I may lose my personal finance membership card for this, but I think math needs to be smacked right off its lofty pedestal. I know the personal finance community is full of optimizers and math evangelists, but please bear with me. You can judge me in the comments later.
Math is not the perfect, rational response to every personal finance question. Just because we’re dealing with numerical values doesn’t mean that they have to be rigorously and exclusively applied.
One of the reasons I think we use math to make decisions is that it’s relatively simple, in a big picture way – it’s input and output. It’s predictable, tangible, and universal. Math can be used to shut down a conversation, because how can you argue with ‘$10,000 > $5,000, the end’?
Math is the easy way out, and it’s far from the whole story. When it comes to personal finance and other issues with a human element, math is only part of the equation. If the information we use is quantified in amounts of money, interest rates, investment yields, and savings percentages, what’s missing?
I don’t know, how about the entire range of human emotion?
Consider these common personal finance questions:
- Is it better to make higher student loan payments or invest?
- Should I pay off my mortgage early?
- Do I settle a personal loan with a family member, or pay off my car?
The math favors paying off high interest debt and prioritizing investing over paying low-interest debt. The problem with this approach is that it does not take several major factors into account:
Many of the mathematical calculations for determining whether to pay debt or invest assume a certain percentage of returns, but the reality is that there are no guarantees in the investment world. Our normalcy bias causes us to believe that things will continue to function in the way that they have in the past.
To accurately weigh two choices, we need to seriously consider events like a market downturn, job loss, or other financial crisis. The additional money we’ve made by investing could be wiped out if we were forced to withdraw a portion of our portfolio in a down market.
We just saw the same biased behavior only a decade ago in the 2008 financial crisis, when we were gambling on the housing market, convinced that it would only go up for infinity.
When the tide goes out, you can tell who’s been skinny dipping. – Dave Ramsey
In a long bull market, confidence is at a high and we tend to discount the potential effects of a future bear market. What happens when the tide turns and you’re overleveraged?
As much as we’d like to think that we’re rational beings, we can still be easily swayed by our feelings. Advertisers know this, psychologists know this, behavioral economists know this. It’s time that we leveraged their research to benefit ourselves!
The standard investment advice is to buy and hold. If we objectively know this, why are there countless questions about timing the market on every personal finance forum?
I’ve heard that you’re not supposed to time the market, but everyone is talking about an imminent crash. Should I wait until it goes down to invest? – Everyone Always
I don’t know about you, but to me that sounds suspiciously like trying to time the f*cking market. We rationally know the answer, yet we ask these questions anyway because we irrationally perceive our own circumstances to be unique.
Why, if math tells us one thing, do we consistently do completely opposite things?
I’d like to introduce you to a little phenomenon I like to call the black box of human emotion.
A black box is a system which can be viewed in terms of input and output, without any knowledge of the internal processing. The human brain is the ultimate black box. We are constantly doing irrational things, no matter how rational we might perceive ourselves to be. In fact, perceiving ourselves as rational when we tend to act irrationally, is irrational in itself!
There are so many examples of irrational human choices that I’d have to start a new blog just to talk about them all. In the meantime, here are just a few examples of the mathematically inefficient choices we make with money:
- loss aversion could explain why we buy things we don’t want, and why we fail to return unused things after we’ve purchased them
- anchoring suggests an appropriate cost of something, even though a rational price might be much lower
- hyperbolic discounting refers to our tendency to choose the smaller immediate gratifications over larger long-term rewards
For some additional reading on the subject, and many more examples of our flawed human mind, check out the books Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely, or Thinking, Fast and Slow by Daniel Kahneman.
The math only works to its full extent if we complete a number of transactions perfectly over a number of years. Are we perfect? Science says no.
There’s something inherently motivating about paying a debt off, especially a small one. The rational strategy is to tackle the high-interest debts first, but getting out of debt is actually more likely to happen using the snowball approach – paying debts from smallest to largest amounts.
A team of Kellogg School researchers has found that people with large credit-card balances are more likely to pay down their entire debt if they focus first on paying off the cards with the smallest balances — even if that approach doesn’t make the best economic sense. – The ‘snowball approach’ to debt, news article by Ray Boyer; research by assistant professors of marketing David Gal and Blakeley McShane.
The motivation factor is why Dave Ramsey’s baby steps are so incredibly successful for so many people, despite being mathematically inefficient – someone pays off a small debt, gets a quick win, and feels a push to keep going.
If our motivation stumbles and we spend a portion of the amount we should have been investing, we slowly eat away at the financial benefit, potentially even losing it altogether. Staying motivated throughout the process is key, and it’s more difficult than we think. We assume that our financial knowledge will insulate us, but this assumption is often biased as well.
Humans are notoriously bad at self-control, regardless of our knowledge, so we need all the help we can get. Ever wonder why you see so many doctors and lawyers and finance majors in poor financial health, despite a higher intelligence or financial experience? They’re human!
In the area of financial decision-making, self-control issues are significant (e.g. Raab et al. 2011; Rick et al. 2008) and can plague even the most financially literate (Brown, Chua and Camerer, 2009. – Small Victories: Creating Intrinsic Motivation in Task Completion and Debt Repayment by Alexander Brown and Joanna Lahey.
So willpower isn’t very effective, and more knowledge doesn’t help us? It’s not looking good for you, math!
If our net worth was the ultimate consideration, why aren’t we all living in a van drinking meal replacement shakes? Why do we make accommodations in the math for things like a home and delicious food, but not for our mental health?
Chronic stress caused by volatile finances or a high debt load can start to interfere with your life in major ways. Stress can lead to fatigue, inability to concentrate, irritability, or even physical ailments. For a risk-averse, debt-averse person, owing hundreds of thousands of dollars while investing in an unpredictable market can take a particularly high mental and physical toll.
If we’re so concerned about being financially healthy, why are we not more concerned about our mental (and physical) condition too? Can’t enjoy our fat portfolio to the full extent if we’re in poor health as a result of worrying about it for decades!
We are not perfect. We are emotional and irrational, and pretending that we aren’t can actually be detrimental. Instead of worshipping at the altar of math, we should be considering psychological efficiency as well as mathematical efficiency.
If you’re choosing to pay down your mortgage instead of invest, or pay back a personal loan from family before tackling your other debt, know that there is science behind your choices. Just because math provides a concrete answer, doesn’t mean it’s the correct one. We shouldn’t be so quick to discount mathematically inefficient choices – they could very well be the best option!
Are you Team Psychology or Team Math?