18 November 2015

John Barton

Director & CEO

We all understand that the way we ask a question can have a huge impact on the answer we receive. In academe, this is called framing and it refers the cognitive bias which causes people to react to a particular choice in different ways depending on how it is presented. For example, people tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented.

For example, the following questions were used in a study performed by behavioural economics researchers Daniel Kahneman and Amos Tversky:

  1. You have $1,000 and you must pick one of the following choices: Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0. Choice B: You have a 100% chance of gaining $500.
  2. You have $2,000 and you must pick one of the following choices: Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0. Choice B: You have a 100% chance of losing $500.

Mathematically the two sets of choices are identical. If the subjects had answered logically, they would have picked either “A” or “B” in both situations — with people choosing “B” being more risk averse than those choosing “A”. However, the results of this study showed that an overwhelming majority of people chose “B” for question 1 and “A” for question 2. The implication is that the way the choices were characterised (framed) made a significant difference to the way people considered their choice and consequently their actions.

This behavioural bias can be a trap for investors, in particular buying high, when greed and optimism are prevalent and selling low when fear of loss becomes the driving force. However, there are ways to use framing to your advantage. One powerful way to reframe your personal finances is to reverse the way you think and to reframe your income as an asset and to characterise your assets and investments as a source of income.

 

What is your income worth?

Let’s start with your income. Generally people think of their income as a cash flow item, an amount of dollars per week, per month or per year. While this is accurate, it doesn’t tell you how much your income is actually worth.

Consider the following example. Bill earns $200,000 per annum and expects to work at this level for a further 15 years. This means that over the next 15 years Bill expects to receive $3,000,000! In fact, this number increases to more than $3,700,000 once we factor in a reasonable level of inflation (3% p.a.). Now $3,000,000 is a lot of money. In fact, for most people more than a few years away from retirement, their future — as yet unearned income — will be their single largest asset. This is even more so for younger professionals and business owners who would also generally expect their income to increase in real terms as they progress through their career.

So, what is your income worth to you and your family? Do the arithmetic for yourself and you’ll likely start thinking and feeling a little differently about your income.

Having realised the asset value of your income your number one action should be to ensure that your (valuable) asset is adequately insured. It is widely acknowledged that, in terms of life, disability and income insurance, the vast majority of Australian’s have significantly less cover than they should. More than one-third of all working Australians have no disability or income support insurance. For those that do have some cover, it is often astonishingly inadequate. The best estimates suggest that across the working population the level of under-insurance is as much as 77% (KPMG, Insurance Disability Gap Report, 2014) which is to say that, on average, people only have 33% of the required protection in place.

Whether you’ve got cover in place or not, be sure to complete a detailed review of its relevance to you in terms of the amount of cover, the type of cover, the specific definitions of your contract and the structures within which you hold the cover. Unless you consider these aspects in detail, ideally with the assistance of an experienced and qualified professional, you run the risk of being caught short when you can least afford it.

A common concern when considering an appropriate level of cover is the cost of the premiums. For most people, the cost of cover is actually surprisingly affordable. It is also the case that with appropriate advice, there are a number of strategies that can be adopted to ensure premiums are well and truly manageable and fully funded. Of course, if your budget is such that the premiums do cause you concern, just think how hard it will be to cope if you find yourself in circumstances where your current income isn’t available!

Whatever you decide, consider your framing and be sure to think of your income, and particularly your future income, as an asset. With this perspective, you’ll be well placed to make informed decisions and take control of your future.

Click here to read Part 2.

Disclaimer: This article contains general information only and is not intended to constitute financial product advice. Any information provided or conclusions made, whether express or implied, do not take into account the investment objectives, financial situation and particular needs of an investor. It should not be relied upon as a substitute for professional advice.