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Economists versus(?) financial planners, part 2: debt snowballs, mental accounting, and investing

In which we continue to discuss what some economists -- and in particular, Yale professor James Choi -- have to say about financial planning, and where this financial planner thinks they have it wrong (or right!). In part 1, we talked about a different way to think about saving and spending, as well as some opposing viewpoints on adjustable-rate versus fixed-rate mortgages. Let's dive right back in, shall we?


Debt snowballs versus Avalanches


You may be familiar with the term "debt snowball", popularized by financial author/speaker Dave Ramsey: the strategy is when faced with a multitude of debts to pay off, to start by paying off the smallest-balance debt first, then the next smallest, etc. Contrast this with the "debt avalanche", where you pay off the highest-interest debt first, then the next-highest, etc.


As you might imagine, the theory is pretty clear on which one is more effective in an ideal scenario: by using the "avalanche" to reduce your highest-interest debt first, you'll pay less interest overall. But the snowball has a key advantage that's less obvious at first glance: as implied by the name, it gives its users a feeling of momentum. By getting wins early, they're motivated to keep moving forward on their journey to get out of debt.


(That's the theory, anyway; I've yet to come across any solid research that indicates how successful it is in practice, aside from Ramsey's popularity. )


Having said that, in this case the economist (Choi), the guru (Ramsey), and the financial planner (me) all agree: the best strategy for getting out of debt is the one you stick with. I've worked with clients who love the idea of pursuing the optimal strategy, and this alone is enough to motivate them; I've also worked with folks who really do need quick wins to stay motivated.


But if you're a machine who'll engage in any strategy, the optimal one is clear, all else being equal: highest-interest first!


Mental accounting


Economists refer to the practice of creating "buckets" for money, with specific purposes assigned to each bucket, as "mental accounting", and they -- Choi included -- aren't big fans. Instead, he says, your money should just go to whatever its best use is at that time, no matter what "bucket" you've put it in.


I have...mixed feelings about this. First off, as a financial planner, one of my fundamental goals is to help clients properly manage their cash, to make sure that every dollar is allocated to the vehicle that best matches when that dollar will be spent. Even economists agree that this is a good strategy; the technical term is "liability matching", if you'd like to look up the literature on it. Dollars needed right now should be in checking, dollars needed in six months can be in savings, dollars needed in a year can be in CD's, dollars not needed for five years can be in investments, etc. "Mental accounting" is an excellent way to calculate which dollar should go where for liability matching purposes, so I strongly encourage my clients to create "buckets" for determining this.


Having said that, I do recognize that mental accounting also has the downside of biasing us towards particular uses of our dollars depending on where exactly they are. If we get a bonus at work that lands in our checking account, we're biased towards spending it, even if the bonus is quite large; if we have money in investments and aren't yet retired, we're biased towards never using that money at all, even if it means carrying a high-interest credit card balance month-to-month! (Yes, I've seen it actually happen, on multiple occasions.)


So again, the optimal strategy -- if you can make it work -- is clear: use accounting just enough to make sure your dollars are in the right vehicle, but ignore it when it would bias you towards sub-optimal decisions!


Investing, dividend stocks, and index funds


On the investing side, the podcast lays out three strong recommendations from economists:

  • Invest in the stock market in general -- which a lot of households don't do.

  • Invest in low-cost funds, rather than trying to pick stocks or pay high fees for active management.

  • Ignore whether or not a stock pays dividends.

And on these points, I 100% agree.


I know there are people who don't trust "Wall Street"; they say, "It's all funny money", or "I'm not really buying anything real." But here's the thing: the stock market has consistently provided good long-term returns, for pretty much as long as it's existed! And unless there is a fundamental change in human nature, we can expect with an overwhelmingly high degree of confidence that this will continue. Moreover, the stock market is mind-bogglingly liquid; I can wake up one morning, sell $50K of stocks, and have the proceeds in my checking account later that afternoon, if I'm in a hurry! The same absolutely cannot be said of (for example) real estate, though it absolutely has its place in a portfolio. To put it another way: as a fiduciary, if I recommended you ignore an investment vehicle with high long-term past and expected returns and high liquidity, you could quite literally sue me and win the case -- the stock market is that clear a winner!


Regarding costs and stock-picking, the research is abundantly clear on the (inverse!) relationship between cost and returns, as well as the lack of effectiveness of most individual stock-picking techniques. Now, there are some subtleties there -- the research is clear that there are consistent factors of increased returns -- but in general, I lean strongly towards low-cost funds.


As for dividends...well, I've written a whole article just on that. Suffice it to say that I agree: dividends should be ignored when designing a portfolio. Again, there's some subtlety here -- high dividends are often correlated with value stocks, and value is one of the aforementioned factors of increased returns -- but high dividends themselves aren't a reason to expect higher returns.


It's all about psychology


As you've probably noticed, a lot of the friction between the economists' recommendations and those of finance gurus boils down to human behavior and psychology: for the most part, the economists would nearly always be right...if humans behaved in a purely rational way. But because of our various cognitive biases, we don't, so they're not.


Here's the thing, though: biases are not "hardwiring", dooming every one of us to make the same exact mistakes. They're biases, tilting us in a certain direction, but not mandating a particular behavior. We're not completely rational, but we're not completely irrational, either!


Moreover, we can change. As we become aware of our instincts, we can examine them and determine whether they should be followed or ignored. For example, I've found that the more my clients understand how the stock market works, the more their risk tolerance goes up. I myself have completely changed my spending habits over the past couple decades, starting by simply becoming aware of them!


So while I definitely agree that you should use the strategy that works for you, you should also be aware that there is such a thing as neuroplasticity -- you can change your behavior, such that what works for you and what is most economically optimal converge!



Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.


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