0:00:02 Michael Port: Welcome to Steal The Show with Michael Port. This is Michael. Today’s guest is Preet Banerjee and he’s the host of the television show Million Dollar Neighborhood on the Opera Winfrey Network. He’s a personal finance expert and winner of the reality tv series, The Ultimate W Expert Challenge, which aired on the W Network in Canada during the summer of 2009. He was subsequently named a W Network money expert. He writes a personal finance column for The Globe and Mail, and is also author of the Canadian personal finance blog, wheredoesallmymoneygo.com, which was voted Canada’s number one investment blog in 2010 by readers of The Globe and Mail. In 2012, he launched a personal finance podcast, which currently ranks as one of the most popular financial podcasts on iTunes. Hello, my friend.
0:00:55 Preet Banerjee: Hey, Michael, how are you?
0:00:56 Michael Port: Okay, I have one question before we get started. Well, actually, we already got started, didn’t we? One of the things I teach when when people are on stage is they should not come out, do a little filler and then say, “Okay, lets get started,” because they started as soon as they walked on stage. In fact, they started when the bio was read by somebody else. So the speech starts early, so it started way before when I read your bio. Now, this is what I call filler. And I’m wondering if you’re rational. Before I start asking you a lot of questions, I need to know if you’re a rational person.
0:01:33 Preet Banerjee: Absolutely not. [chuckle] I like to think I’m maybe a little bit more rational than other people, because a lot of what I do has to do with studying how irrational people are when it comes to the decisions that they make, and so, I kind of hope by just knowing the processes by which we make irrational decisions, I will circumvent them just by having studied them, but I can tell you I’m as irrational as the next person sometimes.
0:02:00 Michael Port: Well, that’s exactly what we wanna focus on today. The fact that we and others are irrational and how to manage some of the behaviors that we have with respect to personal finance, because we don’t always make the most rational decisions, even though we think we are making rational decisions. And this is your area of expertise, cognitive bias, as it relates to personal finance and beyond I’m sure. This what I want to do. Normally, this is a show about performance and public speaking and I bring on so many different guests who have expertise in areas that relate to performance and I’ve been bringing on more and more personal finance experts lately, just because I’m fascinated with it and it gives me an opportunity to talk more about it, but I know how important it is to the people that I serve, and I’m no expert, but you are and we can get into some of the nitty gritty in terms of what you can do to improve your personal finance, but we can also first focus on some of the theory and the philosophy behind how we make decisions. Sound good?
0:03:13 Preet Banerjee: Sounds like a plan.
0:03:14 Michael Port: Alright. Where would you start when looking at our own biases? How do we uncover what our biases are?
0:03:29 Preet Banerjee: Okay, so that’s a really good question, and the field of behavioral finance, which is going back a step is essentially saying the standard models of economics, they assume that people are rational actors. And of course, we know that people make a lot of irrational decisions, especially when it comes to personal financial decisions. There is a researcher, his name is Richard Thaler, and I think he’s probably pretty well known actually. He was in the movie, The Big Short, a Hollywood blockbuster movie, and he was playing himself, and he’s an economist. You know you’re kind of a big deal in the world of economics when you’re playing yourself in a Hollywood blockbuster movie. And what he really said was, “These standard economics models, they don’t make a lot of sense to me, because I know there are a lot of people who make purely irrational decisions all the time.” If you had someone who was completely rational and he described this in a talk that he gave recently at the University of Toronto.
0:04:30 Preet Banerjee: He said, “These people, they’re called homo economicus, they eat exactly the right amount of food, they save exactly the right amount of money for retirement, and so on and so forth.” These people don’t really exist, because a lot of people struggle with these types of decisions all the time. And so, there have been identified now literally over a hundred different biases that get in they way of making the proper most rational decisions and the best way to understand bias for those who maybe are not familiar with the term, and I give credit to Professor Harry Krashinsky at the University of Toronto Rotman School of Management for saying this. I think it’s beautiful. “Bias is just another word for wrongness.” And our biases cloud our decision making, it clouds the way that we look at the world. We have a number of different biases and what’s interesting is that the degree of susceptibility that we have to these different biases varies by individual, so even though there’s a menu of say, over a hundred of different cognitive biases that can effect us, some of us are more effected by some and some of us are least effected by some of those biases. It’s really about understanding yourself first and accepting the fact that, yes, we do make irrational decisions.
0:05:47 Michael Port: Do you think that the financial services industry takes advantage of our biases?
0:05:55 Preet Banerjee: Oh yeah, absolutely. You can say that about any industry out there. Let me give you one example. One cognitive bias is known as anchoring. And more specifically, it’s known as anchoring and adjusting, and this is considered to be the mother of all behavioral biases. And I think it’s best explained with an example for us to see how it works and then I’m going to explain how it relates to people’s personal finances. Researchers did an experiment where they asked a huge population of randomly picked people out of the population, they said, “We wanna ask you two simple questions.” The first question was, “Take the last three digits of your phone number and add 400.” As an example, the last three digits of my phone number are 114, and if I were to add 400 to that, my answer would be 514. If you asked 1,000 people that question, you would basically have a distribution of random numbers, because people’s phone numbers are randomly assigned.
0:06:56 Preet Banerjee: The second question they would ask everyone is to then answer a question which most people would not know and the question was, “What year was Attila The Hun defeated in Europe?” And if you are like me, you have no bloody idea and you would be guessing. If you asked again, the same 1,000 people to answer this question, most people would agree that you would have basically a series of random guesses. Now, we have two responses. Fist response, randomly distributed numbers, people’s phone numbers’ last three digits plus 400. And then the second column of data would be their guess as to when Attila The Hun was defeated in Europe. Now, if you were to plot this on a chart, it’s almost a perfect correlation. This is a very strange thing. And so, the question you would have to ask is, what possible bearing does your phone number have on when Attila The Hun was defeated in Europe? And the answer is, there is no bearing. It’s a completely irrational response. But what’s happening is… See, our brains are designed to fill in the gaps in the absence of information.
0:08:00 Preet Banerjee: And in this particular case, because there is this gap in knowledge, you don’t know when Attila The Hun as defeated in Europe, your brain will anchor onto whatever is swimming around in there. The last thing that was swimming around in there was the question of your last three digits of your phone number plus 400. With nothing else to go on, your brain has basically said, “Alright, well, I’m gonna anchor to that and adjust from there,” which explains why people’s answers were correlated to their phone numbers, ’cause that’s completely irrational. This is an example of how a cognitive bias can work. It is a shortcut that our brains take in order to fill in the gaps in as short as possible time. Now, how does that relate to personal finance? Well, this was a really, really fascinating study. Anchoring, this irrational process that informs our guesses when we have no other information to go on, that means that if you were to take a look at credit card users. You’ve got two types of credit users in the world, those who pay off their credit card balances every single month and those who don’t, that’s it.
0:09:04 Preet Banerjee: And so, a researcher said, “Well, if this anchoring bias is so strong then let’s run an experiment. Let’s see what would happen if we remove a potential anchor from a credit card statement.” And the biggest anchor for most people is the line on your credit card statement that says, “Minimum payment due.” This serves as an anchor in theory, so if people don’t know what they’re doing when it coms to managing their credit, they will anchor to that line and then adjust from there. If the minimum payment required is $30, they’ll say, “Okay, well, if I add $10 bucks to that and pay $40 off this month, I’m doing well.” Then of course, that’s not an optimal financial decision. The researcher said, “Alright, so let’s take out that line and see what happens.” Again, the people who always pay off their credit card balance, if you remove the line on that statement that says, “Minimum payment due,” there’s no impact to them whatsoever, because they were paying it off every month, they never looked at that line. But what was really interesting was if you looked at the people who carried a balance on their credit card month to month and you removed that line, what do you think happened to their monthly payments?
0:10:10 Michael Port: Well, my assumption is they went up.
