I talk a lot about the importance of psychology in investment decisions. In I Will Teach You To Be Rich, Ramit Sethi demonstrates the important role psychology plays when giving advice to a person who has student loans and is considering whether to pay them off or invest. He writes,
Technically, your decision comes down to interest rates. If your student loan has a super-low interest rate of, say, 2 percent, you’d want to pursue option one: Pay your student loans off as slowly as possible, because you can make an average of 8 percent by investing in low-cost funds.
However, notice I said “technically.” That’s because money management isn’t always rational. Some people aren’t comfortable with debt and want to get rid of it as quickly as possible. If having debt keeps you awake at night, follow option two and pay it off as soon as possible—but understand that you could be losing lots of growth potential just so you can be more comfortable.1
He goes on to describe a third option where he recommends considering a hybrid between the first two. I’m not here to comment on what option is the best, but I will say that I’ve used a similar approach before. I like a third way, dichotomy destroying, best-of-both worlds perspective—but not always.
The key here, as Ramit says, is that "money management is not always rational."2 Some people enjoy life more when they give up potential for future return to wipe out every piece of debt. Some people are perfectly happy with the opposite and anywhere in between.
Why? Because people are different, and since people are unique, we give different advice about the same question to different people. We deal with questions like this frequently:
- Should I pay off the house?
- Should I invest in the stock market?
- Should we sell the AAPL that has grown to take up such a massive part of our portfolio?
- Should we buy the latest IPO?
- How big should my emergency fund be?
Answer to all the above: it depends. Not only does each person have distinctive needs, risk tolerance, and objectives, each person has a unique psychology, and that too plays a massive role in their behavior and in the financial advice we give. Some can’t sleep at night if they do x, others can’t sleep at night if they do y.
Psychology matters: which is why you should know yourself and why a good financial advisor will aim to get to know you too. If that kind of advisor interests you, connect with us.
1. page 285.
2. Emphasis added.