The Wealth Narrative

Published On: July 27, 2020

Written by: Ben Atwater and Matt Malick

Behavioral finance is the crossroads of psychology and economics.  It recognizes that investors are not always rational, have limits to their self-control and have biases that influence their decision-making. 

As we continue our series today, we turn to narrative fallacy.  Although most areas of behavioral finance overlap and interact, narrative fallacy may be the glue that binds our cognitive biases together.  After all, we always need a good story. 

The narrative fallacy acknowledges our tendency to weave a story to explain concepts so we can more easily understand or remember them.  Our biology hardwires us to love stories and we let our preference for a good story impede our critical thinking.  The better the story, the more it draws us in.  Stories have emotional content which appeals to our subconscious and stories are easier to remember and conceptualize versus facts and figures.

Today, we are going to look at the narrative fallacy as it applies to wealth building.  In our experience, we see some common myths many of us have developed around wealth building.  Even as professional advisors who do this every day, we ourselves must constantly fight the urges and tendencies of the American wealth narrative. 

Whether it be a particular investment or an investment strategy, people tend to be programmed around stories (or dreams) of big wins.  The reality though is that with big wins comes big risk.  People tend to ignore the risk part of this equation.  Ironically, it is not big wins that build wealth for the vast majority, but rather avoiding unforced errors.  Most investors are better off in a lower risk and lower return strategy than the opposite.

This seems counterintuitive.  How can you make more by setting out to make less?  The reason is that a lower return expectation keeps you from making silly investments (taking on higher risk) that seem perfectly rationale at the time, but severely damage long-term wealth.  Despite the narrative, on a percentage basis, barely anyone builds wealth quickly, rather it is a slow and steady climb. 

In addition to big wins, people seem to associate wealth with complexity.  However, the more you have going on, the bigger chance you have of making a mistake.  Complexity is yet another counterintuitive wealth narrative.  We tend to think of the successful and wealthy, particularly entrepreneurs, as having lots of balls in the air.  Although this is sometimes true, even for those who have succeeded with complexity, an analysis may very well find that much of it was unnecessary.  In our experience, most wealth builders have a streamlined and highly focused process. 

Part of our American success narrative comes with lots of “stuff,” like vacation homes, watches, cars, boats, etc.  Spending in and of itself is not a bad thing, unless it is at the expense of building long-term financial security.  Too often spending takes precedence before saving.  It is not uncommon for the folks with a lot of “toys” to have the least financial security.  Certain big-ticket purchases require wealth beyond that of the purchaser.  To look wealthy is by no means to be wealthy, that is a potentially false narrative, particularly for the mass affluent. 

There is also an opportunity cost to spending, that we frequently forget to consider.  The physicist Albert Einstein famously described compound interest as “the eighth wonder of the world.”  Einstein went on to observe that “he who understands it, earns it; he who doesn’t, pays it.”  Another view of compound interest comes from inventor, publisher and Founding Father Benjamin Franklin who said “Money makes money.  And the money that makes money, makes money.”  Not only does consumption cost what is costs, but it also denies us the ability to save and grow the money.  We rarely consider this part of the spending and saving narrative. 

Even among high earners, one of the components missing for many is simply a taxable brokerage account where they make regular contributions.  These regular contributions allow for dollar-cost-averaging into an investment strategy which will build long-term wealth simply and tax-efficiently.  When it comes to investing in capital markets, a lot of high earners view maximizing tax-deferred retirement accounts as sufficient.  For those looking to invest more, they are often seeking to invest in real estate or other businesses.  The narrative is that wealth builders are businesspeople but, as an alternative, wealth builders need only be savers and passive investors. 

Many of the mass affluent and wealthy heavily identify with their business and their work.  It is a major part of their personal narrative.  Because of this, there is sometimes a tendency to inadequately prepare for the next stage of life.  Particularly as people age, decisions to transition or sell businesses, properties and other interests are fraught with emotion.  Holding on too long seems to be a risk for many.  Maximizing the value of your assets and your interests is important, but getting absolute top dollar is sometimes a bad risk / reward decision.  Exiting assets logically and as part of a longer-term plan is essential.  As COVID has shown us, accurate prediction, particularly the timing of events, is impossible. 

In the wealth narrative, liquid investable assets are highly underrated.  As a wealth builder, the ability to gradually dollar-cost-average into your portfolio, without borrowing to do so, is hard to replicate in other investments.  And when it is time to use your wealth for your lifestyle, generating liquidity from a properly diversified portfolio does not rely on large and concentrated liquidations at what may end up being a bad time.