investment activities.

Also, we are sorry that this months letter was late in coming. With vacationing, preparing for my son  Hank to go off to college and his need for emergency surgery due to appendicitis, I've fallen a little behind in preparing this months newsletter.

Not Enough Information!

While we may assemble big pieces of information and little pieces, it always seems that we can never get all the pieces together! In addition, we often may never know for sure how good our information is either. On top of that, this uncertainty always makes arriving at judgments so difficult and risky.

When information is lacking, we fall back on inductive reasoning and try to guess the odds. Inductive reasoning often leads us to some curious conclusions as we try to cope with the uncertainties and risks we are left to take. Nobel Laureate Kenneth Arrow has done some of the most impressive research on this phenomenon. Early on, Arrow became convinced that most people overestimate the amount of information available to them. The failure of economists to comprehend the causes of the Great Depression at the time demonstrated to him that their knowledge of the economy was very limited.

In an essay on risk, Arrow asks why most of us gamble now and then and why we regularly pay premiums to an insurance company? The mathematical probabilities indicate that we will lose money in both instances. In the case of gambling, it is statistically impossible to expect more than break even because the house edge tilts the odds against us. In the case of insurance, the premiums we pay exceed the statistical odds that our house will burn down or that we will be burglarized.

Why do we enter into these losing propositions? We gamble because we are willing to accept the large probability of a small loss in the hope that the small probability of scoring a large gain will work in our favor. We buy insurance because we cannot afford to take the risk of losing our home to fire, or our life before our time. That is, we prefer a gamble that has certain odds on a small loss and a small chance of a large gain versus a gamble of uncertain but potentially ruinous consequences for our family by saving cost and going without insurance.

In practice, however, insurance is available only when the Law of Large Numbers is observed. This law requires that the risks to be insured must be both large in number and independent of one another, like successive deals in a game of poker. It also means that insurance will only be available when there is a rational way, for the insurance company, to calculate the odds of loss. Consequently, the number of risks that can be insured against is far smaller than the number of risks we take in the course of a lifetime.

In business, we seal a deal by signing a contract or by shaking hands. These formalities prescribe our future behavior even if conditions change in such a way that we wish we had made different arrangements. At the same time, they protect us from being harmed by the people on the other side of the deal. Contracts protect us from unwelcome consequences even when we are coping with uncertainty. Outside of business, people guard against uncertain outcomes in other ways. They call a limousine service to avoid the uncertain ability of getting a cab or having to rely on public transportation. They have burglar alarms installed in their homes. Yes, reducing uncertainty can be a costly business.

How Much Information Is Enough?

Have you ever noticed that the way you make decisions involving gains and decisions involving losses may be different? Where significant sums are involved, would you reject a fair gamble in favor of a certain gain? Or, if the choice was different and involved loss, would your decision remain the same? Also, are our decisions significantly swayed depending on the size of an expected gain or loss?

Academics believe that we display risk-aversion when we are offered a choice in one setting and then turn into risk-taking when we are offered the same choice in a different setting. We tend to ignore the common components of a problem and concentrate on each part in isolation. We have trouble recognizing how much information is enough and how much is too much. We pay excessive attention to low-probability events accompanied by high drama and overlook events that happen in routine fashion. If true, why is this so?

A 1979 paper on Prospect Theory describes an experiment showing that subjects were first asked to choose between an 80% chance of winning $4,000 and a 20% chance of winning nothing versus a 100% chance of receiving $3,000. Even though the risky choice had a higher mathematical expectation (80% times $4,000 equaling $3,200), 8 out of 10 subjects chose the $3,000. These people were risk-averse. Then the subjects were offered a choice between taking the risk of an 80% chance of losing $4,000 and a 20% chance of breaking even versus a 100% chance of losing $3,000. Now, 9 out of 10 chose the gamble, even though its mathematical expectation of a $3,200 was once again larger than the certain loss of $3,000. When the choice involved losses, the subjects were risk-takers, not risk-averse.

These results, although understandable, are inconsistent with the assumptions of rational behavior. The answer to the question should have been the same regardless of the setting in which it was proposed. From the experiment, the authors conclude, it is not so much that people hate uncertainty, but rather, they hate losing.

University of New Orleans economics professor, Edward Miller, cites various psychological studies showing that the magnitude of an expected outcome significantly influences our decisions. Occasional large gains seem to sustain the interest of investors and gamblers for longer periods of time than [when experiencing] consistent small winnings. That response is typical of investors who look on investing as a game and who fail to diversify; [because] diversification is boring. Well-informed investors diversify because they do not believe that investing is a form of entertainment.

If you were expecting this newsletter to discuss how probability works or how to predict the future, you may have come away disappointed. My intent was to focus on how people make decisions under conditions of uncertainty and how we live with the decisions we have made. Hopefully, the concepts touched upon will help you develop a more thoughtful approach in evaluating future risks you will face and those risks you will decide to take.

Why Do We Present You This Discussion On Risk?

At ELF Capital Management, our focus is to help our clients achieve a more certain future. With our financial planning clients, our goal is to identify the most logical, balanced and efficient path to meet their desired lifestyle now and into the future. And, our asset management clients gain comfort in our conservative strategy of seeking to control risk while carefully and methodically growing their investments.

ELF Capital Management Investment Performance Update

It looks like July 2004 signaled the beginning of a new market phase. The Federal Reserve Bank began raising the Fed Funds rate by 0.25%; oil prices hit new highs; and, price volatility is increasing in the US and international equity and fixed income markets. As stated last month, we consider this a major economic event and have already positioned both taxable and non-taxable client portfolios to accommodate this view. Don't fret! This is the type of market environment that our controlled risk approach becomes appreciated most.

For the month ended July 31, 2004, our one-month performance is down 0.30%, our three-month return is up 0.50% and our one-year return is up 6.98%.

For disclosure purposes, past performance is not necessarily indicative of future results and ELF Capital Management LLC (ELF), formerly Hoffman White & Kaelber Financial Services LLC, cannot guarantee the success of its services. There is a chance that investments managed by ELF may lose a substantial amount of their initial value.

ELF is an independent discretionary investment management firm established in February 2003. ELF manages a strategic allocation of primarily exchange-traded index funds (ETFs), and may invest in other carefully selected securities. ELF may also employ hedging techniques, through the use of short positions and options. ELF manages individual portfolio accounts for both individual and business clients.

The ELF ETF Strategy returns presented herein represents a composite of actual results from all client portfolios managed by ELF. Currently, it is the only composite presented by ELF and separate client account portfolio positions are substantially similar, except as may be modified for retirement plan accounts and accounts with net equity of $60,000 or less. There is no minimum account size for inclusion into ELFs ETF Strategy composite and accounts with net equity of $60,000 or less have a tendency to downwardly skew the combined results.

The performance data presented herein includes the reinvestment of dividends and capital gains; as well, ELFs ETF Strategy composite returns are presented after deducting actual management fees, transaction costs or other expenses, if any. ELF charges an annual investment management fee as follows: 1.25% on the first $250,000; 1.00% on the next $750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.

Copyright 2004 ELF Capital Management, LLC. All rights reserved.