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Newton's Third Law of Finance

Over the last two months, I’ve discussed something called Newton’s Laws of Finance. They’re my spin on Sir Isaac Newton’s famous “Laws of Motion” that you probably learned about in school.

This month, let’s look at the third and final law. The original is probably the easiest for non- scientists to remember:

For every action, there is an equal and opposite reaction.

This law is easy to understand. Imagine shooting a cannonball. The ball will fly in one direction, while the cannon will roll backwards in the opposite direction. The same principle applies when firing a gun. The “kick” you feel is just Newton’s third law saying hello.

So how do we apply this to finance? Like this:

For every financial action, there is an opposite reaction.

Or, to put it another way: for every financial decision you make, there is the potential for an unintended consequence.

Here’s what I mean. Let’s say you own 100 shares of XYZ Corporation. The value of your shares has gone up recently, so you decide to sell. You’ll make a nice profit, and have a quick infusion of cash that you can use however you want.

You’ve also triggered a capital gains tax.

Or, let’s say you decide to allocate more of your investment portfolio to bonds instead of stocks. Bonds are traditionally thought of as providing more safety than stocks, and who doesn’t want more safety?

But you also miss out on next week’s stock market rally.

In the first scenario, you turned a profit, but also generated taxes. In the second scenario, you traded in growth for safety.

For every financial action, there is an opposite reaction. One aspect of your financial life goes in one direction, a second aspect goes in another direction.

Of course, you could flip these scenarios around. Maybe you decide to hold onto your XYZ stock, because you don’t want to trigger capital gains taxes. But next week, the stock falls sharply in price. You avoided taxes, but not losses.

Maybe you decide to allocate most of your portfolio to stocks and have very little in bonds. You’ll give yourself more opportunity for growth ... but take on more risk, as well.

The point of all this, «Salutation», is that when people make a financial decision, they often make it without truly thinking about the consequences. They act without understanding the inevitable reaction. They want something, so they decide to get it. They fear something, so they decide to avoid it. It’s not that those decisions are necessarily bad. It’s that they’re made without seeing the whole picture.

Put it this way: an experienced gun owner always braces for the kick before he or she fires.

Whatever financial decisions you decide to make, it’s critical that you brace for the kick. Every decision has consequences. Some are positive, some are negative. Some are intended, some aren’t.

For every action, there is an equal and opposite reaction.

Financial advisors like me often use the word holistic when we describe what we do. For instance, holistic financial planning. Holistic investment management. “Holistic” simply means that we understand that the individual parts of something are interconnected, and they must always be seen that way. They are parts of a whole. Newton’s Third Law of Finance shows exactly why the word “holistic” has meaning. Whenever you make a financial decision, you must make it with the whole of your financial situation in mind.

Example: when you make a decision regarding your investments, it can also affect your taxes. Your estate. Your cash flow. Everything.

So, how do you obey Newton’s Third Law? Well, whenever you need to make a financial decision, always ask yourself: what are the pros and cons of this decision? What are the benefits? What are the risks? How will this decision affect my entire financial life?

It sounds simple. But it’s also the best way to brace for the kick.

Scientists have long used the original Laws of Motion to better understand and control the world around them. By understanding the Laws of Finance, you can better understand and control your finances.

Good luck!

“Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things.”
- Sir Isaac Newton