0:10:12 Preet Banerjee: Yeah. They went up by 70%. It wasn’t even a little bit, it went up by 70%. You could actually argue that a lot of people who say, “Listen, we need to increase disclosure and transparency and highlight this minimum payment due and the effective, only paying the minimum payment over a long period of time.” That’s good, but maybe what would be even better would be to remove that altogether because it serves as an anchor and if people really don’t know what they’re doing, in the absence of information, they’re gonna fill in that with whatever they see and in this case, it is that line that says, “The minimum payment due.” They anchor to that and they adjust slightly from it and that is not an optimal personal financial decision.
0:10:51 Michael Port: And of course, the credit cards companies have a conflict of interest here.
0:10:54 Preet Banerjee: Right, yeah.
0:10:56 Michael Port: Their goal is not to get you to pay it off every month. Their goal is to get you to pay the minimum.
0:11:01 Preet Banerjee: Yeah. And so, they may or may not know the psychological reasoning behind what’s going on, but I do know that many of them have reduced the minimum payment owing that is required to be made, and they’ve probably seen their profits margins go up. And it’s interesting, you have, again, two types of people. People who are really good at making payments on time, whether or not they carry a balance or not, and people who aren’t. And what we find is that people are really good at making those minimum payments, but not much more, so if you lower the minimum payment required, you increase the amount of interest that is gonna be charged over time and that customer becomes more profitable to you. It would be great to run a study and look at actual credit card data and say, “Listen, let’s run an experiment with some kind of financial partner that is willing to do it and see what would happen.” But I imagine that because this would lead to faster payoff times for credit card balances, there’s no profit seeking institution that’s gonna say, “Good to know, let’s now remove the minimum payment due and let’s see people get better with their credit.
0:12:04 Preet Banerjee: But it wouldn’t inform like a policy decision that you could take to government and say, “Listen, the data are clear here, maybe we should take a look at removing this minimum payment due,” because, again, in the absence of information, our brains are designed to fill in the gaps and sometimes they’ll fill it in with crap.
0:12:19 Michael Port: It seems like the thing that is anxiety provoking is that, when we think about this, if we go too deep, we might start reflecting on decisions we’ve been making day in and day out, year after year, and we may discover that we’ve been making decisions that are not in our best interest, and it may feel like it’s a result of other people manipulating us in some way. And so, when I hear this example, I wanna know, how can people overcome this… How can they pull up the anchor and throw it away and set their own anchor? Because, when I was younger, I was the ‘pay-the-minimum-balance’ guy when I was in my 20s. Now, I can make an excuse and argue that, “Well, it’s ’cause I didn’t have much money.” Well, then I shouldn’t have been charging more on my credit cards. You could definitely win a debate with me on that one.
0:13:25 Michael Port: But now, I carry zero revolving credit, and every single card that we have is paid off every single month. And I could argue, “Well, now I have more money, I can afford to. Well, also, I could go run up those cards too.” I changed, and my priorities changed, and I worked on changing the way that I behaved in these areas, but I’m not so sure I know exactly what I did to start to overcome some of these anchors, pull up anchors that other people have put down, so that I could be making decisions that are in my best interest.
0:14:12 Preet Banerjee: Yeah. And a lot of it comes down to the fact that we don’t really teach this stuff ubiquitously in school. I think it’s a fundamental life skill, because it doesn’t matter what vocation you end up in, money is a part of your life no matter what. And we don’t really do a good enough job in educating people to have the basic framework to make good decisions about money. And what’s interesting is that there’s been a research done on financial literacy, and when is the right time to introduce financial literacy, what do you teach people? What they found was, if you actually spend a lot of time increasing people’s financial literacy, it doesn’t have that much of an effect.
0:14:51 Preet Banerjee: And so they’re suggesting that what you need is a JIT, Just In Time delivery mechanism, where, if you’re about to buy a house for the first time, that’s when you need to learn everything there is to know about mortgages and buying houses and how much you spend out of your income on housing, etcetera. Everyone is still trying to figure out, what’s the best way to teach people the fundamentals about personal finance in terms of financial literacy. But the way that I think a lot of people are looking at what financial literacy is today, it’s not necessarily the memorization of all the knowledge that you need to know that’s out there, because even me as an expert in this field, and this is what I do day in day out, I still have to refer to the minutiae every now and then, because there’s so much information to know and legislation changes all the time, so it’s tough to keep on top of it as someone who does this 24/7.
0:15:38 Preet Banerjee: To expect someone who’s not in the industry to be able to be on top of all this stuff is unrealistic. I think what is a better thing to do, is to have a basic framework so that you can make better decisions about money. And that means having a code, just having a code about how you think about money overall.
0:15:57 Preet Banerjee: One of the fundamental rules that I try to get across to most people who are learning about personal finance for the first time is to go back to the very basics. 100 years ago, it was very clear to most people that you shouldn’t borrow money to buy depreciating assets, things that go down in value after you buy them. Borrowing money to buy appreciating assets, things like a house, which goes up over time in value, or to finance going to school, because it increases your lifetime earning potential. These are better uses, these are more effective uses of debt. But borrowing money to buy a depreciating asset used to be a really big no-no, but today, it’s ubiquitous. We think now in terms of monthly payment. And…
0:16:46 Michael Port: Sure. When you go buy a car, they don’t say what do you wanna pay for the car? They say, well how much would you like to pay per month?
0:16:51 Preet Banerjee: That is exactly right. That is exactly right. That is one of the key messages I have in one of my keynote presentations. And I talk about, when you walk onto a car lot today, there’s exactly two questions that they ask you now. First one is, what’s your ideal car on this lot? And the second is, just as you said, how much are you looking to spend per month? Based on those two variables, they’ll go in the back and figure out, well, how long does this loan need to be in order for this to work out? Whereas, 10-15 years ago, a five year auto loan used to be the maximum. Now, I was just actually looking at some data. In 2007, the percentage of new car loans that was six years or longer and amortization was 14%, and that number is scary enough as it is, but today…
0:17:35 Michael Port: What?
0:17:36 Preet Banerjee: Yeah. 14% of all new car loans taken out in 2007 was… 14% of all new car loans were six years or longer in length. But, it gets way worse, Michael. As of this year, in Canada, that number is now 72%.
0:17:52 Michael Port: Wow!
0:17:53 Preet Banerjee: 72% of new car loans taken out today are for six years or longer.
0:17:58 Michael Port: Well, that’s probably because Canadians are so nice, they won’t haggle. [laughter] They’re like, “Oh, okay, whatever you say, that’s fine.” Let me do something. I wanna talk about the framework and the code, and I wanna talk a little bit more about not buying depreciating assets, because that’s a big one. Most of us do buy some depreciating assets, and I wanna get a little bit deeper into that, because I’ve got some questions about that. But before we do, I wanna go back to something you said a little while ago about “Just in time learning,” when it comes to personal finance. I wonder, you used the house as an example. Now, if I’m buying a house for the first time and I’ve never done this before, I’ve never taken out a big mortgage and I’ve saved up money and there’s this house that I just fell in love with and I want it, and I gotta make an offer now, because there’s a lot of demand on this house.
0:18:56 Michael Port: And so, all of a sudden, there’s this time constraint. There is a scarcity, continues to be exploited by the seller. And now, I may now be working with a mortgage broker that I don’t know, this is a first time I’ve ever dealt with them, I may be so emotionally charged up around the purchase that I may not either have the time to do the learning, so I’m beyond the “Just in time,” or I’m so emotional about it that even if I’m learning something that tells me not to do X, because I’m so emotional, my irrational behavior takes over and I do X anyway, ’cause in that case, I wouldn’t have had a philosophy or particular framework or a code that I adhere to when it comes to purchasing expensive assets when it’s a new thing.
