Wednesday, August 1, 2007

Fact V. Emotion in Personal Finance: Do Not Confuse

Feel-Good Finance Folly

Lazy Man recently posted about taking the personal out of personal finance. He and the commenters made good points about how, if people need psychological or morale boosts, they should get boosts by seeing the benefits of the rational choice, rather than wallowing in the bliss of ignorance. I agree so far but there are important distinctions about which "personal" intrusions are bad.

Different valuations are inevitable.

First, people put personal values on items but I do not think that is what we mean by "psychological" irrationality. We cannot say, "You should have bought the whiskey that is on sale because it is clearly a better dollar-value than the milk." Basic economics says that the only reason people trade is because 2 people value the same item differently. You sell a book because you value the $10 cash more than the book--but you have to find a buyer with the opposite preference of valuing the book more than their $10 cash. If everyone shared your preference, you never would be able to sell. Without differential values/preferences/goals, there is no market.

The key is that everyone is rationally pursuing their different values and goals.

The Illusion of Progress:

Psychological irrationality is working against your goals, when you do not pursue/achieve your goals efficiently.

The problem is when someone wants to eliminate debt but pursues the goal irrationally. I do mean people who give lip service to fiscal health but clearly value other things more such as keeping up with the Joneses or refusing to admit a bad investment decision (although there are clearly psychological issues there). I mean people who fool themselves into bad decisions and think that they are gaining wealth efficiently when they are not.

Do not confuse difficult pricing with emotional irrationality.

Two people can look at "X risk level" and rationally decide differently based on their different personal risk averseness--but do not confuse that with 2 people with identical risk averseness who rationally decide differently because they disagree on what the risk level is. When 2 people disagree that the stock market will return 10%, that is not a difference of risk averseness, that is a mathematical dispute. Quantifying risk and estimating future prices is difficult but it is a mathematical job.

The anti-debt scolds might look emotional if stocks bubble--but the stock cheerleaders might look emotional if stocks crash.

Never Prepay Mortgage? Housing Myths Part 1
The $200,000 Blunder: Housing Myths Part 2
Inflating Leveraged ROI Can Ruin You

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