In his book, “The Happiness Hypothesis,” cognitive psychologist Dr. Jonathan Haidt uses a metaphor to describe human behaviour. He says our brains are like a man riding an elephant. The man appears to be in charge unless the elephant gets a different idea.
We have our more advanced frontal lobes giving us our rational and thinking side of our brain, and then we have our amygdala providing our more primitive reptilian side – the one that provides the fight or flight response.
The primitive side is more than capable of overwhelming the more demure rational brain, so we need to be conscious of this when we make our investment decisions. Dr. Haidt suggests that keeping your elephant on track is a combination of being clear on the objective, providing incentive and acknowledging that it’s hard.
When it comes to managing finances, we often let our elephant take us down a path that is less than optimal. Driven by current market events or fear, we may choose investments that feel good in the moment, but don’t really make sense from a long-term perspective.
Gold, for example, is a typical asset that people move to when things look really dicey. Yet, as Warren Buffet pointed out in his last annual shareholder get-together, it really doesn’t make much sense for most.
Buffett said he made his first stock investment in 1942 – right when America was reeling from Pearl Harbor. Gold would appear a safe bet in such a time, but $10,000 invested in gold back then would give you $400,000 today – somewhat less than the rate of inflation. The same money invested in stocks would deliver about $51,000,000.
Knowing this, investors using their lifetime as a planning horizon (which we believe is the most reasonable way to plan) would recognize that stocks seem more rational for the growth part of a portfolio, and more likely to reach long-term objectives.
Getting back to Dr. Haidt’s advice for taming elephants, a year-by-year financial plan is a great way to keep on track. A plan provides clear objectives that can show us what happens if we stay the course and realize the long-term rate of return for an asset class.
A good plan provides considerable incentive. We may see, for example, that a 3% rate of return might lead to running out of money while a 5% rate of return provides a solid retirement income and a legacy to the next generation. With this in mind, the volatility that will have to be accepted to get the higher return is more easily digested.
And finally, when things get hard, whether that be a market correction or a financial crisis, a good plan will help remind us of why we built the portfolio we did – and why staying the course is the best way to ensure eventual success.
Your elephant is all about instant gratification, but also provides the strength and energy required to get to any goal. We all need to harness that energy – and when it comes to finances, the best way to do so is step by step, year by year, through a regularly updated financial plan.