0:19:56 Preet Banerjee: Yeah. And the house purchase is probably the most emotional decision, personal finance decisions that most people will make, certainly the first big one they make is the most emotional. And with the “Just in time learning,” so, this is an interesting example, because the “Just in time” here would actually be delivered right before you start saving up for a down payment on a house. And the saving up for a down payment on a house could take years. In terms of “Just in time,” it gives you a little bit of slack, so when it comes to setting up an investment portfolio or dealing with a financial adviser for the first time the, “Just in time” would be before you start interviewing advisers, what do you need to know about financial advisers and what they sell you, conflicts of interest, etcetera? With home buying, it’s a slightly different equation in terms of how much time you need to determine what is “Just in time.”
0:20:47 Preet Banerjee: But regardless of all that, this again, because it’s such an emotional decision, this is where the most irrational behavior occurs. And you see it all over the place. And it starts with when you’re going to get pre-qualified for a mortgage. So you go to a bank or a mortgage broker, what have you, and they’ll say, “Okay, well, based on your financials, you’re allowed to have a mortgage of, say, $400,000.” And this becomes an anchor for you. Again, going back to what an anchor is, if you don’t know how much you should be spending on a house, or what is ideal or prudent, and someone tells you you’re approved for $400,000, that becomes what you think you should be spending on the house.
0:21:23 Michael Port: That’s the anchor.
0:21:25 Preet Banerjee: That is the anchor, because no one’s ever taught you about what’s prudent. The next thing that happens is now you get a real estate agent and they take you to a number of different properties to look at, and what they’ll do is they’ll say, “What’s your budget?” You tell them that, “Well, I was approved for X,” so that serves as the anchor, and then the real estate agent will do the exact same thing. They will show you three houses around that value and they’ll show you one house that is slightly outside that value. And it might be slightly higher. If you’re approved for $400,000, they’ll show you one that’s $450,000, and you will fall in love with the house that’s $450,000, and you’ll do whatever it takes to find a way to make that work.
0:22:03 Preet Banerjee: You were already starting sort of in the dark, someone tells you, “Well, you’re approved to carry this,” so you think, “Alright, that’s what I should be spending.” And then, because home buying is such an emotional decision, it’s so easy to justify, “Well, yes, it’s an extra $50,000, but it’s only an extra $25 a month in terms of increasing the mortgage payment. And it’s closer to the school, and it’s in a better neighborhood, and it’s got a garden,” or whatever. And you’ll find a way to justify that purchase. And this is kind of linked to another bias that we have, this anticipation of rewards. And the anticipation of a reward tends to be a lot larger than the receipt of that reward in terms of how it makes you feel emotionally. And so, we go back into the sort of the evolutionary theory of where some of these biases come from. The theory is that, when we were living in caves, the cave was a relatively safe environment. And to go outside of that safe environment into a dangerous environment, would be a very risky thing.
0:23:06 Preet Banerjee: You wouldn’t do that. But you’re hardwired to be optimistic, to wander outside that safe environment in order to find a food source, because if you didn’t, if you weren’t hardwired to be optimistic to do that, you wouldn’t wander outside of the cave and you wouldn’t find a food source and you’d wither away and you’d die. That’s not good for the perpetuation of the species, so that was hardwired into you. And when it comes to, say, buying a car, anyone who’s bought a car can tell you the exact same emotional cycle that they went through. For a month or two before they were thinking about buying that car, they’re thinking, “You know what, it’s gonna have a great paint job, it’s gonna smell great, it’s gonna have better mileage, I’m gonna look cool in it, it’s gonna be less maintenance,” and so on and so forth. And you think about this car for maybe a month or two, or if you’re a car guy, maybe three or six months before you buy it. And then you buy the car, and I’m gonna say within about three weeks, you just look at that car as something that gets you from A to B just like your last car did, but now you’ve got a bigger monthly payment.
0:24:03 Preet Banerjee: This hardwiring to be optimistic, and the anticipation of a reward being greater than the emotional satisfaction of actually getting that reward was great, when it was used for us for staying alive and wandering outside of our safe environment to find food. But not so good when it comes to making big purchases, because again, the anticipation, that feeling that you get there, is usually a lot larger than once you actually get there and buy whatever it is that you’re looking at, that buyers remorse that people have.
0:24:37 Michael Port: In terms of doing the “Just in time learning,” or any kind of learning when it comes to personal finance, how do you know who to learn from? You know this was like a big… I think that we’re generally as successful as… Our choices of teachers is of course, very influential with respect to how successful we are. If we pick great teachers, we tend to learn faster, and better and we do well. And people who are very successful tend to pick good teachers, ’cause a teacher is your choice. In high school, you’re assigned a teacher, but as an adult, you choose the books you’re gonna read, you choose the podcasts you listen to, you choose the conferences you go to, etcetera. And, I felt so stupid when it came to personal finance when I was younger, that I just figured, “Oh well, he’s a nice man in a suit, I’m sure he knows what he’s talking about.”
0:25:42 Preet Banerjee: Right.
0:25:42 Michael Port: And I don’t really understand any of the words that are coming out of his mouth and I don’t wanna look like an idiot, so I just go, “Uh-huh, uh-huh, okay, okay, uh-huh, okay, should I write the cheque?” And that was about it. The straw broke for me when I got a prospectus from a financial adviser, because I got to the point where I was a little bit more of a target. I’d meet people who were in the financial services industry and they go, “Oh, yeah, yeah, okay I got something for you, buddy.”
0:26:14 Michael Port: And so, I looked at this thing and he was giving me the pitch and I couldn’t make heads or tails of it, this thing looked like Greek. And I had this feeling that it was intentionally made to look like Greek, I wasn’t really supposed to understand it.
0:26:30 Preet Banerjee: Right.
0:26:31 Michael Port: So I sent it to my father-in-law, who’s a former entrepreneur and CEO, but he’s also just wonderful, wonderful in personal finance, he runs the endowment for the Presbyterian Church on the East Coast, and I said, “Can you take a look at this thing for me and tell me what you think?” And he wrote back within 20 minutes and he said, “Have you given them any money?” [laughter] I said, “No.”
0:27:01 Preet Banerjee: Red flag.
0:27:02 Michael Port: Yeah, exactly. I said, “No,” he said, “Good, be at my house, Tuesday morning, 09:30 AM.”
0:27:07 Michael Port: I said, “Okay.” I get there, and he’s got a whole series of articles printed up for me, stapled together from the Wall Street Journal and the New York Times, he has two books waiting for me, and he has this prospectus for this fund that I had sent over to him, highlighted in various places throughout the document. And he said, “Let’s go though this document first,” I said “Okay.” And everywhere he highlighted was where some fee was being charged that was not clearly disclosed, and by the end, he added up about 4.5% fees on any money that you had in that fund, 4.5%.
0:28:02 Preet Banerjee: Wow.
0:28:03 Michael Port: The adviser takes their 1% for assets under management, but then he found another 3.5% in fees just for this particular fund. And I said, “Oh my God, but I was talking to the guy and the guy said to me, he said, I guarantee you won’t be paying more than 1.8% of an expense ratio, plus our fee.” I was like, “Oh, I guess it’s 80 basis points, that’s not great, but I’ve seen worse.” And it was just complete fabrication, it was a total lie.
0:28:35 Preet Banerjee: Wow.
0:28:35 Michael Port: And I think the guy who’s selling it didn’t know, I think that’s the thing, I don’t think he understood it, frankly.
0:28:40 Preet Banerjee: Right. And you know what?
0:28:41 Michael Port: Yeah. Well, anyway…
0:28:42 Preet Banerjee: Sorry, go ahead.
