Handling Finances

I was talking to a coworker of mine who has an MBA about one of the biggest lessons in business management classes that gets ignored not only in business management, but in national policy and yes, in our own personal finances.  Quite simply, it is never wise to base major decisions on ANY single event!  Terrorism is a big problem worldwide, but the additional safety to our airplanes of having our nail clippers confiscated and eye-drops visible in plastic baggies is insignificant compared to the added cost of even badly enforcing these new rules.  Some oversight of mortgage brokers would be a good thing, but it should be broad and loose rather than simply cracking down hard on a specific two or three practices that led to the recent increase in forclosures.  And yes, spending less than you earn is a great idea, but you shouldn’t decide to save just because you declared bankruptcy!

That’s right, even good decisions should never be based on rare events.  You shouldn’t decide to go with a used car because a friend had to fight with a dealer over whether their new car was a lemon.  You shouldn’t ride your bike to work because you normally drive over a bridge and you heard about the 35-W bridge collapse.  You certainly shouldn’t save for retirement because Enron went bankrupt and their pensions became worthless.

Emotions are healthy, but they can never be trusted to drive major decisions. If you’re looking to buy a car, certainly take the chances of buying a lemon into account, but only as part of your decision.  Look carefully at the price differences, warranties, reviews, safety information, fuel effiency etc…  You might end up buying a used car anyway, but you won’t be risking your hard-earned cash on a hasty decision.  Similarly, don’t save for retirement just because Enron’s collapse scared you — evaluate your expected income from social security, private pensions, annuities etc… and look carefully at how likely they’ll be there until you die.  Hopefully you do decide to save significantly for the time when you may be unable to work, but you’ll be better educated to be able to decide how much you’ll need each year and how much you need to save to meet your goals.

Unfortunately, we are wired to make snap decisions based on emotions. It’s a great survival trick from back when we had to choose to fight or run when staring into the eyes of a tiger.  It’s a great way to be manipulated though as politicians routinely use natural disasters or (in these days) terrorist attacks to get votes.  Yes, it’s best to have FEMA be prepared to respond to the next emergency, and we certainly want to avoid as many terrorist attacks as possible!  Still, it’s important to evaluate the facts — would adding a billion dollars to the INS budget really prevent determined terrorists from bombing shopping malls?  What about ten billion, a hundred billion?  How much liquid does a potential terrorist need to down a plane?  (answer: less than you could fit in a shampoo bottle).  Will suspending the national gas tax bring down the price of gas?  I haven’t yet heard a professional energy analyst say yes — we’d perceive gas prices as a “deal” and increased use would push the price far higher than the 18 cent “sale.”

Of course, emotions are a vital part of being human and they can’t be ignored either.  Any decision should certainly take into account our stress levels and how a decision will affect us emotionally! In some cases, as with tragedies that affect us and our families, emotional factors may even be the primary reason for making a particular decision.  Even when that happens, though, it’s important to step back, look at the facts, and then choose one way or another.  Because while you might feel better for a little while in a large new house to soothe your feelings about living in a tiny shack as a child, reality will eventually catch up and you might wish you’d looked at facts as you’re being evicted.

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.