Do you make decisions based on logic?

In his book “Predictably Irrational”, Dan Ariely details how humans believe that they are rational and make decisions based on logic and reason, however, in reality, we are totally illogical and act on emotion. In fact, a case can be made that humans use the logical part of our brain to justify the irrational decisions we make.

Behavioural Finance looks at the decision-making process that we go through when making an investment. One of the strongest factors influencing our decision making is loss aversion. We’d rather choose something of lesser value or quality that we know will not negatively impact us rather than choosing something that has the potential to positively impact us. Guaranteed products play right into our loss aversion behaviour.

A guaranteed investment is fairly straightforward. Most guaranteed investments are fixed for a 5-year term, capital is guaranteed, and the return is not allowed to drop below a certain percentage. It sounds like a winning formula until you look a little deeper. The investment is a business transaction and the asset managers need to ensure that they are getting paid and earning the return that they need to. What do the asset managers do? Well, they often smooth the returns.

For example, you take out a guaranteed investment for $10,000 that says that your return cannot be negative. Your money is invested in a variety of investments including cash, bonds, equities, and property. The upper limit of the return is set up by the asset manager at 5% per annum. In this hypothetical example, after five years the investment would have grown to $12,762.82, however, the actual return on the investment was 7% or $14,025.52, with 2% going to the asset manager.

Some investors seek comfort in these products even if for a short term when markets are volatile. Extensive research done over decades shows that, over time, investing in equities delivers the best return.

However, there are certain situations when a guaranteed product is beneficial for an investor. A guaranteed investment protects investors against downside risk, but at the cost of any upside. The guaranteed investment does have a place in a retirement plan for most investors that have not saved enough for retirement, or early retirees that have years ahead of needing an income. The bottom line is that medicine has evolved, and people are living longer so some investors get comfort in this type of investments, but there is a price to pay so always check with your financial advisor and consider your risk aversion.