Making Rational financial decisions

Economists have long argued that, given the choices available, people will make rational decisions that provide them with the greatest benefit or satisfaction. Then behavioural economics, led by the likes of Daniel Kahneman and Richard Thaler, came along and showed how people behave irrationally all the time due to psychological, cognitive, and emotional factors.

For example, Thaler’s theory of mental accounting reveals how people place greater value on some dollars over others, even though all dollars have the same value. They might go out of their way to save $10 on a $20 item, but not make the same effort to save $10 on a $1,000 purchase.

Looking at my own personal finance views I’ve found a mix of rational and behavioural driven decisions. Here are three that come to mind:

Dividend investing vs. Indexing

In the dividend investing versus indexing debate I’ve tried to (kindly) argue that indexing is what economists would call a rational choice given the overwhelming body of evidence supporting an efficient market that can’t be exploited by investors over the long term. 

On the other hand, it “feels better” to receive a portion of your investment returns in cash and so it’s not surprising to see investors flock to dividend stocks.

Efficient market theory states that investors would be better off buying the entire market for a small fee. Dividend investors might say that sounds great in an academic paper, but in practice they’d prefer to receive regular cash dividends instead of hoping that markets will continue to grow as they have in the past (bird in the hand theory). Dividends also help investors weather the storm during a market crash (provided the dividends don’t get cut or eliminated).

Maybe it’s more about the illusion of control. Active management “feels better” because you’re exercising control over when and what to buy and sell, whereas index investors might appear to have given up control and left their investing fate to the stock market gods.

But is your judgement really adding value and leading to a better outcome? In my case I felt it wasn’t. Even though my portfolio beat its benchmark for five years, I chalked that up to timing – a rising tide lifts all ships. If you started dividend investing in 2009 like I did then you probably had some pretty stellar returns. But over the long-term, I’ve put my money on rational outperforming behaviour.

Debt snowball vs. Debt avalanche

Two popular debt repayment strategies are the debt snowball and debt avalanche.

The debt snowball focuses on the psychological advantage that comes from making progress with quick, successive wins. Start by arranging your debts from lowest balance to highest. It feels better to rid yourself of your smallest debt, and the idea is that the snowball effect builds enough momentum so that you’ll be more inclined to stick with the strategy.

The debt avalanche method suggests that math trumps behaviour. The idea is that you’ll pay less interest and become debt-free faster when you attack your highest interest debts first.

With a debt avalanche, simply list your debts from highest interest rate to lowest – regardless of the balance or minimum payments due. Direct all of your extra cash toward your highest interest rate debt while maintaining the minimum payments on the other loans on your list.

Advocates of the debt snowball method say it’s all about creating momentum to get you motivated to pay off your debt. But I disagree. Once you’ve made the decision to tackle your debt I think you should use the method that gets you out of debt faster and saves you the most money.

Rational 2, Behaviour 0

Credit cards vs. Cash

People are willing to spend more when they use a credit card instead of cash. It’s a fact that has been proven in study after study. Yet I still choose to use a credit card for my everyday spending, despite the evidence that using cash is the more rational choice when it comes to sticking to a budget and saving money.

My excuses for using a credit card are all behaviourally driven:

  • Convenience – It’s easier to pull out my credit card than to take out money from an ATM (or risk not having enough when you need it).
  • Rewards – I earn 2% (or more) back on every purchase. Alternatively, you get nothing back when you pay for items using cash or debit.
  • Tracking spending – Using one credit card for every purchase helps keep tabs on my spending better than using cash and forgetting to get a receipt.
  • Fraud prevention – I can dispute a credit card charge easily enough, or cancel my card if it gets lost or stolen and have a new one shipped to me within days. None of my money is on the line. If my debit card gets skimmed, on the other hand, I’m out of pocket the damages until the bank or authorities get to the bottom of it.

An MIT study suggested that the credit card premium (the amount people were willing to pay for an item with a credit card instead of cash) was between 59 and 113 percent. That’s not for everyday items, mind you, but for things such as concert tickets or dining out at a restaurant.

I get it. Let’s say I took my family out to a restaurant and only had $75 cash in my wallet and no access to credit. Of course this would influence what we ordered from the menu, whether or not we had drinks or dessert, and even how much we’d tip. But since I know we’ll pay by credit card it becomes much easier to order an appetizer, plus a drink (or two), and watch the bill come in over $100.

