The ‘mental side’ of money management is always important. Given the events of 2020, how we think about money has become even more vital. While no one really knows what the lasting economic impact of the Coronavirus will be, the one thing that we can be certain about is that many of our working assumptions will need to be changed. The new world will not be like the old world. We will all need to think differently when it comes to our finances.
A ‘working assumption’ is sometimes described as a cognitive ‘anchor.’ The term anchor describes how previous information can hold us back, by stopping us from moving away from that information even if that previous information is no longer relevant. It leads to what is known as the ‘anchoring bias,’ where we continue to base our thoughts and expectations on information that has become outdated.
As an example, some people remember well Australia’s last economic recession. It was the early 1990s and followed a period in which many elements of the economy had become quite ugly. To take just one piece of information from that time: during the 1980s the official inflation measure – the Consumer Price Index, or CPI – had risen as high as 12% per year and had rarely dipped below 5%. Mortgage rates were as high as 17%. Life was expensive!
For many people who lived through this time, the combined experience of high inflation and high interest rates is an anchor that continues to impact their thinking about debt and the general state of the economy. For example, we still hear people cautioning that Commonwealth budget deficits are inflationary and thus should be avoided wherever possible – even though the current official inflation rate is actually a negative number (-0.3%, according the ABS figures for June 2020). Prices are actually falling, on average, and many people argue that inflation is actually now less of a risk than deflation (the chance that prices will continue to fall in the medium to long-term). Inflation seems a very remote prospect and inflation in the double digits would be almost impossible. But the 1980s experience of 12% inflation (which, if it continued, would double prices every 6 years) was so intense that many people remain anchored to the idea that inflation is always a risk. This can lead to a belief that Governments should never spend more into an economy that it takes out (which is what a Commonwealth deficit is).
Anchors work on a personal level as well. We hold them in our attitudes to most things to do with money – how we approach personal debt, for example, or what we consider to be a stable job or industry. For investors, one set of anchors that will need to be re-set are those around what constitutes a reasonable return for different kinds of assets. For at least a period of time, lower returns will need to be anticipated.
To give an example, www.finder.com.au reports that in June 2011, a 12-month term deposit with the NAB yielded an interest return of 6.18% per annum. In August 2020, the return for a 12-month term deposit with NAB is 0.85%. People who are anchored to the figure from 2011 will find the 2020 return very unappealing and may therefore choose not to take it on. This might become dangerous if, for example, those people then decided to move their money into the share market, where a higher dividend yield may be possible. That is, if people are anchored to an income return of 6%, they may change asset classes n order to pursue it.
In order to re-set their anchor, these investors need to remind themselves that the key role of an investment like a term deposit is ‘defensive’ – the aim is to preserve capital, not generate a return. When these investors then look at the fact that the share market has fallen by about 15% since the start of 2020, they can see that the higher dividend return can come at a significant overall cost if it means taking on more risk.
All our mental anchors can be re-examined in the same way. The key is to realise that all information becomes out of date – and information gathered before the pandemic is particularly vulnerable. When we do this, we remember to actively seek out new information to ensure we are making properly informed decisions. This is, of course, why we have continued to write weekly articles for you through the pandemic (which has not been without its challenges, we must say!) We want to ensure that our clients and potential clients are being reminded on a weekly basis that things are changing. Good quality decisions require good quality information that is relevant to today’s circumstances.
Time to haul up those old anchors and throw them away!