It’s nearly impossible to have a discussion about finance (or indeed, almost any topic) on the internet without getting into a shouting match over who’s advice is technically correct. The key word here is “technically,” since any financial recommendation that isn’t mathematically optimal is regarded as wrong. I suppose I can understand that point of view since the most commonly-assumed purpose of most individuals is to attain as much wealth as possible over the long term. But is it really? Of course not. Money is simply a means to an end for most people and it doesn’t matter if they die with ten bucks in the bank or eleventy billion.
The (Unjustified) Primacy Of Financial Factors
Few people have maximizing wealth as their primary financial goal. If they did, everybody would go into investment banking and there would be no teachers. Obviously wealth is important: I’ve gone to the trouble of having a wealth building strategy for crying out loud, but he who dies richest still dies and money isn’t everything. Why, then, does practically all wealth-building advice assume the end goal is to be as rich as possible?
Here’s the fundamental question of wealth building, as I see it: is it better to amass a fortune of, say, $5 million through application of rational, non-emotional investing principles or to amass a lesser fortune of only $3 million using sub-optimal but more psychologically palatable principles? From a financial perspective the answer is clear; however, I submit that a sub-optimal approach can actually yield superior results in some cases when measured by overall life satisfaction.
The Case Of The Target Retirement Fund
Consider the surging popularity of Target Retirement Funds. As of December 2011, fully 13% of 401k plan assets were invested in these funds (source: ICIA Factbook). How do you explain their popularity given their sub-optimal construction? Even the very best of Target Date Funds from the likes of Vanguard are more expensive (and thus poorer-performing) than simply owning the underlying funds individually in the same proportions.
Why, then, would anybody choose to own these funds? It isn’t convenience, though that is a common explanation. Think about it: how long does it take you to rebalance a 3 or 4 fund portfolio every year? If your answer is more than 60 seconds, you’re doing it wrong. The answer, I believe, is that people are just more comfortable having an expert manage their portfolio for them. Most people don’t know how much to allocate to which funds or when to change said allocation. Sure, they could just copy what they see other funds doing, but they’d rather just delegate the responsibility to somebody else. And that’s the key: delegation of responsibility. If a professional makes a mistake, you can throw up your hands and blame them for screwing you over. If you make a mistake, you’ve nobody to blame but yourself. People don’t like being exposed to blame and will go to a surprising amount of trouble to avoid it. Thus, there is a very real psychological benefit to owning Target Date Funds over constructing an identically-constructed portfolio of individual mutual funds even though they aren’t strictly optimal investments. They work because they induce people to act where they otherwise might not.
This Is Why Dave Ramsey Is Rich
This is why people like Dave Ramsey and Suze Orman are rich. It’s not that their advice is right (often it isn’t) but that it’s simple, direct, and actionable – and there’s a lot to be said than that. Ramsey’s debt snowball, for example, involves paying down the debt with the smallest balance first regardless of the interest rate. It’s a horribly stupid plan, mathematically speaking, but it works because it helps people maintain their motivation to pay down their debt by rewarding them with small victories along the way. Yeah, you’ll end up paying significantly more in interest than if you just paid off the highest-interest debt first like most experts recommend, but you just might stand a better chance of actually paying off the debt if you do it Dave Ramsey’s way. A well-executed sub-optimal plan yields better results than a poorly-executed optimized plan, in this case.
We Can Do Better
Much of the advice in the personal finance blogosphere (and especially the main stream financial media) focuses on doling out “correct” advice without much regard for whether or not it actually helps anybody, unfortunately, and I’m as guilty of this as anybody. We preach about the benefits of keeping costs low, of investing for the long term, of building multiple income streams, etc, but we usually don’t really put all the pieces together into a coherent wealth-building strategy people are actually likely to implement. What we’re doing so far isn’t working all that well. We are great at informing people about what they should be doing, but not so great at getting them to actually do it. We can do better. How we’re going to do that, I don’t know. Maybe financial literacy isn’t the answer after all. Dentists have been telling us for years we need to floss our teeth, yet how many of you floss daily? Everybody knows they shouldn’t eat McDonald’s for every meal, but obesity is at epidemic levels. Maybe the best financial advice isn’t telling people what they should ideally do but rather telling them whatever they need to be told to actually take action, whether it’s entirely correct or not. Maybe, just maybe, the system is broken beyond repair and we would be better off focusing our energies on fundamentally changing it. Any suggestions?
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