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What are the biggest mistakes people make with their personal finances that could be easily fixed? originally appeared on Quora - the place to gain and share knowledge, empowering people to learn from others and better understand the world.
Answer by Arshad Ahmad, Associate Vice-President & Professor, Finance & Business Economics at McMaster University, on Quora:
People make a lot of mistakes when it comes to their personal finances (myself included)! But one that became particularly apparent in the wake of the 2007-08 financial crisis is our inability, when buying and selling financial assets like stocks and bonds, to properly assess or price risk, which is itself often because we don’t fully understand the crucial difference between risk and uncertainty.
Risk is directly related to return since one expects a higher return to compensate for taking on higher risk. There are many ways to measure both risk and return, but once we have the anticipated return, this can be used to calculate the value of the asset. But this straightforward process is complicated by the existence of uncertainty. In finance, uncertainty has a very different meaning than risk. American economist Frank Knight made the distinction back in 1921, when he differentiated risk - which can be measured and protected against - from uncertainty, which cannot. To use a more recent example, uncertainty means what the former US Defense secretary Donald Rumsfeld famously called “unknown unknowns”.
Confronted with uncertainty, we are simply unable to predict how a future disaster might unfold, even if some might have an inkling about the triggering conditions, as has been the case with a history of market corrections. Moreover, financial calamities can also be triggered by the intersection of finance with outside forces. Geopolitical issues (such as how a sharp decrease in oil prices is mobilized to curb Russian military adventurism in Ukraine) or global security problems (like the threat of terrorism and our ongoing response) continue to chip away the resilience of our current economic and political systems. Then there are unanticipated events like Brexit – which are led by a new class of politicians who are openly challenging the status quo, not with new ideas or reconciliation, but with allegations of corruption and cultural resentment that only fuel the average person’s general anger and mistrust at “the establishment”.
We can also consider another crucial but divisive topic: inequity. No matter how it’s defined, getting a fair share of the economic pie is beyond reach when the richest eighty-five people control more wealth than the poorest half of our global population. The global wealth gap is very serious and very distressing (see this excellent interview from BBC’s HardTalk). It also speaks to the broader issue of globalization, which relates to things like free trade deals, the rise of multinational corporations, and transnational financial markets. These processes are often viewed with suspicion because they have a major impact on the economic well-being of billions of people who have very little influence over them. Many people are beginning to think the system is not working and is rigged against them, with politicians bought and sold by powerful financial interests. This feeds a widespread distrust mixed with loathing of the financial class that is now synonymous with the political class.
All of this to say, financial markets can provide an array of products that help us protect ourselves from measurable risks, but it can do precious little in the face of true uncertainty. So a crucial concern when managing your personal finances lesson is to learn how to distinguish the two, because when markets stop pricing risks correctly, we have corrections, which can become recessions and even depressions!
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