Sunday 22nd April, 2007

 

Calculated risk improves savings

 
 
 
 
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Availability Error is a term used by psychologists to refer to the tendency to assess risks by whatever comes first to one’s mind. Last week, we spoke about beating the odds. That doesn’t happen on its own—it’s the result of a calculated risk.

Regardless of how simple we are, or how sophisticated, every risk we take or every risk we subject ourselves to, is the result of a decision. There is a technical term for the practice of large numbers of people to make decisions while completely ignoring the uncertainties—it is called naive decision-making.

At other times we simply make educated guesses. This involves some reading, and some elementary estimates. But true risk analysis involves the concept of taking calculated risks.

Calculated risk-taking incorporates the use of tests that try sample data, against certain probabilities and certain outcomes. It tries to determine how behaviour will influence result. We all do this, while driving for example, making estimates of speed and estimates of engine capacity, to overtake on the roads, to stop at signal lights, etc.

And just as such measurements or judgments become more accurate with experience, so too will your ability to make calculated risks in financial planning. Our greatest failing, however, is the availability error.

The Availability Error trap, forgets that we must know what assumptions we make. Many people assume they don’t earn a lot of money and, therefore, can never save. They make this assumption perhaps because they spend all the money they earn. But there is another way to look at it.

Hypothetical

You started working at age 19, and earned $2,500 per month, for six years. In the seventh year you got a salary increase to $4,000, and continued working for four years. You then changed jobs for a higher paying one, and earned $7,500 per month for ten years.

You are not yet 40 years old and your have earned roughly $1.2 million. If you take away 30 per cent in taxes and compulsory charges for social security, you have earned a huge amount of money over 20 years. You still have another 20 years (an assumption) to earn, with an average salary higher than in the first 20 years. Did you think that money was never available during those 20 years to allow savings?

Do you think that because of the increases in cost of living, and your own increase in standard of living, the higher current salary, still prohibits saving?

The rhetorical question is: why do we need to save? When you retire at age 60, your salary will stop. You will still have to live, eat, repair house and car, and now have to pay large medical bills.

Some weeks ago I asked a young couple if they had ever thought about the effect of a divorce on their decent financial position. It would have been near catastrophe. So get out of the Availability Error mindset, and take steps to reduce your exposure to risk.

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