Gails Blog

People are not rational. This isn’t news to me. I’ve been watching people do really stupid things – things against their own best interests – for years. But WHY do they do stupid things? Ah, that’s the question.

Well economists and behavioural scientists are coming together to uncover the source of our irrationality. I’ve blogged before about the latest in economics – called neuroeconomics – that studies how our brains actually respond to things. We’re not guessing how people “feel” anymore. Now we’re using MRIs to take pictures of how we “feel.”

A breakthrough report cited on Economist.com used active MRIs to show that failure to choose an optimal outcome in the Ultimatum Game correlated with an area in the brain said to be involved with reward and punishment decisions.

Here’s the gist of the ultimatum game:


“Take two people and tell them they have the opportunity to split $10. Furthermore, tell one person that, as first mover, they get to make a one time offer, and tell the other person that, as second mover, they get the opportunity to either accept or reject this offer. If the offer is rejected they both go home with zero.”

According to standard economic theory, as long as the first person offers any money at all, the proposal will be accepted because the second person prefers something to nothing. That’s the rational thing to do.

Here’s the interesting part: lots of people would rather have nothing than accept the offer of just one dollar. So much for “A bird in the hand…” We’d turn our back on a dollar because we’d rather have the other person get nothing than make $9 while we walked away with just a buck. Hmmm.

This may be the very reason why people are unwilling to settle for reasonable rates of return on their investments. If they feel they are being bettered, their F-U switch clicks on and they’d rather lose everything than settle for the bird in the hand.

I get a lot of letters from people who want to earn “a better rate of return” on their investments. Better than what? Better than your brother, you boss, your broker? Better is relative. And so is risk. If you’re prepared to lose everything you’ve worked hard for, you can potentially earn a better return than if you stayed with a completely safe investment option. If that scares your pants off, then you should turn off your F-U switch and settle for a return that lets you sleep at night.

For more information on the relationship between risk and return, go and read How Greedy Are You? 

I received two questions this week on very different topics that dovetail quite nicely. The first was from a young investor who wanted to know what types of safe investments were available that could return a rate greater than the 3% or so available on a GIC to grow retirement assets at a decent pace. The second came from someone who said:

You said to a couple in one of your shows if they save 500$ a month they will have 700,000$ for their retirement. The couple was around 30. How is this possible? My banker told me it’s not. It doesn’t matter what you do.

Ah, yes. Another case of The Banker! Hmmm.

I’m going to answer question number 2 first.

You can most certainly have $700,000 in assets if you start investing in your retirement plan early enough, earn an average return of 7%, and (this is important) reinvest your tax benefit.

A $500/month RRSP contribution adds up to $6,000 a year, resulting in a refund of about $1,800 (at a marginal tax rate of 30%) which then increases your contribution to $7,800. Iin each subsequent year, your refund is slightly larger, pushing up your overall contribution.

I do use an average rate of return of 7% for these calculations, which you should be able to achieve over the long term, with a balanced investment portfolio.

How, when GIC rates are at a pathetic 3%, barely beating inflation? Well, a GIC would be considered a very conservative investment. Remember the investment pyramid? (If you didn’t read these articles, go find them in the retirement section.)

As you move up the investment pyramid, you’re taking more risk, but earning a higher rate of return.

Which brings me to the first question. If you want to earn more than you can get on a GIC, you must look beyond a GIC, and it’s safety, to do so. And even if you decide to stick with a GIC, you’ve got to be more selective about WHERE you buy your GIC. While The Banker may only be offering 3%, there are alternatives today offering as much as 4.7% for the same level of security.

However, the rate of return is only one aspect. The other is how long the money will have to grow. Start investing in your 20s or early 30s and even with a fairly low rate of return, you’ll have a very handsome amount when you’re ready to retire because your return will have had time to compound — earn a return on your return. And — like the idea of using your tax-refund to boost your RRSP contribution each year –this painless growth of your assets can mean BIG BUCKS over the very long term.

Ready to try something new? You need to learn about various alternative investment options - things like bonds, preferred shares, and balanced mutual funds.

I will tell you that using 7% as a rate of return over 35 years (some years will be higher, some lower, this would be the average), $500 invested a month, with tax refunds reinvested, would grow to:

• $107,000 in 10 years
• $204,000 in 15 years
• $338,000 in 20 years
• $528,000 in 25 years
• $793,000 in 30 years

So, yes, it can be done.

I was intrigued to read in USA Today that baby boomers are losing confidence in retirement savings. While 20% of those surveyed felt they were “equally confident”, a whopping 56% are “less confident.” With the financial marketplace in a constant swirl, it’s no wonder really.

Are interest rates going up or down? Can you trust investments that have been previously touted as “secure” when 32  BILLION DOLLARS in asset-backed commercial paper are frozen?  And remember when they said gold would never see $800 again? Ha! Never say “never.”

The uncertainty about what we can trust has sent sales of money market funds through the roof. While Canadians continue to pour gobs of money — $2.6 billion in net sales per month - into the mutual fund sector, according to the Globe and Mail, in March ALL of it went into money market funds, which now hold over $66 billion of our hard-earned dollars. People are parking their money in the hope that some clear signal will come from above telling us its safe to invest our money again.

There are a lot of people who are saving (or planning to save) for retirement, but just don’t have a clue where they should be putting their money. I keep saying, “Get a handy-dandy advisor; I have one.” But I’m beginning to think the questions I’m getting are even more fundamental than “where.” So I’m going to do a series of articles for you on how to save to retirement.

The decision on where to invest is at once complicated and simple.

“How much do you want to have saved when you retire?”  seems like a simple enough question, right? But if it were, then there wouldn’t be this constant chatter about how much you’ll need, and the fact that a million bucks won’t cut it in the future. And there wouldn’t be this quiet sense of desperation on the part of people who believe they are doomed, so they might as well just stick their heads in the sand and pray nothing creeps up behind them and bites them on the butt.

“How greedy are you?”  would be another of those simple questions that has a ton of implications. If you’re content to hold an investment paying you a 2% return, and can stand the scorn of all your friends and relatives at your niativité, your lack of ambition, or your sheer stupidity, then you’d been pretty low on the Greedy Scale. If you’re insisting on an investment that will turn your $1,000 into the Magic Million in ten-seconds-flat, then you’d be right up there with Gordon Gecko.

“How committed are you?”  is a simple question, that has a wide range of answers from  not at all committed, to somewhat committed, committed, very committed, and passionately committed. Do you know what you are?

“How much time do you have?”  How long you’re planning to invest has a big impact on the investment alternative you might choose. Pick the wrong time-line and you could find yourself a little sad when cash-out time comes.

Along the way, you’ll have to learn what an RRSP  is, the various types of investments available to you and where they fit on the Investment Pyramid, and how to diversify your portfolio to create the Asset Mix  that’s right for you.

These articles cover the basics of what you have to think about as you plan for the future. Whether you’re investing for the long-term for your retirement, or for the medium-term to send your kids to university, or for the short-term  to buy a home, the fundamental issues remain the same:

• know how much you’ll need,
• know how long you have,
• know how brave or chicken you are,
• know what you know - and DON’T know, and
• mix it up a bit.

With a little determination, you CAN have what you want.