0:28:43 Michael Port: Yeah, yeah. No, just to finish up the story, that was the turning point for me, because he showed me that, then he had, read these articles, read these books, and just the two books that he gave me, and the articles that he showed me, it opened my eyes, and when my eyes were opened, then I started digging in and then I started learning everything I possibly could. And I got better at choosing my teachers, I wasn’t going to conferences, but my teachers in terms of, what authors I was reading, and what podcasts I was listening to, etcetera. And everything changed for me, it was just that one moment in time is what flipped the switch.
0:29:23 Preet Banerjee: Right.
0:29:23 Michael Port: I felt very fortunate that I had someone like that in my life, but before that I didn’t, and many people don’t. So how do you counsel people on where they should learn, who they should learn from, and how will they know whether or not someone has a conflict of interest?
0:29:41 Preet Banerjee: Yeah, there’s so much to unpack there. First thing that I picked up on your story was, talking about maybe this adviser maybe didn’t know that they were mis-selling or misconstruing this information, and that’s because the barrier to entry to becoming a financial adviser, in my opinion, is way too low. I know there are a lot of great financial advisers and financial planners out there, I know a lot of them, but I also know that there’s a huge variation in the skill level and the competency level that exists in the industry. Because if you take a look at other professions, doctors, lawyers, engineers and what have you, they’ve targeted undergraduate programs, graduate programs, residency and you are looking in extreme cases 10-15 years before you can call yourself a professional. When I first became a financial adviser, back when I was a financial adviser, I am no longer, it was a two week self- study course and I got a 94% and I didn’t know anything about finance before I started studying that test. There’s just a giant chasm of a divide in terms of skill required before you can say, “Yes, you are now licensed to take care of someone’s health or in the world of financial advice, manage their lifetime savings.” That is a huge responsibility.
0:30:58 Michael Port: Sure is.
0:31:00 Preet Banerjee: And the barrier to entry is so incredibly low, so that’s one issue, which leads to problems. The second issue is that there has been, historically, a huge structural conflict of interest, because if you were to ask most people over the last five decades and you say, “Your financial adviser that you deal with, do you think they are supposed to put your interest above their own?” And they would say, “Yeah, of course,” if they are professionals they’re giving some advice on financial matters, I would expect that they have some kind of oath or duty to ensure that they are doing what is in my best interest first.” In your country, you’ve got this brand new fiduciary rule that is being, well, possibly put off now with your new incoming administration, but here, north of the border, that’s still not the case for the vast majority of advisers and…
0:31:52 Michael Port: Let me give the listeners just a little update on that, so they know exactly what you’re talking about. When you are giving advice on a mutual fund that is not inside a retirement account, the financial adviser doesn’t have to give you advice that is in your best interest, it just has to be suitable, which of course is a ridiculous standard. However… And the SCC is the one who manages the regulations around that type of advice. However, when it comes to retirement plans, the Department of Labor is the one that is in charge of retirement plans, so they said, “You know what? We can actually make a change. We can say if you are giving someone advice around their retirement account, then you must give them advice that’s in their best interest, you must act as a fiduciary.” I don’t think the law has gone into effect yet, although I’m not sure, because the financial industry was fighting this very hard and now I don’t know how in court you make the case that you shouldn’t give somebody advice that’s in their best interest. [chuckle]
0:33:02 Michael Port: I would love to see the lawyers dance around that one, but even if the Department of Labor is able to get this through, that it doesn’t get struck down in court, it’s very hard to police. It’s very, very difficult to police, so I still wouldn’t make the assumption that one is getting advice that is in their best interest.
0:33:29 Preet Banerjee: Right. And again, if you look at the structural conflict of interest, again, you’ve got consumers who for the most part are thinking, I’m just assuming that they’re supposed to do this. Some of them don’t even know that you should be asking whether or not the adviser you had is held to a fiduciary duty or not. Some are, some aren’t and if you look at the compensation models that have existed for a long time, they’re essentially either commission driven or based on a percentage of assets managed. There’s a dislocation between the incentives between the service provider and the service seeker, so there’s the structural conflict of interest. And then, when it comes to how do you find a good teacher, not only do you have people who are compensated based on sales quotas and whatnot, they’re hunter gatherers with this conflict of interest, you also have all these seminars and online programs and ads on the Internet that show you how you can become a millionaire, become rich, how to manage your money properly and there are a lot of these seminars, which are run by slick looking people in expensive suits and they know the talk, and they are really good at sales, but less than scrupulous.
0:34:40 Preet Banerjee: And so, they take advantage of a lot of people, because a lot of people have this desire to earn a lot of money and are looking for a lot of shortcuts to getting rich quick and that doesn’t really exist.
0:34:51 Preet Banerjee: You can gamble and get rich quick, but that was because you gambled and maybe you won on the off chance, but when it comes to prudent wealth management and acquiring wealth over a lifetime, it really is following a code and getting rich slowly by doing these consistent behaviours over a long period of time. How do you find the people who can teach you or advise you and know that you are finding a good person? This is a real struggle. I don’t have a perfect answer, I can give you some anecdotal information. Back when I was in the industry and I was looking for clients, I tried to do all the great things that I thought I would look for in a relationship. I would give people the option of saying, “Listen, you can pay me by commission, you can pay me a percentage of asset, you can pay me by the hour based on your personal financial situation, here’s how much it would cost in each case here, the pros and cons, here are the conflicts of interest.” For me, this was about offering transparency and what have you not, and I thought that was going above and beyond the current standard. Since I had left the industry, I have way more people asking me to manage their finances than when I was holding my shingle out there looking for people to take on as clients, because what that does, that tells me that there’s this inherent distrust between the consumer and the industry, and it’s been built up over a very long period of time.
0:36:12 Preet Banerjee: And not to say that there aren’t great advisers that can rise above these conflicts of interest, but I’m just saying that the problem has been so pervasive for so long that people have this inherent level of distrust, and that’s a real issue. How do you find someone that is a good teacher or a good professional adviser? And time and time again, and I’ve talked to a lot of people in the industry, outside of the industry about cracking this nut, which is a very tough nut to crack, it really comes down to what I think is a large factor, their level of candor. If everything is sunshine and rainbows and there’s no downsides or pro and con analysis, that’s probably a bit of a red flag. You wanna look for someone who’s willing to say, “Hey, listen. There are some issues in the industry.” You want someone who’s gonna be upfront about conflicts of interest. You don’t want someone who’s just going to, again, give you a song and dance.
0:37:07 Preet Banerjee: You want someone that you can have an honest conversation with, that you feel is being honest with you. And unfortunately, that’s the best advice I have for people, which is sad. And really, the only way to solve this nut is a higher level of regulation and higher standards. But we’re eons away from that.
0:37:26 Michael Port: Yeah. I just look continuously for conflict of interests. That’s what I look for. I read Tony Robbins’ book, “Money,” because it was very hot, everybody was talking about it. And people were asking me questions about it, because they knew that I read a lot of these types of books, and they said, “What do you think of Tony’s book?” And I said, “I don’t know. I didn’t read it.” So I got it and read it. And there were some things in there that offered, there were some advice in there that was sound. Certainly, there were some in there. But the number of conflict of interests that presented themselves were significant. And he would disclose them sometimes, but if you didn’t have experience in finances, I’m not sure you would understand the conflict of interest, because it wasn’t disclosed at length. He wasn’t doing anything illegal in having partnerships with the different financial services, firms, that sell the kind of products that he was talking about. But that’s what I would look for. I was looking for, “Hmm, okay, so he’s recommending that, and he’s also recommending a company that you can talk to about that. What’s his relationship with that company?” Then I’d research it. And if he had a relationship with them, then it potentially could color his opinion, even if he has integrity.
