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It Doesn't Add Up
Lots of things in life don’t add up – you see it everywhere. Numbers are misunderstood or misused and this directly impacts the quality of your decisions.
Numeric ability follows you throughout life. Studies estimate that fewer than 25% of the adult population in the U.S. is math proficient. Innumeracy is the norm. Your ability to think critically suffers unless you have a reasonable grasp of numbers.
Research by Nobel laureate Daniel Kahneman on mental shortcuts – heuristics – has demonstrated the connection between innumeracy and irrational thinking. Without critical thinking, your decision quality suffers.
This issue sometimes comes up when discussing financial planning with clients – innumeracy and even simple arithmetic comprehension. A brief example shows what I mean.
WHY INNUMERACY IMPACTS DECISION QUALITY
We worked with Greg and Ann as they were saving and accumulating assets for retirement. They outlined several specific long-term goals, usually without considering the cost. We started attaching dollar amounts to the goals in order to help them prioritize – they needed help making tradeoffs. If they bought the $1million vacation house, they would have less money available to travel – but they wanted to do both! Greg and Ann needed around $5 million to fund all their goals, but they actually had about half that amount. When we added the goals up on the whiteboard, they couldn’t comprehend why the numbers didn’t work.
Greg and Ann’s innumeracy manifested itself as irrational thinking – just as Professor Kahneman hypothesized. Greg and Ann decided, (irrationally), that they simply needed substantially higher investment returns in order to accomplish all of their financial goals. If 7-8% annual returns wouldn’t work, maybe 12-13% returns would. We strongly advised them to concentrate on the tradeoffs and to keep the risk versus return connection clearly in sight.
When you misjudge probabilities one time that’s a problem – but when you fail to comprehend numbers continuously, that seriously handicaps your financial well-being. Small mistakes accumulate over time and grow into big mistakes.
HOW NUMERACY HELPS YOU UNDERSTAND RISK
Some of the difficulty investors have with numbers starts with framing – how concepts are presented. For good or ill, many investors prefer good stories over probabilities. Stories tap into your feelings and this overrides the risk versus reward component of decision making.
How you perceive buying something like hamburger meat at the grocery store depends on how the numbers are framed. If the store describes the meat as 20% fat instead of 80% lean you have a distinctly different impression. The meat is the same, but the way the percentages are framed differs. Numbers can sometimes be used to distract your attention.
Highly numerate investors develop a feel for numbers and what they mean. If you can understand the subtle distinctions of the framing of percentages with the hamburger meat example, you will likely be able to spot the misuse of numbers in other types of messaging.
Financial communications often contain numbers to establish a point. If you comprehend the relative importance of the numbers, it helps you in assessing risk and making smart decisions. Start there.