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:
Rational Financial Decisions
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 return 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’re going to have 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.
American money guru Dave Ramsey swears by the snowball saying 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.
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.
My two-ETF portfolio is more expensive than other indexing options, for example, but a cheaper solution involves more complicated workarounds such as using Norbert’s Gambit to convert U.S. dollars to Canadian. I also still pay $9.99 per trade even though cheaper options (and even free ETF buys) exist. Reason being is that I like 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.