Nest Egg: Risk and the behaviour gap

When considering investing or just to keep your money on deposit, the concept of risk always must be discussed.

I could sit down with anyone for as long as they want and discuss it in numerical or behavioural terms to tease out what level of risk should fit best.

However, it should always come down to their personal circumstances and what feels right for them, once they’ve understood the possible outcomes as much as is possible. There’s a fantastic book that I would recommend to anyone who is interested in investing – it’s called 'The Behavior Gap – Simple ways to stop doing dumb things with money' by Carl Richards.

He simply describes it as follows – “Risk is what’s left over after you think you’ve thought of everything. It’s the car you never saw that kills you.”

Even leaving your money sitting on deposit isn’t zero risk. You still have what is known as counterparty risk – the risk that the financial institution might default on its contractual obligation to give you back your cash.

In reality, no bank in the world could come up with every depositors’ cash at the same time as that’s not how banking works.

The author Carl Richards mentioned above has a series of excellent hand-drawn sketches that paint the picture well instead of hours discussing the various financial planning topics and two of my favourites are below:

The first drawing (top) shows what you should spend your time being concerned about. And in terms of your investments or savings, that’s definitely not the Russian/Ukraine situation, Covid 19, inflation, Brexit or the possibility of another stock market crash. All these things will always be outside your control. The way to combat these external forces is to have a financial plan for your household, and with the aid of your financial planner, make sure you stick to it.

The second drawing sums up his entire book. The behaviour gap is the difference between the rates of return that investments produce when investors make rational decisions, and the rates of return investors actually earn when they make choices based on emotions.

The difference has been estimated to be up to four per cent per annum! In other words, if an investor just leaves their money invested in the stock market and lets time take care of delivering compounded returns, then a century of research shows they should earn about 8.2% per annum. However, in reality investors tend to make poor choices, not have a plan or not stick to their plan, and actually only earn circa 4.25 per cent per annum. This is the behaviour gap.

So, the thesis of the book is to have a plan and stick to the plan.

Goal-based investing is a relatively new concept whereby the money you invest is all about progress towards specific life goals, such as saving for children’s education or your retirement nest-egg. It’s not about trying to get massive returns in the short term. It’s all about your own plan.