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.

8 COMMENTS

  1. The statistics definitely back up that psychology trumps math for the vast portion of society. From how many sold out their portfolios during the last crash to the average return of investors compared to the average of the market. All signs point to our emotions getting us in trouble. I recognize the issue and I make plans that mitigate my own emotions. Things like making decisions before the emotions arrive and sticking to them.

  2. Great article, I honestly hadn’t quite thought about it in this light. Very cool synthesis of these two ideas! This is why I think it’s so important to make small decisions that build on each other. This way, every decision seems like a victory on your way to enacting big change.

  3. I definitely am of the psychology camp. I have 2 loans all under 3.2% and I still want to pay them off. My student debt particular as it has been hanging over me for so long. The home mortgage I will likely let ride as I can see my self selling the home in 4 years and taking the equity and running.

    Oh well. Humans are emotional and as long as the emotion doesn’t harm us it is okay to go down that route.

  4. I’ll add dividend investing as a psychology play. People like the idea of receiving regular checks without actively selling principle. Nevermind the math that says most of us would be better off with no dividend, selling shares when money is needed.

    Best,
    -PoF

  5. Interesting article and on point. When doing the math, psychology won for me to agressively pay down debts. Plus, then you are used to living on less and have more for investing down the road!

  6. Awesome article! It is definitely a mind game when it come to finances. In my opinion paying off the student loan should come first. I know a mortgage is an acceptable debt but the student loans even at 4% are just a stress no one needs especially when the person is a young adult and has the time to be more aggressive with the investing once the loans are paid off.

LEAVE A REPLY

Please enter your comment!
Please enter your name here