We love “free.”
According to Dan Ariely, author of “Predictably Irrational: the Hidden Forces that Shape Our Decision,” we are drawn to “free.” In one study of human choice, participants were given the option of paying 15 cents for a fancy Lindt Truffle or one cent for a Hershey’s Kiss, 73 percent chose the Lindt Truffle even though it cost 14 cents more. However, when the Truffle was offered for 14 cents and the Kiss for free, still a 14-cent difference, 64 percent chose the Kiss. The price differential was the same but more participants picked the free item – why?
Ariely explains that we avoid downside risk, meaning we avoid the possibility of loss. In the study, participants opted for the free item to avoid the loss of paying 14 cents more for the fancy chocolate.
Our fear of loss shows up in the way we think about our money and our savings, too. As a financial adviser, I see clients of all financial means. They all share their fear of running out of money. Clients feel better after completing financial planning exercises showing high probability of not running out of money. But the small, nagging feeling of running out of money stays with them. That concern drives the decision of how to balance spending and saving. Clients worry that spending too much now will leave too little later. Lindt or Kiss?
Risk is an integral part of investing. Although we crave it, a high return with low risk doesn’t exist. We all know that the higher the potential return, the more risk you absorb. But we make choices about risk despite our fear of loss. Some of us gravitate to low risk while others are risk seekers. How do you balance the need for return versus the fear embedded in risk?
Free, yes, free investment advice is coming. But you have to keep reading – and there is no downside risk to this free advice.
Late last year Eugene Fama, the “father of modern finance,” was awarded the Nobel Memorial Prize in Economic Sciences. Professor Fama was honored, along with fellow professors Lars Peter Hansen and Robert Shiller, for their “empirical analysis of asset prices.” Among America’s most prolific and cited researchers, Fama focuses much of his study on market prices and has made a large impact on our lives. While most investors build their portfolios without a plan – as if they are baking a cake with no recipe or building an engine with no blueprint, Fama and his longtime friend David Booth engineered a new way to create wealth. Booth, a co-founder of Dimensional Fund Advisors, created one of the largest mutual fund companies using low-cost, globally diversified, passive mutual fund investments. Booth says you balance your need for return versus risk based on these principles: invest in low-cost, globally diversified passive investments with the appropriate bond-to-stock mix.
The logic is so simple. If you invest your savings in thousands of stocks and bonds from all over the world, your savings or portfolio is somewhat like the ocean: it rises and falls – as will your portfolio. Unlike the ocean over the past 100 years, the value of these thousands of stocks and bonds rose more than they fell.
While no one can guarantee that the future will be like the past, Fama and Booth are really saying that we should invest in our growing world. Since the world is a pretty big place, we can focus locally to benefit from the expected growth in our local economy.
In a report titled Manufacturing Industry Clusters, developed last year through a partnership between the Workforce Boards of Metropolitan Chicago and the Metro Economic Growth Alliance of Chicago, we get a glimpse of our possible future economic growth in the Northeast section of Illinois. The area, which includes McHenry County, is projected to have growth in advanced materials, biotech/biomed, and business/financial services as well as important growth in chemicals and printing/publishing.
While many of our largest local businesses are private companies, we can invest in those that are publicly traded, such as Catalent Pharma Solutions and Snap-on. By buying stocks and bonds in our local companies, as well as those from all over the globe, we can minimize our risk and minimize our fear: a winning combination.
• Amy Barrett, CFA, CFP, CDFA, is founder and financial adviser at Barrett Wealth Connection LLC in Spring Grove. Reach her at 815-529-7527, firstname.lastname@example.org, or www.bwconnect.co.