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.)
Interesting topic. As Jane pointed out to me, I think this is an issue where our psychological construct is dealing with all the uncertainties of life. And I would argue that there is a high degree of certainty that those uncertainties will occur.
What looks irrational might actually be us factoring in hidden costs that Economists incorrectly (or conveniently) overlook.
A couple of points:
1) The irrationality argument would be true if people had constant income throughout their life. As self-employed folks, we know this is laughably incorrect. But even folks who have consciously pursue “dependable” jobs experience it – hello gov’t employees facing furloughs from the sequester. Because we know this, we address items via an “envelope” that prioritizes items by utility, or cost of disruption of that utility.
2) Housing is an extreme case of debt and utility. And I suspect the study discount both of these. By utility, I mean that we all need a place to lay our heads. Housing is critical to our physical, psychological, and financial health. And I suspect the study discounts the cost AND LIKELIHOOD of disruption of housing utility. Lord knows all the rating agencies and banks underestimated the likelihood of mortgage defaults. Psychologically, we who understand the legal constructs around debt recognize that a single missed payment could result in foreclosure. Therefore, I think it is very rational to devote extra resources to getting out from under that burden.
3) I think this “hidden cost of disruption to items of utility” argument extends to other investments – like a car (admittedly a car has varying utility based on your public transport or biking options).
I imagine the counter to my argument is that the study normalized for savings. That is, many folks should not be under the threat of default on mortgage if they just liquidated other savings. But I think this gets back to the uncertainty of value of investments vs. your future needs.
Anyway, its a great subject. And one that every person should keep in mind relative to keeping a rationale for personal investment priorities. As a side note, I received a note in my mailbox (as did my neighbors) offering to pay cash for my house. Made me think about my options. And made me realize the housing bubble is back.