Many personal finance questions boil down to a decision between psychology and math. When deciding between two options, you can run the numbers and know which option makes more sense financially. However, even while knowing the math, some people choose to ignore the numbers, and make decisions that don’t maximize their net worth. Are these bad decisions? Not necessarily. In many cases, psychology is more important than math.
Examples of Psychology vs Math
Buying versus Renting a Home
The decision to buy or rent a home is a difficult one that many people agonize over. There are many buy vs. rent calculators (the one by the New York Times is my favorite) that can help you run the numbers.
The general rule of thumb from these calculators is that it is better financially to rent than to buy if you are planning to own the home for fewer than 5 years. This is because you need time for the house to appreciate and overcome the transaction costs of buying and selling a home. It’s hard to do that if you only own the home for 2-3 years.
Despite this math, many physicians, especially residents, are motivated to buy homes. From a cash flow perspective, the monthly mortgage payments are generally lower than the rent for an equivalent house. There’s the hope that the house will appreciate enough to recover the closing costs. And then there’s the satisfaction derived from achieving the “American Dream” of owning a home.
Sometimes buying the home works out, such as for those residents who have bought in the past 5 years. Sometimes it doesn’t, especially for those who bought homes before the financial crisis.
Paying down mortgage/student loans versus investing
In the current interest rate environment, many people have financed their homes or student loans at rates of 4% or less. The expected nominal (before-inflation) return of the stock market is higher than that, and the nominal return of the stock market over the past 90 years is 9.53%. It makes financial sense to invest rather than pay off debt.
However, there’s a great feeling to not have debt. It’s liberating to know you own your home outright or don’t owe money to anyone.
Investing more aggressively or less aggressively
In general, investing more aggressively, such as putting a large percentage of money in stocks or investing in riskier asset classes, will lead to a higher expected return. But with the higher expected return comes a higher risk, and some investors would rather sleep better at night than seek higher returns.
Is math or psychology more important? It depends.
For some people, math = psychology. Knowing that you are maximizing your accounts and net worth may be what’s most important to you. Leaving money on the table bothers them, and math and psychology become one in the same.
But for most people, psychology trumps the math. Many people derive non-monetary benefits from their decisions. Living in a home that they own is something that some people value immensely. Even when it doesn’t make sense financially, they feel the need to buy a home and be earning equity instead of just paying rent to someone else. They pay a price to feel like they have achieved the “American Dream”.
I think most people would rather maximize happiness instead of maximizing money. In general, more money is correlated with more happiness, but the marginal benefit of each additional dollar declines after a certain point. So if you derive a lot of non-financial benefits from a sub-optimal financial decision, then you may be happier to let psychology trump the math.
Making The Big Decisions
So when you’re making important financial decisions, know the math, but don’t feel bad if you’re making a decision that deviates from the math. You’re not a corporation trying to maximize shareholder value and profits. You’re a human being, making money decisions that make the most sense for you.
It’s important to understand the math and the psychology of your big personal finance decisions. That’s what this blog is all about. If you know the math and you know the psychology of your personal finance decisions, then you can make the decisions that are right for you.
In medicine, there’s a principle called informed consent. Doctors give patients the risks, benefits, side effects, and alternatives of a prescribed treatment. With informed consent, patients can make the medical decisions that are best for them. You can do the same thing with your personal finance decisions. Be an informed financial decision-maker.
What do you think? Do you favor psychology or math when making personal finance decisions? Have you made a financial decision that didn’t make sense from a math perspective but made sense from a psychology perspective.