My personal issue with carrying cash is that I think I tend to spend more when I have it in my wallet. Almost as if it’s found money.

Perhaps I need to do an all-cash challenge for a couple of weeks and see if it a) helps control discretionary spending, and b) is as big a pain in the neck as I think it will be.

For now, score one for behaviour over rational decisions.

Final thoughts

When I switched to indexing, I sided with math over behaviour. But that doesn’t mean all of my investing choices are rational financial decisions.

For example, my one-ticket investing solution consisting of Vanguard’s VEQT is more expensive than other indexing options. The problem is, a less expensive solution involves more complicated workarounds such as using Norbert’s Gambit to convert Canadian dollars to USD (and vice versa).

And, for years, before I switched to Wealthsimple Trade, I paid $9.99 per trade at TD Direct even though cheaper options like Questrade existed. Reason being that I liked having all of my accounts in one place.

We’ve all heard that personal finance is personal. The point of thinking about all of this is not to determine whether you’re a rational or irrational person. It’s about finding a system that helps you achieve the best outcome. Sometimes that outcome will be the “rational” choice, while other times you might forgo the optimal solution and choose simplicity or convenience instead.

Tell me about a time when you made an “irrational” financial decision.

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13 Comments

  1. Guy Langevin on July 15, 2020 at 10:26 am

    Hi Robb,

    On the subject of dividend investing vs indexing, have you ever considered building a globally diversified index portfolio “large enough” to live off the distributions “only” without the need to sell any investments?

    In essence, this is basically a play on dividend investing but with all the benefits, safety, and diversification of broad market indexing. (e.g. so your portfolio would not be “concentrated” in just high yield or growth-orientated dividend stocks).

    I realize that a portfolio indexed globally would only return about “2.2% percent or so” annually so the portfolio would need to be large the size (e.g. 2 to 3 million), but if one has the ability to reach this level, what are your thoughts on the strategy?

    I imagine that over time a portfolio of this nature would experience volatility but that would be no different from regular indexing however it would likely grow over time and outpace inflation due to the low rate of withdrawing.

    With all the talk about lower expected returns in the future, this strategy should hold up well into the future?

    Any thoughts?

    • Robb Engen on July 15, 2020 at 2:15 pm

      Hi Guy, I think the idea sounds great in theory but you’re right that it would require a large portfolio to make it work.

      As much as I like the idea of living off the dividends I just don’t think it’s practical for people who want to enjoy a comfortable retirement at an early to normal retirement age. To me, it’s not about growing the biggest pile and leaving a large legacy. I want to grow a large nest egg, but be able to spend my capital throughout retirement.

      That’s why I like the asset allocation ETFs even in retirement because they’re constantly rebalancing for you and you can make systematic withdrawals without worrying about aggressively depleting your equity portion.

      • fbgcai on July 16, 2020 at 8:52 am

        Hi Robb,
        from your comment above:
        “I want to grow a large nest egg, but be able to spend my capital throughout retirement.”
        I have the same sentiment but would add “hoping my capital expires shortly after I do”.
        Any thoughts on how to implement this? Perhaps fodder for another column? Thanks

        • Robb Engen on July 17, 2020 at 11:44 am

          Hi fbgcai – great question. The financial planning software I use allows you to run what’s called a sustainable spending scenario. For clients who prefer their last cheque to bounce (or the ‘die broke’ scenario), I’ll run this to determine the maximum they can spend each year to age 95 without running out of capital. Very useful, and I agree it’s worth a post to explain how it works.

          Note that I’ll typically run this sustainable spending scenario with retired homeowners and purposely leave the paid-off house in their estate, so there’s a potential backstop “just in case”.

          I’ll also caution clients that the sustainable spending amount should be treated as a ceiling or upper bound – not a target to hit every single year. That way, if you’re taking a dynamic approach to your retirement withdrawals, you know you can safely spend up to your ceiling in years with good investment returns, and then spend less in years with poor returns.

          • fbgcai on July 17, 2020 at 7:54 pm

            Thanks for your response Robb, looking forward to the column – that sorta puts you on the hook doesn’t it :-).
            Leaving the paid off house out of the “spendable amount” makes sense but that could also leave a very big chunk of (tax free) change in the estate – personally I’d like to expire in my own place (hopefully many, many years from now). and my heirs would(should?) be very happy with just the real estate portion.
            Realistically I foresee a downsizing some time in the (distant) future but I’m not looking forward to it.

