Handling Finances

In a recent post, Psychology Trumps Math in Finances, I discussed how as emotional creatures, we aren’t always capable of making the best financial decisions. Unless we learn to deeply value making decisions based on numbers and real statistics, we’ll simply make decisions that feel right — like when people refuse to fly for fear of crashing but drive to work daily, utterly ignoring the statistical realities of fatalities in transportation.

Sometimes, however, we can use our feelings to help us achieve our financial goals. PaidTwice recently published a blog post where she urges readers to make sure snowflakes stay snowflakes. The idea is that when you come across some extra savings or a little extra income, you should keep the extra out of your budget so it can be used as an addition to debt payments or to savings.

In math, this strategy has zero value. It neither increases your income, nor does it decrease your expenses. However, I think there a couple of key reasons that PaidTwice left unspoken which makes this strategy valuable for many of us.

1. Keeping extra savings or extra income ‘extra’ reduces the temptation to spend it. Some people struggle not to spend every dollar they touch and even after establishing a budget, if the budget says they’ll have an extra $20 a week, there’s a huge temptation to blow it rather than accelerating debt payments. Personally, I’d just increase my weekly allocation toward debt repayment, but that’s just because I’m a math geek. If you can help yourself to reach financial goals through keeping extra money out of the budget, go for it!

2. Extra money feels like a reward. Especially if you work hard for the extra money — perhaps with a part-time job or by carefully planning grocery lists — it can be extremely rewarding to keep this money separate. Every month, you can look at your budget and see your hard work paying off by reducing debt or increasing savings by more than you’d planned. Again, since I’m more comfortable with balance sheets than “naming each dollar” in a budget, this wouldn’t be very effective for me. This time, I’ll blame my nerdy parents who got me interested in reading profit/loss statements for companies my dad helped me buy in college.

3. It just works. With a zero-sum budget, you allocate all your income before it’s spent. PaidTwice makes the comment that if you eliminate the additional money in the future, you’ll still be working within the budget. She’s not strictly adhering to a zero-sum budget where she would allocate this extra income toward debt repayment and simply adjust the budget to have lower debt payments if the extra income dried up. But the important point is that it’s not a particular budgeting system that’s important but the results.

PaidTwice has found that tweaking her budgeting habits to fit her feelings results in faster debt repayment (her current major goal). Instead of giving in to her temptations and simply spending the extra money after it became regular, and instead of simply following the letter of a budgeting system that didn’t quite feel right, she built her own rules that made sense to her. It’s vital, when learning about budgeting and achieving financial goals, that we don’t try to force ourselves into uncomfortable molds. Keeping a budget takes time and effort, but the form of the budget and the goals at the end are entirely up to you. If you find budgeting to be more an annoyance than a useful tool, try to look at which details are causing the problem and simply do a little tailoring so the budget fits you like the worn-in sneakers you just can’t bear to throw away.

Our brains are not well suited to handle finances.  They are great at recognizing patterns (like faces) and interpreting those pattern (recognizing emotions on a wide range of facial features).  In comparison, facial recognition software is extremely difficult to design and even some of the best programs have difficulty with changing light and shadow or different angles.  At the same time, our brains are so good at recognizing patterns, they see them where they are not significant like in clouds, tea leaves, or grilled cheese sandwiches.

We’re particularly poor at evaluating probabilities and risk.  We tend to focus on the possible outcomes while ignoring both the probabilities and magnitudes of the possible outcomes.  For example, when people invested their retirement savings in Enron, they were probably right that the chances of Enron disappearing were very low, but the magnitude of that possibility’s effect on their savings is huge.  If I have a 99% chance of gaining $100 on a $10,000 investment, and a 1% chance of losing $10,000, the value of the investment is about $9,900.  Similarly, some of the best paying state lotteries pay around $0.70 for every dollar collected.  People are happy to purchase a $0.70 piece of paper for $1.00 because of the same mental error – we focus on possible outcomes rather than the statistical value of an investment.

Another huge problem is in our propensity to ignore overall performance and instead continually reset to a new reference point.  Many people have gotten deeply into debt as they borrow money, and then become accustomed to their current level of debt and lose any aversion to further debt.  Similarly, in a market boom, if somebody’s net worth jumps from $500,000 to well over a million, and then drops back to $800.000 in the following slump, they’ll often feel like the market has performed very poorly.  It’s important to recognize and resist this error to stay focused on the overall performance rather than falling into the trap of focusing on recent performance without considering long-term performance.

We also tend to jump to conclusions based on too-little information.  I’ve often seen market analysts judged based on the success or failure of a single stock pick.  An internet-based article that mentions specific stocks is virtually guaranteed to get at least one comment pointing out how a stock mentioned last week/month performed poorly.  Similarly, a money manager who sold just before the bubble burst in 2000 might be featured as an economic genius.  Without much more information, there’s no way to separate skill from luck in these cases.  Given the number of money managers moving money around at any point, the probability that somebody will succeed in any particular set of market conditions is extremely high.  We always hear about those who recently succeeded as if they’re incredibly good at what they do, but since future market conditions are unpredictable, a really good market analyst or manager will likely underperform in highly volatile and risky markets.  Next time you see a story about the latest hot market guru, take a look at the justification.  If the ‘guru’s’ success is based on a single market call or period, discussion of that person is worthless.

There’s a number of other errors we make simply because our brains aren’t optimized for dealing with finances, numbers or statistics, but in general, it’s just very important to think carefully about numbers and probabilities to make sure that good numbers are running our finances, not just what makes us feel the most comfortable.

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.