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Money …. Cause-and-Effect

May 19, 2011

Which Stones Will Make Big Ripples?
When it comes to making financial decisions, there is the belief that cause-and-effect relationships are at work in the universe, and that those who understand these relationships can both accurately discern the past and confidently predict the future. Theoretically, this paradigm is correct. But practical application of it is almost impossible. Why? Because there are so many inter-related causes and effects.

If you hear the following phrases (or something like them), be on your guard:

“We should have seen this coming.”

“In light of these facts, there is only one reasonable conclusion.”

One is a statement about the past, the other about the future. Both statements embody the belief that cause-and-effect relationships are at work in the universe, and that those who understand these relationships can both accurately discern the past and confidently predict the future.

Theoretically, this paradigm is correct. But practical application of it is almost impossible. Why? Because there are so many inter related causes and effects. In a laboratory, scientists can isolate one or two factors, conduct focused research, and derive concrete conclusions that are both observable and repeatable. But while this information may give insight into the functions of a particular system or its interaction with a specific number of variables, the results may or may not have practical use in the “real world.”

For example, lab research may show a direct correlation between cigarette smoking and the incidence of cancer. Further field studies may indicate that smokers do in fact have a higher incidence of cancer than the general population. However, research cannot explain why some smokers do not succumb to cancer. Why? Because there must be other cause-and-effect factors in play as well.

Perhaps there are genetic patterns or lifestyle choices that offset the negative effects of tobacco. Maybe age and gender make a difference, or geography plays a part in either contracting or resisting the disease. As much as we know about the harmful effects of smoking, cancer and other related diseases, no one can say with absolute certainty that abstaining from tobacco is guaranteed to keep you from getting cancer. Even with the benefit of hindsight, there is often no way to determine which decisions, which environmental components and which genetic factors ultimately “cause” the events that come to pass.

Economics is another field in which we encounter overwhelming complexity and a limited ability to determine which factors lead to success or failure. Ask 100 economists to determine the causes of the real-estate bubble, or how to reduce the national debt, and you will get 100 different answers – with supporting research. These differences of opinion aren’t because today’s world is more complex; the same divergence of opinion has applied to assessments of previous economic events as well (after 80 years of debate, there is still no consensus over the causes of the Great Depression).

This inability to adequately understand and respond to the cause-and-effect events that impact our lives can be disheartening. On one hand, we know our decisions will impact our future. On the other hand, we don’t know precisely what the impact will be, good or bad, from those decisions. As we consider the future, each decision is like a pebble dropped in a pond, and we are constantly asking, “What ripples will come from this decision, and will the effects be good or bad?”

Dealing with complexity: Better Models or Basic Principles?

In general, there are only two approaches to financial decision-making that stand any chance of succeeding. One approach is idealistic and should be continually studied; the other is pragmatic and should be used in the real world.

The idealistic approach to financial decision-making is to develop ever-more complex models to explain and predict events. Today’s computers make it possible for data to be assembled, sifted, and analyzed to a degree that was unthinkable even 20 years ago. As a result, there are “new and improved” economic models for all sorts of issues. In theory, these historically-accurate, probability-factoring, multi-scenario financial calculators promise to deliver a better retirement, build a bullet-proof investment portfolio, determine whether it’s better to buy or lease, and inject “certainty” into your financial affairs.

Some day, in a perfect world, the breadth and depth of our knowledge may finally match the complexity of our world, and when it does, we will unravel the mysteries, anticipate the unforeseen, and master the universe. This is a noble pursuit, and anything that adds to our financial knowledge is worthwhile. However…

Even in their most advanced forms, these models are largely dependent on human factors. Someone has to decide which data is relevant, and someone has to interpret it. Inevitably, some of these human decisions will turn out to be faulty, which means progress toward a perfect financial model is going to be a long history of trial and error. Knowing these limitations, do you want your decisions tied to financial models that might prove to be in error tomorrow?

Further, even with increased knowledge, understanding the past and predicting the future are two different things. Assuming a financial model could get the history right, there is still no way to account for future events that might add new variables into the decision-making equation. Thus, while better analysis and more complex financial models may make us more knowledgeable, these programs still aren’t smart enough to predict the future and guarantee financial success.

Instead of futilely seeking perfect information on which to make a perfect decision, the pragmatic view is to recognize that you can’t know or control all the variables. It is a more productive approach to recognize and consistently apply general financial principles. These principles are statements of economic reality that are generally true; and if followed, they will bring about positive outcomes, under almost all circumstances. For example:

  • Save consistently
  • Reduce debt
  • Avoid financial losses
  • Maintain flexibility in your financial programs.

This is not new information and it is not complex. But can anyone dispute the validity of these statements? Can anyone say, “You know, what’s killing you right now is that you keep saving money.” No. They might take issue with where the money is accumulating (under your mattress as opposed to the bank), but not with saving money. Likewise, can you imagine someone telling you, “If only you had more debt, you’d be better off?”…or “Losing money is going to make you rich!” Please.

While these general principles always work, notice they don’t quantify the extent to which they should be applied, or guarantee the magnitude of benefits that will follow. For example, the general principle to save consistently doesn’t say that if you save at least 10 percent of your annual income for 30 years at a 5 percent annual rate of return you will be guaranteed a comfortable retirement. It just says that all other things being equal, saving money is always a good thing to do, and saving money is always a better decision than not saving. And this is the key: Regardless of the details, deciding to do these things always moves you forward. It’s like dropping small pebbles in the pond, and knowing that every little ripple that hits the bank, no matter how large or small, is going to be a good one.

With the advent of complex financial models, all sorts of people have touted new “discoveries” and “secrets.” Some of these claims are pure marketing from people looking to make a buck. Others come from intelligent, well-intentioned people who really believe they have found the magic bullet for financial profitability and security. Then remember that meteorologists have a hard time explaining or predicting the natural phenomena that influence the weather. Financial issues are impacted by at least as many factors – including the often irrational actions of human beings. In the face of this much complexity, relying on a model to guide your decisions is a risky proposition. Better to stay with what works than chase an ideal that cannot be found. Remember, the results from principle-based decisions might not always make big waves, but the ripples are always positive. Over time, these positive decisions, no matter how small, have a cumulative effect.

2 Comments leave one →
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