Future Focus: The case for the inefficient path to investing
I draw a clear line between investment decisions and life goals.
There’s an uncomfortable truth with investing - the most efficient path is not always the right path. My goal for my column Future Focus is to help readers make better financial decisions with clear frameworks to follow.
Our content at Morningstar reflects the simple truth that each investor is different and must invest in the way that suits themselves and their financial goals.
Sometimes this means that the inefficient path is the one that leads to a better life.
Most financial content ignores the human element. It focuses purely on optimisation, tax efficiency, portfolio construction models and the minutia of saving a basis point here and there. Small differences in returns do matter over time but an investor that is too focused on efficiency can lose sight of what they are trying to achieve.
It is conflating the means with the end. This is my argument for the inefficient path – drawing a clear delineation between investment decisions and life/financial goals.
Investments vs financial goals
An investment is a tool to get you the outcome you want. A financial goal represents that end outcome.
Financial goals can be multi-dimensional. My financial goals include financial security and independence. But my goals also include lifestyle goals, stability and peace of mind. Some of my goals can be measured in dollars and cents and some can’t.
This is where efficiency and other measures of success start to blur.
The efficiency trap
Investors fall into the efficiency trap when the entire focus is on one question, and one question only: What is going to give me the highest net expected return?
Only asking this one question ignores the realities of life and personal circumstances. Many people turn to professional investors for guidance. Professional investors manage large funds and do not need to think about the individual circumstances of their investors. They don’t know what investors are trying to achieve.
The embodiment of a focus on a single outcome without consideration for other factors is the Financial Independence, Retire Early (FIRE) movement. Central to the movement is sacrificing severely in the pursuit of the highest return. It is forgoing all other goals to maximise your wealth, with the hope that it will lead to a life of financial independence as soon as possible. For many in the FIRE movement, the end goal may not get them what they want.
There’s plenty of financial news media and marketing that’s willing to give you the answer on the most efficient way to build wealth – this may not be the right path for you.
Children are financially inefficient, and completely rational
If you took the efficiency standpoint and focused on wealth maximisation, having children is one of the least efficient financial decisions a person can make.
Raising a child in Australia is expensive. It’s estimated that it costs between $300,000 to $500,000 including housing, food, education, childcare and the opportunity cost of reduced work hours. There is no financial return on this decision.
If your only goal is net worth maximisation, the rational decision is obvious.
A colleague told me that she sat down with her husband and crunched the numbers on children. They estimated the extra expenses and how this would impact their cashflow.
This exercise made my colleague anxious. She worried that a child would put them on a financial precipice in an expensive city like Sydney. This conversation happened when she was visibly showing at six months and was not far off her maternity leave.
Wealth is not the only goal in life. I used the example of children to make this obvious. Many struggle with applying this concept to less obvious trade-offs between finances and non-financial goals. Many people don’t consider happiness when making (relatively) less consequential trade-offs.
Housing
A classic example is housing.
Property can be an investment, but a home is more than a financial goal. I’ve covered my experience previously about how much it cost me to buy my first home. I bought in an area with low rental yield and a house with capital works that would not be recouped if resold immediately.
At the time my house was tenanted with an old rental agreement from early 2020 with non-market rent. The gross yield was 2.04% on a two-bedroom terrace, 1.5 kilometres from Sydney CBD. From a purely financial perspective, this was a very bad investment. I would have gotten a higher return in a savings account.
From a purely financial perspective, renting and investing the difference can often produce better long-term returns than buying an owner-occupied home. Buying a home means accounting for transaction costs, maintenance, insurance, rates and the concentration risk of putting a large portion of your wealth into a single asset.
On paper, the ‘efficient’ move may be clear. People, however, do not live on paper. A home provides stability and control. It provides a place to raise a family. It provides an environment that you can customise and make your own without fear of repercussions. None of these factors are included when you look at the ‘total return’ of an asset. The human element matters when making a decision.
Calling a home purchase a ‘bad investment’ misses the point. It may be a perfectly good financial goal, even if it is not the most efficient capital outlay.
The HECS/HELP question
I’ve written before on when you should pay off your student loans. In Australia, the loan is indexed, instead of having an interest rate applied to it.
You would be hard pressed to find a better loan, so rational financial advice dictates that there are only certain circumstances where you should prioritise paying off this loan. These circumstances include having children where you may need extra cash flow or buying a house and having your borrowing capacity reduced due to the loans.
Our approach to money and finances are shaped by personal experiences. There are some people that face genuine anxiety from holding any kind of debt. I empathise with this group.
Anxiety is not a rational feeling. You can’t argue away anxiety with bulletproof rationale, logical workings or exhortations to ‘forget about it and embrace the best loan you’ve ever get.’ If you truly cannot put the loan into the back of your mind – pay it off and move on with your life. At the end of the day, a debt paid off is not the worst thing you can do for yourself. There are people with much worse proclivities.
If the efficient choice is giving you anxiety choose another approach. Money is about choice. Choice allows you to pursue the life you want to live. That means taking all aspects into account.
The behavioural return premium from the inefficient path
Your behaviour has a meaningful impact on the outcome you get. The best portfolio is not the most efficient one. It is the one that you can stick with over the long-term.
I encourage investors to invest based on their risk capacity – understanding the return you need to achieve your goal allows you pick the right investments. Understanding how your investments are connected to your goal lowers the chance of you behaving poorly. That raises your returns.
How this plays out will look different for each investor. It may be holding more cash in your emergency fund to grant you peace of mind. It may mean paying down debt early to reduce anxiety. It may mean owning your own home to provide stability. It could be as simple as choosing a simpler portfolio that you understand, so you know how it will behave which increases confidence.
Always being in the most efficient investment may make sense from a pure return perspective. However, it may mean that you will incur transaction costs and taxes which means less money in the end.
The investment industry is always coming out with new, shiny investments with lower fees, platforms with no transaction costs and more efficient operations. In theory this will result in better outcomes. Your job as an investor is juggling these advantages with the frictional costs of making changes.
You need to consider the total efficiency over time, and not just the most efficient path at a certain point in time.
How to strike the right balance
The inefficient path does not mean indulging in every want and whim and throwing away your financial plan. It is about balance and trade-offs.
To help frame the trade-offs it helps to go through a comprehensive goal setting process to understand what you actually want from life. Our behavioural research team developed a process to help improve the way a financial adviser helps clients set goals You can read about it here. The beauty of this process is that it helps you to clearly segregate between a financial goal and an investment.
If you don’t know where to start, I’ve also gone through some of the most common financial goals. See if there are any that relate.
If you can’t define a goal and what ‘enough’ means for your life, optimisation becomes an endless crusade. You are constantly going to be searching for the most efficient path, and the best ways to maximise your wealth.
I’ve written about one common area investors struggle which is buying a home – either as an investment property or home. Read more here.
A framework to follow
Go through these questions to help add some context to your goals.
Invest Your Way
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