The psychology of money can screw with you!

Background

I am busy writing "The Simple Guide to Investing for your Child's Education". It is a no BS guide for South African parents. If you want to be notified once it is released please sign up at the bottom of this page.

The post below is an excerpt from the guide.

Goals Based Investment vs Home Loan Strategy

I like to have a dedicated pot of money for each of my goals. For my retirement goal, I have an RA investment account at 10X. Saving towards a new car? Allan Gray Money market fund. Emergency fund? My Home loan access facility. A children education fund? Passive, low-cost ETF.

Why? This approach is called goals-based investments. It works well because you are matching your future liabilities (your goals) with dedicated accounts, each optimised to meet that goal. What does that mean? Generally, the longer time you have, the more risk you can take. If I am saving for retirement - in my case about thirty years away - I am able to take on significantly more risk compared to saving towards a down-payment for a house or car. Therefore, my investment strategy and the risk I am taking will differ between these goals. Here is another example. I am currently saving for a bigger car as the family is getting bigger. For this goal, I will need +/- R250 000, which will get me a nice second hand family car. I require certainty that my monthly savings towards this goal will not fall in value. Therefore, I will not invest in volatile stock markets as these can fall abruptly over short time periods. This would result in me delaying the car purchase until my investment recovers or taking up car finance. I do not like either of those options. Thus for short term goals - where I require certainty - I use money market accounts or fixed deposits. For longer-term goals - like my kids tertiary education fund - I can afford to take more risk and reap more rewards.

The psychology of money & investing all your excess savings in a home loan. Consider the following scenario. Instead of having separate, dedicated accounts for each goal, you invest all of your savings into one account. A great example is investing all your excess savings into your home loan. Kid’s education? Home Loan. Emergency Fund? Home loan. Additional retirement savings? Home Loan. You get the picture. This is not a bad investment strategy. You can compare investing into your home loan to getting very high interest (ie at the rate of your home loan, typically around prime) in a bank account. All tax-free. This is a good investment! However, when it comes to money, you need much more than just a good investment strategy. You need to get the psychology around money right. Case in point, thousands of people have got maxed out credit card debt. They know they need to save, rather than buy another pair of shoes from their second credit card. They know the “investment strategy”. Save the money. Pay down that debt. Do not buy those extra pair of shoes. However, money management is a funny thing. It is much more than just a good “investment strategy”. It is psychological. And getting the psychology around money right is arguably even more important than a good investment strategy.

Now you may not be a person with maxed out credit cards and two wardrobes full of high heels (women) or toys (men). In fact, you may be very good with money. However, the point is that getting the psychology of money right is just as important as getting the investment strategy right.

How to set yourself up for success from both a psychological and an investment point of view. Let us go back to our "pump everything into our home loan plan" investment strategy. You will be getting good returns (at around prime), tax-free with no uncertainty. Awesome. Now, let’s withdraw some money from our home loan access facility to pay for our car. Great. And the December holiday. No problem. Your home loan is back to where it was about a year ago. But you should still be okay for all those other goals you had, right. Right? Here comes the tricky part. You have no way of knowing whether you are on track to be able to pay for your kid’s education in a few years time. What about retirement? Are you able to retire comfortably? There is no easy way of knowing because all the goals are jumbled up in one account. Your home loan.

You see, when you are unable to track progress towards your goals, your great investment strategy becomes a blind one. You start chucking in more goals into that great home loan pot. The mother of all goals. Second child on the way? Ah our home loan will take care of it. Need a car upgrade. Home loan. Jumbled up, blind investment strategy.

The message is this. Set up dedicated accounts for your different goals. Each goal has got a different time horizon and therefore will dictate the risk you are able to take. If you are saving for your child’s tertiary education by putting money into your home loan, you may need to rethink that strategy.