The Two Ways To Make A Financial Decision
For years I’ve been fascinated by how we make financial decisions. We like to think we take a logical, considered decision-making process, where we take into account all the facts, do all the financial calculations and then make a decision based on what makes the most financial sense.
Wrong!
We really don’t use our brains much at all when we make financial decisions, and frequently decide on a course of action that actually costs us more than the other option(s).
But there’s not necessarily anything wrong with this.
For years as a financial planner, I watched my clients make financial decisions and came to the conclusion that there are two factors that they consider – the economic (financial) factors and the lifestyle factors.
The economic factors are all about the numbers. It’s the way an old-school accountant would look at things – what gives the best financial result.
The lifestyle factors are all about how it affects your day-to-day life and the pleasure you receive from taking that course of action. And in most cases, I saw the lifestyle factors win out over the economic factors.
As an example, I’ve seen clients wrestle with upgrading cars. We know that when you buy a new car, you can drop around 20% off the price once you drive off the car lot. And we know they’ll do most of their depreciation (in monetary terms) over the first few years.
But for some people, the new car smell is irresistible. I’ve had clients where one of their goals is to buy a new car at least once in their life. So when they’re in a secure financial position, they do it.
From a practical point of view, it’s just a car. It gets you from point A to B.
But at a lifestyle level, it’s so much more than that.
And it’s not that they’re not aware of the financial impacts of their decision, it’s just that the financial decision is only one of the factors they’ll take into account.
It’s just a car…or is it?
Holidays are another example. Living in Australia, if you want to travel to Europe or America, it’s going to cost around $2,000 just for the airfares. We took a family holiday to Europe and the total cost for five weeks away was around $AUD35,000.
From an economic point of view, that made no sense. We could have used that money to reduce debt or put it towards our retirement savings. I don’t need to run the numbers to know that that would make economic sense.
But from a lifestyle perspective, we had a great time together as a family, got to see some amazing places and created some awesome memories. How do you put a value on that?
Musee D’Orsay in Paris. Travel is awesome, can be expensive, but the experiences can also be priceless.
I’ve been reminded of these two decision-making factors recently when I’ve been reading some posts about debt reduction – should you pay off the loans with the highest interest rates first or should you pay off the loans with the smallest balances first?
The argument for paying the highest interest loans first is simple – over the long term, you’ll pay less money in interest. Simple. And it ticks the ‘economic’ decision box. But the argument for paying off the loans with the lowest balance first is also compelling – people say it’s more motivating to feel like they’re going to have a quick win and as a result, they’re more likely to stick to the plan if they can see progress.
It doesn’t make as much sense financially because you’ll pay more interest, but many people say they wouldn’t stick to the plan of paying off the loans with the highest interest first because they have large balances and it’d take years to repay those loans. They’d become demotivated and stopped trying to make any extra repayments.
I get it. Early in my financial planning days, I used to try and convince clients to make a decision based purely on the numbers, but I soon learned that wasn’t the only way.
If you prefer to repay debt based on the smallest debt first and this motivates you to keep going with your debt reduction plan, then good for you.
If you prefer to have a holiday rather than add extra money to your retirement plan and you’re comfortable with the trade-off that provides (i.e. maybe needing to defer your retirement date by a year or two), then go for it.
There has to be a balance between having a good lifestyle and at the same time making good financial decisions.
So next time you’re faced with a financial decision, have a think about the two considerations – the economic decision and the lifestyle decision. Take the time to weigh up both factors and make an informed decision that suits you.
What do you think? Are you aware of how you make money decisions? Do you think that lifestyle factors are more important than the economic factors? Leave a comment below and let me know what you think.
Download your FREE report - 5 Money Mistakes You Don't Realise You're Making
These money mistakes are costing you money and you probably don't even know you're making them.
About the author, Allan Ward
I think sometimes lifestyle factors are more important while other times the economic factors take precedence. It’s all about balance. But on the whole, I think lifestyle factors have the edge because of the way we’re wired.