Math is important and certainly a big part of financial literacy, but many focus solely on the math and often do not place the appropriate value on the non-math factors when it comes to decision making. If all decisions were based purely on the math, then one could make perfect decisions if all factors are considered. However, in life that is just not the case. The reality is we need to consider the “Human
Capital” that we have referred to in the past.
I subscribe to the belief that personal finance is a science and that successful planning actually happens with elements like logic, research, process and discipline as opposed to things like luck and intuition. That being said, I also believe that emotions also play a very important role in your financial decisions.
PSYCHOLOGY VERSUS MATH IN PERSONAL FINANCE
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, because in many cases psychology is more important than math.
Is math or psychology more important? For some people math = psychology. Knowing that you are maximizing your accounts and your net worth may be what’s most important to you - leaving money on the table bothers you. This is when math and psychology become one and 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 necessarily make sense for them financially, they feel the need to buy a home and be earning equity instead of just paying rent to someone else.They potentially are paying a price to feel like they have achieved something.
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 actually 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
In medicine there is a principle called informed consent. Doctors inform patients of the risks, benefits, side effects, and alternatives associated with a prescribed treatment. With informed consent patients can then make the medical decisions that they believe are best for them. You can do the same thing with your personal financial decisions. Be an informed financial decision-maker:
1. Keep your company pension in place, or take the commuted value at retirement.
One solution provides consistent retirement income and the other potentially leaves a larger estate to your family.
2. Topping up unfunded years in your company pension, or keeping additional funds in an RSP.
Some prefer to have access to additional funds versus being on a fixed income.
3. Establishing a trust in your estate to protect a spend thrift child.
This will protect your hard-earned money from frivolous spending, but it also has the potential to be taxed at a higher rate.
4. Wrapping up a holding company that no longer serves its purpose.
Taxes associated with the wind down of a company could be offset by annual reporting fees and the lack of simplicity of your financial picture.
5. When to take your government pensions.
The math indicates the longer you wait the higher the monthly amount, however many believe they are entitled to the money and should receive funds as soon as available. The “sleep factor” or consistent cash flow is often appealing.
6. Borrowing to invest.
In certain circumstances the math can work, with there being a net benefit after borrowing costs and taxation. However, many are just not comfortable with being in debt, even if there is still a net positive on the math side.
We often refer to actuarial calculations, however our date of death is not known so the calculation is only an estimate or assumption based on tables of data. The reality is there are pros and cons, consequences and benefits to each option.
So, when you are making important financial decisions, know the math, but don’t feel bad if you are making a decision that deviates from the math. You are not a corporation trying to maximize shareholder value and profits. You are a human being making financial decisions that make the most sense for you.
At Northland Wealth, we are here to help our clients with both sides of the equation. It’s important to understand the math and the psychology of your big personal financial decisions. If you know the math and you know the psychology of your personal financial decisions, then you can make the decisions that are right for you.