We make financial decisions every day. When we order a drink in a pub, we make a decision on our discretionary spending. When we make a payment on a credit card, we make a decision on debt management. Or when we accept our employer’s auto-enrolment into a pension scheme, we make a long-term decision that will affect our retirement. Financial decisions are mainly about investing and spending. But these are competing goals, the first seeking to increase wealth, the second to reduce it.
Most people associate making financial decisions with making investment decisions. Should we put money into cash or bonds or shares? Is now a good time to buy or to sell? Should we borrow or should we pay off debt? Getting such decisions right is crucial to growing or keeping our wealth. And building wealth is essential when planning for retirement.
Before we can make good investment decisions, we have to ask ourselves the right questions. These should start with asking ourselves how much risk we can tolerate. We also need to understand our time horizon for investing. There’s no point in making a great high-growth, high-risk investment if we’d be tempted to sell out on the first dip.
Investment-related financial decisions
The investment universe is huge. This can be daunting. Choosing a portfolio that balances risk and reward appropriately for us is hard. We need either to become experts ourselves, or to rely on the expertise of others. Even deciding to invest in index tracker funds requires financial decisions as to which index or indexes to track. If we make an investment and it performs well, it’s tempting to believe we’ve made a great decision. This feeling may last till there’s a downturn, when we may start doubting our ability to make good financial decisions. The point is, crazily stupid decisions can work out well, and excellent decisions can work out badly.
There are other financial decisions related to investment. How do we utilise tax shelters such as SIPPs and ISAs to minimise tax liability? Do we pay off our mortgage early, or wait until full repayment is due? Should we buy a lifetime annuity that guarantees us an income, or should we stay invested? Should we take out tax-free cash from our SIPP all in one go, or phased? Once again, if we make the ‘wrong’ decision, things may still work out for us. And the ‘right’ decision is no guarantee of success.
Financial decisions also include our decisions about spending. The most important first step is to understand what’s essential and what’s not. Not everyone will have the same definitions of ‘essential’ spending and ‘discretionary’ spending. For some, a daily latte may be essential, for others discretionary.
Once we’ve identified what’s essential, we can try to cut costs. For example, home energy is clearly essential, but switching energy suppliers can save us money. And the money we save each year on expenses is worth more than the same amount added to our annual salary. Why? Because our salary is taxable.
That leaves discretionary spending. By definition we can choose whether and how spend it. Once you get used to a particular level of discretionary spending, it can be hard to give it up. Conversely, many people increase their discretionary spending in line with their salary. That’s called lifestyle creep, and can cause problems later in life. The key is sustainability. Our level of discretionary spending this year should be such that if we were to continue with it year on year, adjusting for inflation, we’d have a low probability of running out of money, or (if that’s important) depleting the value of our estate for our legacy.
Choosing a sustainable level of discretionary spending is one of the most important financial decisions we need to make. Every other financial decision should contribute towards increasing it. If we set too high a level, we might not realise it if our investments perform okay at first. But if there’s a stockmarket crash after we’re retired, our over-spending may come back to haunt our finances.
Getting our financial decisions right
Good financial decisions don’t guarantee good financial outcomes. But they make them far more likely than bad ones. So how do we go about making the right decisions? The best place to start is by using our Intelligent Financial Planning Calculator. This will help you with the big picture, and with setting a sustainable level of discretionary spending. For specific investment decisions, we recommend seeking the advice of an independent financial adviser.