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.
Investing
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? These decisions can have a significant impact on growing or preserving wealth, which is an important consideration in retirement planning.
Before we can make good investment decisions, it can be helpful to ask 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. A high‑growth, high‑risk investment may not suit someone who would feel compelled to sell at the first downturn.
Investment-related financial decisions
The investment universe is huge. This can be daunting. Choosing a portfolio that balances risk and reward in a way that feels comfortable can be challenging. People often either build their own expertise or 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 make use of tax shelters such as SIPPs and ISAs to reduce 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.
Essential spending
Financial decisions also include our decisions about spending. A useful first step is understanding what counts as essential and what doesn’t. 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 essentials are identified, some people look for ways to reduce 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.
Discretionary spending
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. A central consideration is sustainability. A sustainable level of discretionary spending is one that, if continued year after year (adjusted for inflation), results in a low modelled probability of running out of money or, if relevant, depleting the estate.
Choosing a sustainable level of discretionary spending is one of the most significant financial decisions many people face. Many other financial decisions can influence it, directly or indirectly. 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? A helpful starting point can be to use our Intelligent Financial Planning Calculator. It can help you explore the big picture and model sustainable levels of discretionary spending. For specific investment decisions, we recommend seeking the advice of an independent financial adviser.