Personal finance is one of those fields in which our human brains seem tailor-made to fail.
- We’re overconfident in our abilities,
- We try to make everything fun/exciting, and
- We’re hardwired to run at the first sign of trouble.
Often, the best approach is to recognize our psychological shortcomings and make concessions to deal with them. For example, if Investment Approach A is mathematically superior to Investment Approach B, but we don’t have the psychological traits necessary to carry out A successfully, it might be better to go with B.
A few examples:
Mathematically, it makes more sense to put all of your fixed income investments in your tax sheltered accounts before putting any equity investments in them.
Yet it’s much easier to simply use the same asset allocation for each account. (For example, if you intend to have a 60/40 stock/bond allocation in your entire portfolio, use a 60/40 allocation in your 401k, in your IRA, and in your taxable accounts.)
Also, using the same allocation in each account eliminates a situation in which one account is extremely volatile (and therefore worry-inducing) because it has all of your stock investments in it. One single mistake–like bailing out of the market after a downturn–would eliminate any gains derived from tax-sheltering your bonds instead of stocks.
Mathematically, there’s no question that the best approach is to pay off debt in order of interest rate, regardless of balance. So, typically, that means consumer debt, followed by mortgage debt, followed by subsidized college loan debt.
Yet Dave Ramsey’s “Debt Snowball” method of paying off debt encourages people to pay off debts in order of size (smallest first), and it’s possibly the most successful debt repayment method ever devised. It takes advantage of the fact that frequent victories early in the process tend to motivate people to keep at it.
Invest First, Or Pay Off Debt?
Mathematically, you should invest prior to paying off debt anytime you expect to earn a rate of return that’s greater than the interest rate of the debt you’d be paying off.
How do you resolve it?
Do you find yourself running into these same math vs. psychology conflicts (or others that I didn’t mention)? If so, how do you attempt to resolve them?