It’s a fly ball heading your way. Do you do calculus to find out where it will land? Of course not. You fix your eyes on the ball and run. If you adjust your running speed so that the ball stays in the same place in your field of vision, then you and the ball will meet in the same place at the same time.
Lots of choices in life are like this. We either don’t have the time or we don’t have the information available to make a decision that is exactly right, so we rely on rules of thumb or mental shortcuts to get the job done. In short: Shortcuts work.
When it comes to managing our money, most of us don’t need an advanced degree or a sophisticated strategy to make solid decisions. For example, knowing exactly how much you should save for retirement involves a lot of things you may not yet have considered such as what your health may be like in your 70s, where you want to live in your 80s, or how many grandchildren you’d like to help put through college. The rule-of-thumb answer to the question is that by the time you are 30, you should have about as much as your annual salary saved. By 40, you should have twice as much, and four times by age 50. The rule is not perfect by any means, but it’s good enough to get you going, and following the rule of thumb is certainly better than letting the complexity of the problem keep you from getting started.
Good is Good Enough
Smart, simple rules of thumb can help the beginner investor make “good-enough” decisions. By good enough, I mean that you can make decisions based on sound logic even if you are skipping over some of the more complex and nuanced reasoning.
If you want to employ the optimal asset allocation for your unique situation, then you should speak to a financial advisor or learn the theory and math behind different investment strategies and why they are applied in various contexts. If, on the other hand, you simply want to earn more than you would in a low-interest savings account while making sure you don’t take on too much risk, then you can probably do fine with a basic DIY portfolio made up of a few well-diversified index funds and skip the math classes.
If you want to know the basics that can help you make good-enough choices and avoid rookie mistakes, that’s what this column is for. Here we aren’t concerned with perfection. What we want is smart, practical ideas that can get us started, and we want to be on the lookout for the ideas that might seem right but will actually lead us down the wrong path.
Not All Shortcuts Are Smart Shortcuts
Like well-written code or an elegant formula, smart shortcuts help us focus on the most important information for making a decision, ignoring everything else. They make us both smart and fast.
There is a caveat, though.
Some shortcuts are actually more like mental booby traps that lead to bad outcomes. The market has been up for 10 straight years, so we start to feel like it’s due for a downturn; not because we’ve analyzed the fundamentals, but just because our gut is uneasy. Trusting your gut is a shortcut of intuition, but this can be a trap. Traps of intuition are especially common when we’re thinking about probabilities (read: When we’re considering an investment).
Which Shortcuts Are Smart Shortcuts?
Your brain uses shortcuts. That’s inevitable. It’s how we operate. It’s how we accomplish so much! Still, you shouldn’t be blindly following rules of thumb and mental shortcuts that are maladaptive to your situation. Knowing what’s a smart shortcut and what’s a booby trap is critical to making good decisions.
In this column, I’ll talk about many of the common mental shortcuts people use when managing money. I’ll separate them into what I call smart shortcuts and what I like to think of as mental booby traps.
The Right Rule of Thumb for the Right Place and Time
The trick to mental shortcuts is to apply the right rule of thumb to the right situation. The rule and the environment in which it’s applied are both important.
In this column, I’ll talk about one mental shortcut every week, and by the end you should be able to see whether it is smart ... or not. You can then take the smart ones and use them well while learning to catch yourself walking into a booby trap. In time, you should have an arsenal of simple, memorable tools to help you in many of the decisions you will make with your money.
I look forward to going on this journey with you. I will read and welcome your comments, and I especially welcome stories of times when shortcuts helped or hurt you personally. The more we see these things in our own lives and the lives of the people around us, the smarter we can all become.
This post by Sarah Newcomb was first published on Morningstar.com
