Tuesday, February 26, 2008

To Be or Not To Be Mathematically Optimal

J.D over at Get Rich Slowly http://www.getrichslowly.org/ reviewed Dave Ramsey's Total Money Makeover. Having never read the book, I can't speak to it. But one of Dave's points is that the debt snowball he recommends is not always mathematically optimal, but it gives small wins, and a sense of success to those deep in debt.

That comment, along with a conversation I recently had with someone who presented compelling numbers about why it's not in my financial best interest to pay off a house early hit an interesting nerve, and I've been mulling it over ever since.

So, is it ever financially smart to do what is not mathematically optimal when it comes to money?

I believe the answer is yes.

That said, let me be up front here. I don't like debt. It may be considered a 'fact of modern life' but I disagree it has to be - at least it shouldn't be a permanent addition.

I think a lot of really smart people have really good points when they say things like "if you can make more in the stock market than your interest rate on your debt, you should invest that money". It's not a bad point, but it's a point that has more holes in it than swiss cheese. Here's why:
  • First, it assumes your portfolio is going to have the gains to offset the debt.
  • Second, it assumes you can weather a financial crisis and still maintain the minimum debt payments for as long as that crisis lasts, or otherwise always be able to maintain your expenses.
  • Third, it underestimates what can be accomplished with the savings and investments for the rest of your earning life that step up when you no longer have to send in a car payment, a mortgage payment, or pay a credit card bill.
  • Fourth, it makes personal finance purely about the finance. It isn't - there's a lot of human emotion involved in our financial life, which study after study shows. It makes the assumption that we humans make decisions purely on logic. Nothing could be further from the truth.
So let me tackle the first assumption: My portfolio will have the gains to offset the debt

Over time, this has been historically true. But in practicality, sometimes it will, and sometimes it won't, is the more likely reality. Few of us are Warren Buffett. I spent several years in the early part of this century watching my 401k balance just stay the same, no matter how much I deposited - and that was with some serious deposits, and highly rated funds. Now, I was in it for the long haul, but I bet there were a good many people who probably had investments that they intended to have use during that period.

I believe in saving and investing - very much. I believe if you aren't saving an absolute minimum of 10% of your gross income for retirement, and another 10% of your net for a rainy day and your goals, you aren't saving enough.

Investing in index funds is the only way to fly, in my opinion, as they statistically outperform actively managed fund.

Still, there are no guarantees. Past performance does not indicate future results, as Wall St. likes to say. And a bird in the hand.....

Assumption 2: I will always be able to make those debt payments, no matter what

Really? So you will never experience a job loss? Or a chronic medical condition that forces you to stop working long before you planned? Or a family crisis that comes just when the big bills are due? Or a reduction in pay?
Oh, and you are sure your emergency fund (assuming you have one) will hold out for as long as it takes?

Well, best of luck to you. I certainly hope you are correct, and all those bad things happen to other people.

Maybe you could lower your outgo so that a job loss wouldn't send you under?

Many people manage to live on one income, and that's a great way to do protect against a financial crisis. But unfortunately, unless you are living on one income and saving the other, and the other is sufficient to cover your expenses indefinitely, the risk of losing that income you live on is tremendous to you.

We now live in what has been dubbed 'the uncertainty economy'. Stagflation seems to be heading our way. I personally don't see a bright and cheery future for every person's job over the next few years, but hey, whatever works.

Assumption 3: Even with no debt, the years of compound interest on the investments will be worth more.

There's some actual hard math to support this one. But let's take my mortgage payment. We spend about $3600 a month in a high cost-of-living area. Now let's say in 15 years I no longer have that mortgage. So I invest the money...in addition to everything we currently invest.

And I have no mortgage. I still bet I retire mighty comfortable. And I've had 15 years where I can tell a bad boss to take this job, 15 years of taking the work I like over what I need, or 15 years off my work life all together. Seems like a good trade.

Assumption 4: The math, and the money, is what matters

If that's what drives you, good. If you can get past the three hurdles I listed above, and you still think that maintaining your low-interest debt is worth it, then it works for you. And that is what counts here most in personal finance - applying what works best for you.

There is no single answer. Me, I'm security minded. I grew up with very little, and a huge amount of insecurity and lack of stability. The peace of mind I will buy with a big old zero in the debt column is worth more than the Sultan of Brunei - to me. And the freedom? I can taste it.

Still, I acknowledge it isn't for everyone. Sometimes the math matters. The only one that can search your soul and figure out what is most important is you.

There's more than one way to live, that's for sure. But for me, there is no greater freedom than the freedom to choose what to do with all of my money because I owe no one anything.

As for you, well, you'll know what the right thing to do is.