Right Answer, Best Answer: Why Good Financial Decisions Go Beyond Just Numbers

Is there such a thing as the right answer in personal finance?

This was the question on a recent episode of Freakonomics Radio. If you’re not a listener, it’s a weekly podcast that is one of the most popular shows on Apple Podcasts. Its host Stephen J. Dubner co-authored (with Steven Levitt) the best-selling book Freakonomics.

To answer this question, Dubner compared how personal finance decisions are made by two different kinds of experts—economists and personal finance gurus.

Economists tend to be rationalists. They prefer to approach economic problems, including personal finance questions, in terms of numbers. Their audience is other economists—other very rational people. For this episode, economists are Dubner’s stand-in for the highly rational mindset.

Financial gurus are popular, by definition. They become popular by serving up advice that people can understand, use, and recommend to other people. For Dubner, financial gurus represent a mindset that is broader than purely rational—one that provides “advice delivered with people in mind, and that people actually take.”

The Difference Between “Right” and “Right for Me”

There’s a big difference in how these two mindsets make personal finance decisions. A great example is whether to pay off a mortgage. Let’s say you still owe $200,000 on a home mortgage at 2.5%, and you’ve just come into an inheritance of $300,000. Should you use the inheritance to pay off the mortgage?

An economist might answer with a question: Can you earn more investing that money elsewhere? Paying off debt is the same as “earning” the interest rate you’re paying on that debt. A 2.5% mortgage rate is very low. To an economist, it’s almost free money. Even a relatively conservative three-year U.S. Treasury bond is earning 3.6%.

That would net you a 1.1% higher return than paying off your mortgage. To a rationalist, the question is very easy. Keep the loan and earn more!

What would a financial guru advise? Dubner spoke with Morgan Housel, who is not exactly a financial guru but who has written two best-selling books on personal finance.

When Dubner asks Housel what his worst financial decision was, Housel doesn’t hesitate. “My wife and I paid off our mortgage when we had a 3 percent, 30-year, fixed-rate mortgage. It is the worst financial decision we have ever made, but the best money decision we have ever made.”

From an economist’s rational viewpoint, it made no sense. But from the viewpoint of the investors themselves—the Housel—it made complete sense.

He and his wife would rather sleep well at night than get the highest return possible. Their goal wasn’t based solely on the numbers—“it was, how can we use money as a tool to make ourselves happier, and give us a sense of independence, which is always what I’ve wanted to chase.”

In fact, this “mistake” was their best decision, because it aligned with their values. And their values couldn’t be captured entirely by a number. “…  In our household, there is nothing we have ever done with our money that gave us more joy, more sense of freedom and independence and stability for our children” than paying off their mortgage. 

That’s not to say that another couple would reach the same decision. As someone who’s deeply interested in how people think about money, Housel has mentioned this decision to other people who wouldn’t have done the same thing. “They have a different personality, a different risk tolerance.” They’re different people.

With Financial Advice, the Numbers Are a Starting Point

To paraphrase Kyle from his last post, the numbers are a great starting point for decisions, but they often aren’t the answer by themselves. Financial decisions should move us toward living “the life we want to live.”

The behavioral economist Dubner had on the show, James Choi, says pretty much the same thing. “What’s really hard is to get to the optimal solution… life is complicated... and there are so many factors that our economic models don’t really take into account,” because they are so specific to each of us.

That doesn’t mean we can’t reach answers that we’re happy with. We can. As Choi says, “ … to get somewhere reasonable where you have a comfortable life and you’re not worried about money all the time and stressed out, I think that’s pretty doable…”

So quantify what you can, but recognize that most financial decisions will go beyond the numbers. The comfort of a correct number may not be within grasp. That will be especially frustrating if you’re an ultra-rationalist. Just remember that you’re not necessarily looking for the right answer. You’re looking for the best answer for you.