            My VERY simplistic modelling is to take my capital amount (leaving the house out), divide by the number of years to the assumed end point (say to 95) and if that covers my expenses, which I track accurately, I’m good to go – so far it’s working as the capital amount changes little year over year – maybe that means I should spent more?



  2. Grant on July 15, 2020 at 12:03 pm

    Rob, I wouldn’t mind betting that you will do better over the long run with a single asset allocation ETF in all accounts, simply because the rebalancing is done for you, thus avoiding the behavioural issue of not rebalancing when you should. It’s not easy selling those nice bonds that are going up and buying stocks that are crashing, similarly selling stocks and buying bonds when stocks are on a tear. In addition Ben Felix has written extensively on the marginal and uncertain benefits of asset location with 3 or more ETFs, not to mention the complexity of doing this. I think that if I were setting up again, I’d buy one of the asset allocation ETFs and put it in every account.

    • Robb Engen on July 15, 2020 at 2:17 pm

      Hi Grant, that’s the other reason why I’m sticking to the one-ETF solution. The added complexity leaves plenty of room for error – including from exercising my own judgement about timing, etc. Not worth it for me when a perfectly great solution is available.

      You could certainly do a lot worse than holding the same asset allocation ETF across all accounts and getting on with your life.

      • Sébastien on July 15, 2020 at 4:05 pm

        I like the one ETF solution. However, I’m more tempted to do a 100% XAW TFSA as well as some VCN in a taxable account for tax purposes. Any leftover cash would be invested in VEQT in the taxable account. Do you think the rebalancing hassle is worth it in the long run? You have more experience than I do, ha.

        • Robb Engen on July 15, 2020 at 5:24 pm

          Hi Sebastien, I address the topic of ‘asset location’ in this post and determined that investors should just hold the same asset mix across all accounts: https://boomerandecho.com/forget-about-asset-location-why-you-should-hold-the-same-asset-mix-in-all-accounts/

          Not only is the rebalancing more difficult to manage, it’s also prone to error from your own judgement and decision making (not to mention a host of other issues that may not work out in your favour).

          • Sébastien on July 15, 2020 at 8:21 pm

            Very insightful post indeed! I 100% get the major benefits of owning VEQT in all acounts if the allocation is 100% equities. However, my situation is pretty unique. I currently have around 60% of my holdings in taxable accounts – and I am not in the top marginal tax rate, as in Ben’s paper. Ultimately, I’m taxed at around 37% on foreign dividends and around 10% on eligible Canadian dividends due to the way the dividend tax credit works. I haven’t made any calculations, but the difference seems significant. And XAW does not require any rebalancing in the TFSA. In any case, holding VEQT everywhere also makes a ton of sense.



    • Grant on July 15, 2020 at 3:57 pm

      Guy, you don’t need to be worried about selling off slivers of shares from an index portfolio in retirement. The research shows you can draw 4% a year, adjusted for inflation (perhaps 3.5% now as valuations are high) and not run out of money over 30 years. Whether you take dividends or sell a sliver of capital gains makes no economic difference because when a dividend is paid, the shares will drop by the same amount as the dividend just as if you sell a sliver of shares the value of your holdings will drop by that amount. The value of the shares grow back over time, just as you get another dividend at a later time. So just take the dividends and sell off some shares to get your 3.5-4%. The single asset allocation funds are a very easy way to do this – just take your retirement pay check every year, or quarter or even monthly as you choose by taking dividends and topping up by selling a sliver of shares. If you were to rely only on dividends you’d have to save a lot more than necessary and end up with a large portfolio when you die. No point in being the richest guy in the graveyard.

  3. Maria @ Handful of Thoughts on July 16, 2020 at 7:54 am

    Like you my irrational behaviour would be favouring my credit card over using cash. I still carry cash in my wallet but try to use it less frequently.

    We have also decided to be a 3-vehicle household even though only 2 of us can drive. Seems irrational but works for us.

    • Robb Engen on July 17, 2020 at 11:47 am

      Hi Maria, I’d love to get us down to a one vehicle household but then I think about our oldest daughter who is somehow already 11 and will soon be driving(!).

      I try to explain away my irrational use of credit over cash by including all of the cash back and travel points I’ve ‘earned’ over the years. I’m probably still overspending but at least that makes me feel better 🙂

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