I read a lot of blog posts on a weekly basis. Doing so is really one of my favorite parts of blogging as I get to see other people’s perspectives and ideas on how to maximize finances. It gives me new ideas for posts and even new ideas on how to approach finance. This post is an example of the latter. A common refrain on any personal finance blog is that finance is personal. But what does the personal in personal finance mean?
The Mathematical Aspect of Personal Finance
Let’s get this out of the way quick, like a band aid. Mathematically, there is only one way to maximize your financial position. The max position is theoretically the same no matter who you are. That includes which stocks you should invest in, when you should place it in the market , how much you should spend, how you pay your debt, and any other personal finance topic under the sun. In the world where we are all robots we would all just follow this mathematically optimized tactic. There would be one finance blog that outlined the how to and that would be it as everyone who cares would follow the exact same path regardless. It would be a dull time to be a reader of personal finance blogs, that’s for sure. That defines the Mathematical side of Personal Finance.
The Personal in Personal Finance
More than One Goal
Fortunately for all of us who enjoy writing and reading about finance there is a major wall in between the mathematical superior route and success. That wall is thee. To start we are not mathematically maximizing robots who only care only about finance. We have this little thing called a life to contend with. We make decisions every day that consider both finance and a million other goals in life. Those decisions are trade offs. They could include anything: the goal of exploring the world, giving charity to help someone else, helping a family member along, or any number of other things. These goals mean the mathematical finance path is no longer ideal.
The thing is, if we stopped simply with competing goals then we would still probably have only a few groupings of paths. You’d make a few strategic decisions to trade off between your finance goals and other goals. Then away you would go as everyone follows the same tactics. For example, it wouldn’t change how you pay off debt, as called out by Heartland Hustle, or how you manage budgets. That being said there is still more variety amongst individuals to consider. We’re still missing a big part of Personal Finance.
The Emotional Path Aspect of Personal Finance
Emotions play a huge part in your personal finance. I’ve highlighted in the past a number of biases many people are prone too: Recency Bias, Sunk Cost, and Loss aversion to name a few that have been featured prominently in posts. I also routinely mention here the concept of risk tolerance and the impact on your decisions. The thing is all of these emotional drivers come into play when choosing what the personal in personal financial means. After all, following the maximized mathematical path is only good for as long as you stay on it.
Emotional Poor Decision Avoidance, the Personal in Personal Finance
All too often the emotion causes us to stray from the mathematical. This could be in the form of poor decisions. Someone could sell all their stocks after a market dip in response to market news, or be afraid to drop a down investment due to what they already invested. The drive to do these things can really derail your financial plans if you give into it. So sometimes you have to set a plan based purely on keeping you on that path.
So for example there is a lot of talk about how to pay off debt in the personal finance community. There is the concept of paying the debt towards the highest interest rate first, the concept of paying the lowest balance first, and the concept of paying all debts equally. Now the highest interest rate is by far the mathematically superior. Paying a higher interest rate first will always save you more money then the lower rates all other things equal.
However imagine the highest interest rate debt also has the largest principle. That would mean it would be a long time between starting to pay and seeing the achievement of paying off one of your debts. For some that might lead to a discouragement that will cause them to stop paying off their debts. Hence, the Personal in Personal finance means for some it would be better to choose one of the other debt payoff tactics.
No one is a Mathematical Robot
Before I move to positive emotional decisions in personal finance let me say one thing. No one, no matter their claims to the contrary, is simply following the mathematically superior path and ignoring emotion. Even those who do follow what is that path are doing so with some sort of emotional tie.
Take our debt payoff tactic one more time. For high interest rate prioritization, the person choosing the financially maximizing route is probably using the reduction in interest paid or some other such metric to motivate themselves. They are just doing it differently. Everyone motivates themselves differently, but we all have an intrinsic need to do so. To deny the emotion exists for you is to invite failure. Embrace what your emotional side means for your choices and incorporate it into your plans.
Emotion and Good Decisions, The Personal in Personal Finance
Not all decisions motivated by Emotion are poor. Take Risk Tolerance. Your risk tolerance can cause you to make a poor move, like mentioned earlier in this post, but it can also lead to you making the right decision for you. For example if you can’t sleep due to the risk involved with your portfolio, then regardless of the mathematically optimized path you need to change your plans for your own well being. The good decision is to choose sleep over your portfolio. Moreover, without emotions you wouldn’t give to charity. Many studies have shown giving is a happiness maximizing move, but you’d never know that happiness if you followed a financially maximized path. You need to listen to that emotion sometimes in order to maximize all aspects of your life.
Plan Ahead to Handle Emotion in Personal Finance
So, how do you maximize the good emotional decisions and minimize the poor emotional decisions? The key is to make the decisions before the emotion hits. Become in tune with what will cause you to experience the given emotion. Then plan in advance how to handle that situation. When it occurs follow that plan. Thus your decisions are not influenced in the moment by the emotion. So take risk tolerance. You know for a fact you will freak out if you see the stock market collapsed by 50%.
So the solution might be to define that you won’t check the market but once every x months and that you will not sell under any circumstances. It still will cause you consternation when the collapse occurs, but if you can drive yourself to stick to your plan you’ll be better off. This is what so many Personal Finance bloggers are such big proponents of an Investment Plan.
Timing, The Personal in Personal Finance
I would be remiss if I did not mention one more mathematical aspect of finance the optimal mathematical path often ignores. Beyond Emotion or differing goals there is the factor of time. Every person out there is on a different time schedule with their life. You could start focusing on your personal finance late, either by lack of knowledge or by choice (for example a doctor chooses to start their financial path much later then other professions). You could have poor health or believe you will die early. You could have a non financial goal like buying a home or having a child in the nearer term.
Let’s take the last goal, to buy a home next year, motivated purely by the concept that you want a home (let’s take out the financial question of a home from this hypothetical discussion). This means you will need a down payment of some sort and amount when you plan to buy this home next year. This need of X cash has a short defined timeline of 1 year. However if someone else wants to be a renter for life, in theory (their may be many other financial needs) their need of X could be 30 years from now. That changes the necessary optimal path. The person buying the home needs X in a low risk liquid investment to pay for the home. The person investing for retirement meanwhile does not need the money for 30 years, so it can be illiquid and near term volatility is less of an issue.
Millions of Optimal Paths
These time horizons along with the other factors I mentioned above essentially split the optimal path into millions of optimal paths specific to your situation, personality, and goals. That’s the Personal in Personal Finance.
The key to optimizing your route along that path is to benchmark and observe others. Learn tips and tricks to deal with both the mathematical and the emotional. Meanwhile monitor your own performance, analyzing what drives you and how your plan has performed. Then take the best bits that fit you particularly and refine your plan. It sounds easy in theory. In practice no matter who you talk to or where they are on their financial path they likely have room for improvement. But like anything, a bit of self reflection, planning, practice and adjustment it will improve. Anything worth doing, is worth optimizing.
Any tips for managing the personal in personal finance? Any revelations of how your situation is unique?