0:38:49 Michael Port: That’s the thing that’s so interesting about finance, or about anything, I guess. And maybe you can speak to this from a behavioral or economics perspective, that even if somebody has integrity and they’re a good person, and they wanna be in service of others, if the advice that they give them, if the outcome of the behavior of the person who gets the advice serves the person giving the advice, do they from a behavioral perspective, unconsciously give advice that is in their best interest? Because that’s the thing that’s so tricky about this is that, we might say, “Okay, we gotta look out for the people who are the sharks and the charlatans,” but advice is always biased, because it’s coming from somebody with an opinion. It’s always biased. It’s not necessarily always right. That’s the thing. This is one of the things that I wonder also is, even when you’re dealing with people who seem like they have your best interest at heart, if their advice could help them a little bit more than you, they may unconsciously lean that way.
0:40:15 Preet Banerjee: Yeah. Well, here’s an example of how this is not a black and white issue. And I think this speaks to what you’re trying to get at here. Let’s say you’ve got someone who is working in a commission model. They eat what they kill. There are a lot of people out there who may never even start a long term savings plan until one of these slick guys comes along who’s paid on a commission basis, and they convince them to start saving for the long term. While this model may not look great to everyone in the industry and say, “Well, there’s a conflict here,” there’s value in actually getting someone to save for the first time. That is really hard to capture with any study, right? A lot of studies out there look at the impact of financial advice on the outcomes of households, and they’ll say things like, “Yeah, people with advisers tend to do better.” “I have more assets.” But you have to control for, well, is it because people with money seek financial advisers, and financial advisers only seek people with money? You have to tease all this stuff out.
0:41:21 Preet Banerjee: But what’s really hard to figure out is the person who, maybe if they never met someone who is, say, commission-hungry and is a pure financial sales person and totally in it to make money for themselves, if they never met that person and they never started saving in the first place, they would then maybe be worse off, right? Again, this speaks to how this is not a purely black and white issue in terms of, yeah, there are conflicts of interests, but sometimes, that can actually lead to better outcomes for the individual. Philosophically, you can pick this apart for weeks and years and whatnot.
0:41:56 Michael Port: I gotta say, I really appreciate that because that’s the first time that someone has suggested that particular point of view and that really resonates with me. For example, if Sam wasn’t saving any money, he meets a financial adviser who is very commission driven, and this guy is so good at sales, he gets Sam to start savings. Well, Sam is not gonna get much of a return because this guy’s commission and the fees associated with the mutual funds he’s putting him in are so high that they’re just eating into any return he’s getting, however, he has actually been saving, and otherwise he may not have. So he didn’t get the return he could have, and that he should have, given what he could do with that money without that financial adviser, but your point is really well taken. I have to say. I really do, I appreciate that. Let’s talk about the framework. Let’s talk about this code that one could adhere to, to set themselves on a productive personal finance path.
0:43:11 Preet Banerjee: Sure, I have a firm belief in the Pareto principle when it comes to people’s personal financial framework. There are a lot of people out there who will never read a book on personal finance. They may never read personal finance blogs or the business section of the newspaper, ’cause they’re just not interested in anything to do with money. There’s a small percentage of people who will read all of the books out there on personal finance and investing and what have you, and so for the small percentage of people, they’ve got access to information, and it’s an overwhelming amount of information. But what I’m concerned with is the majority of people that aren’t going to access that information. And what I want people to know is, you’re probably on average operating at a C plus starting from ground zero, if that.
0:44:01 Preet Banerjee: And yes, a small percentage of the people will aim for an A plus, by reading everything and spending hours per week learning about personal finance, and that’s great. But what I want to instill in people is, to have a framework that gets you from a C plus to an easy A, and that easy A is again, 20% of your behavior’s gonna drive 80% of your results when it comes to personal finance. And that’s where this code, or this framework comes into play. And it’s very simple, spending less than you earn, everyone knows that, not everyone does that. When it comes to financial fitness and physical fitness, there’s a lot of analogies. If people wanna be in better physical condition, what are the two simple things that everyone has to do if they want to be in better physical condition a year from now? It’s eat a balanced diet and go to the gym semi-regularly.
0:44:49 Preet Banerjee: You just do those two simple things, not even well, you just do them consistently, you’re gonna be in better shape. Everyone knows that, but not everyone does something about it. And I was firmly in that camp myself a few years ago, and then I came across this website, I think it was the American Heart Association’s website, and it said, “The average number of heartbeats over a lifetime is 2.5 billion.” And that started to give me a slightly different perspective on health. And on that website was a calculator that allowed you to enter in your age, and your resting heart rate, and based on that model would tell you the day that you’re gonna die.
0:45:24 Preet Banerjee: And so I thought…
0:45:25 Michael Port: Oh, well, that’s good. So I can do some planning.
0:45:27 Preet Banerjee: Yes. [chuckle] So I know I’m gonna die on a Thursday.
0:45:30 Michael Port: Right. [chuckle]
0:45:30 Preet Banerjee: I don’t know which Thursday, I remember that. But I remember it struck me, and I thought, “Wow, that is a different way of looking at health. I’ve never had that perspective on health before.” And I thought, “Well, I don’t like this result. I wanna change it.” Well, you can’t change the model, the 2.5 billion is the 2.5 billion. You can’t really change your age, it only gets worse from here. The only thing you can change in those variables is your resting heart rate. And the lower it is, the longer and presumably healthier life you’ll live. How do you lower your resting heart rate? Well, it’s the same two things that you already knew you had to do, which is, eat a clean balanced diet and go to the gym every now and then. And if you do that, you’re gonna lower your resting heart rate. It was the exact same conclusion that I already knew. But now I had this behavioural drive to actually do something about it. And when it comes to financial fitness, I draw a very simple analogy for people as well. So, okay, instead of looking at the total number of heartbeats over a lifetime, let’s look at the total amount of income that you earn over a lifetime first. If you project out a new graduate from university, maybe they’ll earn $3 million, adjusting for inflation over their lifetime.
0:46:36 Preet Banerjee: Well, if they wanna retire at 65 and maintain their lifestyle, their lifetime expenses, because there’s gonna be a shortfall in retirement, is gonna be about $4 million. So, lifetime income $3 million, lifetime expense is $4 million, and this forms the narrative that a lot of people have about what you’re supposed to do with your money, and that is, you run a budget, you take a surplus in that budget, you take that surplus, you invest it, you earn interest, and over time, it’ll cover up this million dollar shortfall. Everybody knows that, but not everyone does something about it. Maybe they need this perspective-ship just like I needed when it came to my physical fitness. So, I came up with this little story about, instead of looking at the merits of earning interest, taking a surplus, earning interest, and what have you, let’s take a look at the impact of paying it over a lifetime.
0:47:23 Preet Banerjee: And, so, again going back to this car analogy, if you have a young couple and they wanna buy this $35,000 car, they walk into a car lot, their loan is probably gonna be something like seven years long, and their gonna pay $43,000, principal and interest for the $35,000 car. Had they taken the amount of the monthly loan payment that they’re gonna commit to, and instead, do what they used to do in the old days, and save up ahead of time, and put their money even into a plain old high interest savings account, earning one and a half percent interest, it would only take them five and a half years, using the same monthly allotment to commit $34,000 out of their income and earn $1,000 in interest.
0:48:02 Preet Banerjee: Moral of the story is, this $35,000 car, either costs you $34,000, if you save up for it ahead of time, or $43,000 if you finance it after the fact. That’s a $9,000 difference for the exact same car. If you control for inflation, and you look at the stats would say that the average driver owns nine cars over a lifetime. And many people perpetually finance every single car that they own. And if you have two drivers in your household, that’s 18 cars times $9,000, which is $162,000 in interest on financing vehicles over a lifetime. To put a different perspective on that, that’s 4.6 more cars you could have owned if you simply saved up ahead of time using the same monthly cash flow, as opposed to financing every single car that you owned. So, 4.6 more cars, which is the paradox. In your rush to consume, you end up consuming less over a lifetime. If you simply made this one simple switch, which is realizing that you do not finance depreciating assets over a lifetime, like cars, and perpetuity.
0:49:06 Michael Port: That’s fascinating.
