Handling Finances

Why do people sell hurting stocks just before the price rebounds? Why do people buy stuff they don’t need at prices they can’t afford? Why do people skip saving for retirement and buy lottery tickets every day? Quite simply, for the majority of people in our culture, financial decisions are driven by emotions, not by careful research and planning. While our instincts that drive us to compete with others and to compete for status in a community might be productive in many areas of life, they are incredibly easy to manipulate as demonstrated by the success of advertising. When our instincts are wrong (or misled) they can lead us to financial ruin without a hint of the problems to come. That’s why taking control of one’s own emotions and instincts are vital to becoming and staying financially secure.

Ultimately, the triumph of our emotions over reason is why seemingly horrible financial advice can actually be brilliantly effective. For those who have never understood debt or compound interest and don’t particularly care about debt-to-income ratios or interest rates, becoming swamped with debt is rather easy to do. Dave Ramsey, a rather successful speaker and writer, targets these people with his advice to pay off the smallest balances first rather than the debts with the largest and most damaging interest rates. This strategy inevitably costs his adherents thousands of dollars each year… but costs a lot less than if they weren’t actively attacking their debt. In fact, the strategy is so successful, as evidenced anecdotally by the large number of fans on the net who claim to have paid off hundreds of thousands of dollars of debt following his advice, that I hesitate to criticize his math. By giving people minor victories as soon as possible (by closing accounts with low balances) Ramsey makes these people more likely to continue paying off their debt and gives them a better chance to get their finances under control.

While this particular situation is rather specialized, it illustrates a larger financial truth. Psychology trumps math in finances. One example that particularly bothers me is how many banks make most of their money by selling debt to people who are least likely to be able to pay back the debt. People who pay no more than minimum payments and accumulate late fees are the most profitable slaves customers. They’re much more likely than average to trust their bankers and often assume that credit and mortgages will only be offered to those who will be able to repay the debts (as was common 3-4 decades ago). Since bankers are generally hired on sales experience these days rather than banking or financial experience, they have the skills to easily manipulate the average customer into accumulating more debt than they can repay. Doing the math should be a top priority for anybody considering debt, but if customers are repeatedly assured that the payments will be low and that they can afford the debt, there are a whole lot of people who don’t have the education or experience to know what to watch for.

Similarly, in many communities, debt is the norm so the average family is living well above their means. When most families in a community have expensive vehicles and electronics, envy starts to set in and drive others in the commnity to match the spending habits of their neighbors. Decades ago when debt was hard to come by and quite uncommon, people were much more content as people in like communities generally had similar incomes and could afford the same luxuries. Now in many communities, nobody can keep up with the Joneses though we’re driven to try through peer pressure and heavily materialistic advertising. If we valued math, we’d be perfectly happy to simply stick to a clear budget regardless of the consumption of our peers, but numbers have never evoked the same emotional reactions as peer pressure.

It can be really hard to learn to be content with one’s situation instead of trying to keep up with those who are living with debt, but the freedom in financial security is well worth enduring any envy caused by spending less than you earn. Just the understanding that the Joneses are deeply in debt these days can help, but in the end it’s important to find value and happiness in responsible finances so that emotions and psychology can work for you instead of against you when making financial decisions.

This entry was posted on Wednesday, February 6th, 2008 at 6:20 am and is filed under Debt, Investing, Saving. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.