I know about finance from several perspectives. I have a traditional academic background and teach traditional corporate finance (efficient markets, rational actors, time value of money). I worked for an investment company and two investment bank, so I have a real-world perspective (people are irrational, bubbles and crises are more common that you might think.) And, I’m self-employed, so I live with the ongoing tension between generating income and generating cash flow.
The academic finance, professional finance, and small business – family management groups are all speaking different languages.
For example, my family’s plan is to pay off the mortgage before our kid starts college, then dedicate that monthly amount toward his tuition bills. The interest rate on the mortgage is practically nil, and the financial logic would say to keep that debt as long as possible. Furthermore, money is fungible – interchangeable – so allocating funds like that is irrational. Emily Oster, at economist at the University of Chicago, made this point in a recent critique about the envelope system. In behavioral finance, the term is mental accounting, and it’s a way that people behave irrationally.
It has never struck me as irrational, though, because to me, cash flow is key. It is in many families, too, especially given how much risk there is to earned income. Many people will find themselves unemployed at some point in their careers, which makes them do things that don’t seem logical. If you want to make sure you have the money for a particular need, you may want to set it aside in an account. Money that shows up after that is allocated would go into a different account. Unless you know that the cash will arrive when you need it (a key assumption in academic and professional finance, but less likely for small businesses and families), keeping accounts makes sense.
I’m sticking with my envelope-based budget until I get a better explanation of why it is illogical. If you have thoughts, I’d love to hear them!
(This is cross-posted on Chicago on the Cheap.)