0:49:08 Preet Banerjee: Yeah.
0:49:08 Michael Port: That’s great math.
0:49:11 Preet Banerjee: You think of it this way. I say to people, “Listen, when you walk into a bank, you don’t actually borrow money from a bank, you borrow it from yourself. You’re borrowing it from your future self. You are pledging a part of your future income for the next five, six, seven years or whatever, to access $35,000 today. It’s gonna cost you $43,000 out of your future income. When you are borrowing money, you are successfully negotiating a pay cut with your future self. If you’re going to do that, you have to make sure that the borrowed funds are for something productive, like an appreciating asset or something that gives you a return, like going to school and increasing your lifetime earning potential. The flip side of that coin is, you consider saving money today as negotiating a pay raise with your future self, because that’s exactly what you’re doing as well. So, this code, this framework, is really just saying, forget about the numbers, think about philosophically what you’re doing. If you are borrowing money, you are negotiating a pay cut with your future self. And if you’re gonna do that, it’s gotta be worth it.
0:50:13 Michael Port: And, when you talk about those things, it just gets me thinking about all the different choices that I make with respect to what I own and what I do. Let’s talk a little bit about the difference between buying things and buying experiences.
0:50:29 Preet Banerjee: Right. [chuckle]
0:50:30 Michael Port: Because I know this is big for you and this is big for me too. Now, of course, my experiences require a really big boat. I have to buy that for the experiences. Now, you can come up with a whole way of getting on other peoples’ boats, sure, doing it cheaper, but, I like to have my own. You know people say, “Oh, the best kinda boat to have is a friend’s boat.” But, not me. I don’t want a… I want my boats, not friends’ boats. People say, “Oh yeah, I heard the expression, two best days of boat ownership is the day you bought it and the day you sold it.” I don’t understand who… I’ve never met one of the people myself, ’cause the people that I know are obsessed. It is a lifestyle that we live. And boats, I own two of them, if you count the Tender, three. They are not appreciating assets. They depreciate faster than cars.
0:51:25 Preet Banerjee: Right.
0:51:25 Michael Port: I don’t know what would depreciate faster than a boat, frankly.
0:51:31 Preet Banerjee: Oh, I can tell you. Actually, I’ve got a great story about that. Because what we’re noticing now is with the next generation of financial consumers. They go out to fancier restaurants than their parents’ generation did. And part of the reason is, they wanna take photos and put on Instagram and Snapchat, and what have you. But they can’t afford these fancier restaurants, because they’re putting the bill on their credit cards, and they’re not able to pay off the balance at the end of the month. Well, that is the answer to your question. You will not find a faster depreciating asset than food.
0:52:01 Preet Banerjee: Because 12 hours later, it’s literally crap.
0:52:08 Preet Banerjee: There you go.
0:52:11 Michael Port: That’s very funny. Oh my gosh. Yeah, it is really true. It’s so interested how each one of us is just a little bit different. We’re all human beings, we’re flesh and blood. We might have different blood types, but fundamentally, we’re very similar. But, just based on our personalities and based on our environment growing up, we have different ways of interacting with the world. I don’t like going to very fancy, very expensive restaurants, ’cause I don’t find the food that much better than my wife’s stepmother can cook. She is unbelievable. We go to her house each week, it’s fantastic.
0:52:53 Preet Banerjee: Right.
0:52:54 Michael Port: Now, of course, when it’s a special occasion, all of that, yeah, but some people love that. It is so important to them. It just is a big part of their life. And that’s where they get their enjoyment. And just like somebody else would have absolutely no desire to go out on the water all the time. How should somebody make their financial decisions with respect to the things that they love? That spending the money on it is probably not the smartest financial decision. If I didn’t own boats, I’d have even more money and I could probably retire even earlier, but I would be miserable up into the point that I retire.
0:53:35 Preet Banerjee: Yeah. And…
0:53:36 Michael Port: Talk to me about that. How do you work through that, so that it’s not just an emotionally based decision, when you’re trying to figure out what decisions to make with respect to your personal, financial investments choices.
0:53:49 Preet Banerjee: Yeah. Again, this is sort of part of the code that people have to develop for themselves. And what that might be is, it’s okay to have a vice. Because if you’re scrimping and saving and amassing all this wealth and you don’t do anything with it, what is the point of that, right? You can have a vice, you just can’t have them all. And personal finance, at its very core fundamental concept, is all about tradeoffs. And so, if you’re wildly successful, like I know you are, and you’ve done well over a long period of time, then it is absolutely okay to have more than one vice, because you can afford to do that, because you’re not sacrificing your future. You’re not saying, “All right, I’m gonna live the high life now and be destitute in retirement.” You’re increasing your wealth faster even though you have incredibly depreciating assets such as these multiple boats.
0:54:40 Michael Port: Just when you say it, it makes me laugh.
0:54:44 Preet Banerjee: But again, it’s okay to have one vice. You just can’t have them all. These tradeoffs are actually really a core part of financial decision-making. I wanna tell you about two studies. This was inspired out of a blog that came out of the World Bank a few years ago, and I think this is really fundamental to understanding how we make decisions about money and how it relates to financial tradeoffs, which is what personal finance is all about. There are these two studies which are seemingly unrelated, but give me a little leeway and I’ll explain how it all ties together. Researchers lured in subjects under the guise of studying the effects of environment change on memory recall and what they did was, they said, “All right, 50% of the subjects are going to memorize a two-digit number and the other 50% of the subjects are going to memorize a seven-digit number. And everyone, after they get their number, they’re gonna walk down this long hall, so that’s the change of environment, and they’re gonna find a researcher in other room and they’re gonna recount what their number is.”
0:55:47 Preet Banerjee: Again, lured under the guise of studying this impact of environment change on memory recall. And as the subjects left the room, as almost a throwaway statement, the researcher said, “Oh, hey, listen, as you walk down the hall, there’s gonna be a snack cart and on the snack cart, there’s gonna be fruit salad and chocolate cake, pick one.” And that is actually what they were interested in seeing, what they would choose. And as it turns out, if you had to memorize a two-digit number and you came up to the snack cart, you pick the chocolate cake and a fruit salad in relatively equal proportions, but if you had to memorize a seven-digit number, you almost always pick the chocolate cake. And the question is, “Why? What is going on here?” Well, if you have to memorize a two-digit number and you get to the snack cart, memorizing a two-digit number is simple. It doesn’t take a lot of cognitive resources to do that. And so you see the chocolate cake and you think, “Yes, I want to have this chocolate cake, but I know I should have the fruit salad, it’s healthier for me.”
0:56:48 Preet Banerjee: So, you exercise willpower to make this optimal choice for you. But if you have to memorize a seven-digit number and your working memory capacity is seven items, effectively, your cognitive resources are fully allocated. When you get to the snack, you see the chocolate cake, you have no cognitive resources left to exercise willpower to choose the fruit salad, so you almost always pick the chocolate cake. That’s experiment number one.
0:57:13 Preet Banerjee: Experiment number two, which again is gonna sound strange, but again, give me some leeway here. There were two tasks that researchers asked subjects to perform. Task number one was to squeeze one of those exercise hand grips. But in the world of psychology, these exercise hand grips, they’re not stiff. It’s not a test of physical strength. They’re set to be relatively loose and they’re a measure of willpower, so the longer you can hold on, the more willpower you have. And so, the average holding time for everyone is two minutes. The second task was to make a decision about whether or not you wanted to buy a brand name soap that was highly discounted, yes or no. These are the two tasks. The researchers then gave 50% of the people, they said, “You squeeze the hand grip first and then you make a decision about the soap.” And the other 50% of the people, “You make a decision about the soap first and then you squeeze the hand grip.” If you had to squeeze the hand grip first, you were able to hold on for two minutes, just like everyone else, and then you make your decision about the soap.
0:58:14 Preet Banerjee: Didn’t matter what the decision was, you just had to make the decision. But if you had to make the decision about the soap first and then squeeze the hand grip, if you were rich, you were able to hold on for two minutes just like everyone else. But if you were poor, you could only hold on for a minute and 20 seconds, a full 40 seconds less than everybody else. And the question is, “Okay, what is going on here?” And the answer is, well, if you’re in the rich group and you’re making a decision about the soap, you’re just thinking, “Well, do I want this soap, yes or no?” It’s not a big deal to you. But if you’re in the poor group and you’re asked to make this decision about this premium brand name soap that’s highly discounted, you have to give something up if you wanna buy that soap. You have to trade something off, and making that tradeoff decision means you have to exercise willpower. When you make that decision about the soap, you exercise willpower, ’cause you’re in the low income group, and then you squeeze the hand grip which, remember, is a measure of willpower, it’s been depleted.
0:59:14 Preet Banerjee: Basically, what they’re saying is that, a couple of things, willpower is like a muscle. It’s depletable, but it is replenishable, and it gets expended whenever you make a decision that involves tradeoffs. There’s huge ramifications for where we see this happening all around us. Because this is not just a high-income, low-income story. That’s part of it, but really, it’s about the fact that anything that requires you to make a tradeoff decision depletes your willpower. The perfect example is you go to the gym, it takes a lot of willpower to work out, push those weights, run for 10K or whatever, you’re more likely to eat junk food right afterwards, ’cause you’ve used up all your willpower. [chuckle] You can no longer pick the optimal food. And so, the moral of this story is, however many decisions you need to make that require you to exercise willpower, no matter if it’s financial or whatever.
1:00:02 Preet Banerjee: If you make them successively one after the other, the optimality of your decisions decrease, because they all take this toll on your ability to exercise willpower which gets depleted as you use them. Personal finance is all about tradeoffs and if you understand that, this is going a long way to changing the way that we give people advice about money, about the decisions that people make about money. Behavioral finance is so, so fascinating.
1:00:31 Michael Port: I tell you, I’m still stuck on the fact that the World Bank has a blog.
1:00:39 Preet Banerjee: Yeah.
1:00:42 Michael Port: What you’re talking about is so true. I have none, no willpower whatsoever. I’m a naturally impulsive person, more so than most. So in order to mitigate the damage that I can do based on my natural ability to make impulsive decisions, is I create constraints. Because if the cookie is there, I’ll eat it. And if there’s 20 cookies in the bag, then I’ll eat 20 cookies in the bag, ’cause they’re there. I just can’t say, “I’ll only have two.” It just doesn’t work that way for me.
1:01:21 Preet Banerjee: Same with me.
1:01:21 Michael Port: Yeah, you too. Okay. Then I just say, “No cookies, just no cookies”.
1:01:27 Preet Banerjee: Right, and that’s your constraint.
1:01:28 Michael Port: That’s my constraint. People have been telling me my whole life, “Well, why don’t you just try moderation?” I’ve tried, it doesn’t work for me.
1:01:36 Preet Banerjee: I’m laughing because it does not work for me either.
1:01:39 Michael Port: What’s interesting is that the extreme nature of, and I’m going out on a limb here saying, our personalities, if moderation doesn’t work, it actually helps us in certain aspects of our life. And one of the reasons I think I’ve been effective at the choices I’ve made professionally is because I have a sense of urgency. When I wanna do it, I wanna do it and I’ll go all the way. I’m not moderate with respect to the choices I make in my business. I make big choices and I follow through on those big choices. But, I don’t love looking at the P&L. I don’t love all the systems and processes that need to be in place. What have I done? I’ve created constraints. If you work in my company, you’re responsible for creating standard operating procedures and documenting them for every single thing you do. If you don’t do that, you don’t work here. Period.
1:02:31 Preet Banerjee: Right.
1:02:32 Michael Port: It’s a constraint. Same thing with the P&L. My wife actually, she’s the one who manages… One of her roles is the CFO type of the business. But then every two weeks, she brings me the P&L, and we have a constraint that we sit down and we go over it. Because it’s a very easy thing to just ignore, if not, same thing with investing. We have a defined benefit plan. And when you have a defined benefit plan that is, you file a tax return with that. It’s not something that you can choose to contribute to or choose not to contribute to. Once you set that plan up, you have to contribute a certain amount of money over a certain period of time and if you do not, you are penalized by the IRS significantly. You are in trouble. I have no choice, I have to. And so, we make our financial decisions around that. Now did I have to use a defined benefit plan as the vehicle that we use? No, I could’ve used other vehicles, which would’ve given me some more flexibility, but I chose the one that actually is more constraining, it doesn’t give us access to that money, we have to do it every year, a minimum amount each year, and the minimum amount we’ve chosen to maximize. It’s just a constraint. This way, it has to be done.
1:03:54 Preet Banerjee: Well, this is an excellent segue into the world of tax and constraints. [chuckle] Because if you look at people who go from the employed world where they have payroll tax deductions and they switch to the self-employed world, this is a perfect example of how constraints work so effectively for so many people. Because if you’re salaried and you get a paycheck every two weeks and you’ve got your taxes deducted at source and they go right to the IRS, imagine if that wasn’t the case. Imagine your $20,000 in income tax that you pay at the end of the year or whatever it is, imagine if it wasn’t deducted in little bits and pieces over the 26 paychecks you got over the course of the year. But instead, the IRS said, “You’re gonna keep your full gross paycheck every week and at the end of the year, come tax time, we’re gonna ask for the $20,000 in a lump sum.”
1:04:45 Preet Banerjee: Most people would not be able to pay that, right? By having that constraint of the payroll tax deduction is one of the only reasons that so much income tax is actually collected and the government knows that if they let it be the other way, they would not be as successful. This is actually one of the struggles that a lot of people have when they branch out into entrepreneurship and they leave the employed world with a comfy salaried paycheck and benefits and all of that. They hang out their shingle, and they are responsible for collecting the revenues and remitting their taxes either quarterly or at the end of the year. And it’s a huge struggle for a lot of people as they start their entrepreneurial journeys, because they don’t budget accordingly, because they don’t have that constraint imposed upon them. They usually learn this the hard way. And another example of constraints and just understanding yourself as an individual, I am the exact same as you. In that I’m impulsive and I need to set constraints on myself in order to achieve certain goals. On Monday morning, I have about seven emails that hit my inbox at 7:00 AM, which list out all the multiple automated transfers that occur from all of my various different bank accounts into my retirement savings, my short-term savings, my tax account.
1:06:02 Preet Banerjee: Everything happens on an automatic basis, and I don’t have to think about it at the end of year at all. The only thing I have to worry about is, I have an allowance account, so one of the transactions is to my own personal allowance, what I’m allowed to spend per week. And all I have to do is make sure that balance doesn’t hit zero by the end of the weekend. That’s the only thing I have to look at with respect to my finance, because everything else is automated. Because if they weren’t, I would not accomplish half the things I set out to do financially.
1:06:30 Michael Port: Amen, it’s so true. It’s interesting. When I went out on my own, I started as a sole proprietor, and of course, you have to pay your quarterlies, and I wasn’t great at that. Over time, I re-classified to file as a S corp and set up payroll. And of course, when you do payroll, taxes are taken out. I don’t really get many deductions at this point, but what one can do is start out even if you’re… When you’re starting your business, start out… If you set up an LLC, start out classify as an S corp, and then you give yourself a salary. You wanna keep it as low as is reasonable, so you’re not paying unnecessary payroll taxes, but what you can do with that salary is have every single penny of that salary deducted.
1:07:24 Michael Port: I mean, have the taxes taken out. For example, I don’t get any money from my salary, it just all goes straight to the government, all of it, every penny of it. Because of course, most of my money is made through distributions, through profits. But this way, I don’t… I know that entire piece is just gonna automatically go right to the government, and then the rest of the taxes, I have to be concerned with through my distributions and various other income sources I have, those go into a tax account. Every single month, a certain amount is put in. And then every quarter, I have a tickler that makes sure that those taxes are paid. But you can set it up so that a lot of tax is taken out even if you’re just starting out earlier in the business rather than trying to give yourself every single penny, greater constraint that way.
1:08:20 Preet Banerjee: There you go.
1:08:21 Michael Port: Does that make sense?
1:08:22 Preet Banerjee: You should be a financial adviser, man.
1:08:23 Michael Port: No, no, no, no.
1:08:25 Michael Port: No. Absolutely not, but I’ll tell you one thing. I would love to continue to create an environment where more people can start to pay attention to this. And because I never will be in the business, I’ll never have a conflict of interest. This way, I can just recommend books, and people, and things like that. But, no, I definitely… Plus, I wouldn’t want the responsibility.
1:08:53 Michael Port: It’s a lot of responsibility to be giving advice when you’re not an absolute expert. There’s one other thing I wanna talk about, and then we’re gonna wrap up. Before I ask you about that, I wanna compliment you and commend you for something that you do on your website. When you go to Preet’s website, it’s P-R-E-E-T-B-A-N-E-R-J-E-E.com, I’ll put that on the show notes, ’cause that’s not an easy one to remember, but [chuckle] P-R-E-E-T-B-A-N-E-R-J-E-E.com, Banerjee. When you go there, there’s right on the home page, on the place that most people try to get your email? He has a big thing that says, “Conflict of interest disclosure.” And you click on that and it goes to a long, long, long page where he’s outlining all of the potential conflicts of interest he may have. Now, when I looked at that, none of them were actually conflicts of interest to me, but maybe he may have worked with one company and so that proves a conflict of interest to another company. But you disclose all of it, and I just love that. As soon as I saw that, I said, “Oh, he’s gotta come on the show. I gotta get him.”
1:10:10 Michael Port: I gotta get him on the show.
1:10:12 Preet Banerjee: Oh, thanks. I appreciate that. When I was writing that out, I thought what do I want when I’m looking for people and I just wanna cut to the chase, like, “Can I trust you or not?” And anyone who I’ve seen who has had something similar to that, instantly in my eyes, you just earned a lot of trust. And no one’s perfect. Everyone’s got some degree of conflict of interest, so just throw it all out there and let people make up their own minds. And for the most part, most people have actually said, “It’s actually the reason that I’m talking to you is because of that, because it’s so rare to find people who are truly transparent about it.” I would recommend to everyone, sit down and think about all the different conflicts of interest that might exist and put it on a statement and disclose is out there, so people don’t wonder. You just sort of put it out there up front and address it head on. And, yeah, I get a lot of people actually commenting on that, so thank you very much. I appreciate that.
1:11:15 Michael Port: Oh, yeah, you’re welcome. In wrapping up, I wanna talk about the gambler’s fallacy.
1:11:20 Preet Banerjee: Sure, yeah.
1:11:21 Michael Port: And how that relates to personal finance.
1:11:24 Preet Banerjee: Sure. The gambler’s fallacy is an interesting one. What it is technically, it’s an irrational underestimation of streaks in data. What I mean by that, probably best explained with an example. If I were to tell you, “We’re gonna flip a coin 10 times,” and a fair coin, heads and tails, and what have you. And the first nine times, it lands on heads, most people believe that the next flip is more likely to be tails than heads, even though the odds of any singular coin flip are always 50/50. People have this irrational belief that it is so unlikely to have streaks in data that they believe too much in this reversion to the mean. The opposite of this is the hot hand fallacy, which is when someone is on a streak and you think, “Well, it’s gotta end soon,” even though it will continue on. If someone’s shooting free throws, and they’re on a hot streak, and they hit, say, normally 80%, and they hit 15 in a row and you think, “Well, okay, it’s not gonna happen the 16th time.” Really, what this gambler’s fallacy is saying, again, is there’s an irrational underestimation of streaks in data.
1:12:43 Preet Banerjee: If you were to take 1000 coin flips, you’d probably get pretty close to a 500 and 500 distribution of heads and tails. But within those 1000 coin flips, there’s gonna be streaks of 10 heads in a row, 20 tails in a row, maybe 30 heads in a row. It’s gonna happen, right? That’s all part of random chance and whatnot. These streaks exist. And where it impacts people is really, really prevalent in the world of personal finance and in the industry. One study looked at loan applications that had been judged and… I think they’re actually in India. And so, it had these loans which had been judged by credit officers, and so these became the fodder for an experiment.
1:13:26 Preet Banerjee: And the researcher said, “Okay. These loan applications have already been judged, so let’s assume that these are the right answers, right? They’ve been judged by professionals, and they’ve analyzed all the inputs, and they made a decision to approve or deny these loan applications. Let’s take these exact same loan applications and reassign them to other professional loan officers, except what we’re gonna do now is we are going to manipulate the sequence in which they are presented to these other professional loan officers.”
1:13:55 Preet Banerjee: And to make a long story short, what they ended up doing was, they said, “Alright, well, we’re gonna give a sequence of six loan applications to these loan officers, and we’re gonna organize them so that the first three that they get are all really good applications.” They approved the first three, and the fourth one was much more likely to be denied even though the right answer might have been that it should’ve been approved. But simply because there’d been three previous positive loan applications that they saw, and because of this gambler’s fallacy where they say, “Well, these streaks can’t exist. They shouldn’t be this common.” They’re more likely to deny that application even though they shouldn’t have. The error rate introduced simply by manipulating the sequence that these loan applications were provided was 8%. And that is significant. An 8% error rate being introduced simply due to sequencing is a big deal.
1:14:53 Preet Banerjee: Now, there is a follow up study in this experiment. What they did was they said, “Alright, well let’s test out the impacts of different incentive schemes and see if we can see a change in the results.” They had three different incentive schemes. The first one was a weak incentive scheme, where the loan officers were just paid a salary to do their job. The moderate incentive scheme was you paid a little bit more when you’re right and a little bit less when you’re wrong. And then the strong incentive scheme, which was you’re paid a little bit more when you’re right, but you’re punished severely if you’re wrong. And it was only under the strong incentive scheme that they reduced the error rate from 8% back down to 1%. In other words, you need an incentive not to suck, for people to overcome.
1:15:36 Michael Port: That’s the moral of the story?
1:15:39 Preet Banerjee: Right. And when you look at the incentives that exist in the industry, that doesn’t exist, right? It’s bonuses for good behavior. There’s not really financial penalties for your sales force if you do a bad thing. You can’t get rid of some of these irrational behaviours that exist both on the consumer side, as well as the sales side.
1:15:55 Michael Port: Okay, so what I’m gonna do is, I’m gonna go to my staff and say, “Hey guys, listen. I was just talking to this fella and he… ”
1:16:00 Preet Banerjee: Not my idea.
1:16:01 Michael Port: “He said I should instill some really significant punishments if you do anything wrong. So I’ve brought in all this torture equipment. If you have a problem with it, go talk to him.”
1:16:12 Preet Banerjee: Hey, it’ll work.
1:16:15 Michael Port: Yeah. Right. Except, I’ll have no staff left to…
1:16:19 Preet Banerjee: Right. [chuckle]
1:16:20 Michael Port: To use them on. Hey, listen, thank you so much for taking the time to share yourself and your experience and your advice with our audience. It’s just been fantastic.
1:16:33 Preet Banerjee: Michael, thank you for the opportunity, I appreciate it.
1:16:36 Michael Port: Guys, keep thinking big about who you are and about what you offer the world. Thank you for the opportunity to be in service of you. I never take it for granted. I think it is a privilege and an honor, and I will continue to get up every day and try to do my best for you. Until next time. Bye for now.