It’s an odd title, right?
You can choose to not make the “smart” financial decision. I put smart in quotes because there are many people who see financial decisions as purely a numbers decision. Does it increase their net worth? If yes, they choose that decision.
Unfortunately, personal finance is…you guessed it – personal.
People need to make decisions that work best for them, and sometimes the best decision is not the one that maximizes their money.
Instead, it maximizes their well being, confidence, and comfort.
It does not matter if someone makes the best or the “smartest” financial decisions if they lead an unhappy life.
We are human beings with emotions. We are not robots. Sometimes, making slightly less optimal financial decisions from a numbers perspective can actually lead to better outcomes – both from an emotional and financial perspective.
I will talk about how that is the case below. I will also discuss some of the personal decisions I have made that make very little financial sense but I have done anyway because they make me feel good.
As with all financial things, balance is important, but consider this post one that gives you permission to not always make the “smart” financial decision; it validates past decisions you knew improved your emotional well-being but made very little financial sense.
Holding Too Much Cash
Most personal finance experts recommend anywhere from 3 to 12 months’ of living expenses in cash. They recommend this range because it is enough that if someone lost a job, they can usually find another one within that time frame while still paying their normal living expenses.
It’s called an emergency fund, and it is the wall between losing your home, not being able to afford food, and having your heat shut off.
While it is important to have a fortified wall between you and many bad outcomes, larger walls are not necessarily better.
If you wanted to build a larger wall, you would build a larger emergency fund, perhaps 12-24 months’ of living expenses; however, amounts above 12 months is usually a drag on investment returns and a slower path to financial independence.
Holding more cash is problematic because it does not earn a good financial rate of return. It earns a high peace of mind return.
For example, Ally bank currently offers 0.5% interest on its high-yield savings bank account. While it is far better than some national banks offering 0.1%, it is far less than historical bond or stock returns.
More importantly, the cash you hold is losing money almost every year in real or after-inflation returns.
For example, if inflation was 2% this past year and you held $10,000 in cash earning 0.5%, your real or after-inflation return was -1.471%. This means your $10,000 only buys about $9,853 worth of goods. While not a big deal in one year, it becomes a huge deal over many years.
Inflation is referred to as the silent killer because you do not feel it every year, but compounded over decades, it eats away at the purchasing power of your money. If inflation continues at 2% and you only earn 0.5% on your cash, after 20 years, your original $10,000 will only be worth about $7,435 in real terms.
Again, inflation is the silent killer. While it provides a great peace of mind return, it is a terrible long-term investment.
With that said, holding more cash than 12 months can actually be a good thing for some people.
You must be thinking, “What? You just established why holding too much cash is bad. How can it be good?”
It can be a good decision to hold more than 12 months’ of living expenses in cash because people have different comfort levels with investing and their careers.
For example, imagine someone who is not very familiar with stock markets and is very uncomfortable with the ups and downs. They hold four months’ of living expenses in cash.
Back in March of 2020, they had most of their investment portfolio in stocks when markets fell 30%+ in about three weeks and decided to sell near the bottom, locking in a 30% loss. They decided to stay out of the market because the world felt uncomfortable, they thought markets would do poorly, and they were unsure if they would lose their job. This meant they missed the subsequent recovery and instead of being up about 15% this year, they lost 30% by selling.
Their investment portfolio was worth $10,000 at the beginning of the year, which meant they now have about $7,000 after selling.
Imagine a different scenario, where instead of holding four months’ worth of living expenses in cash, they held 16 months, and that allowed them to sleep more soundly through the pandemic – at least enough to not sell near the bottom. By staying invested the entire year, their $10,000 would be worth more than $11,000.
By switching from 4 months to 16 months’ of living expenses in cash, it gave them peace of mind if they lost their job, they would be okay. An additional 12 months’ worth of living expenses in cash was enough to change their investing behavior during difficult times.
Although 16 months’ worth of living expenses in cash is considered by many to be “too much cash”, it prevented a $4,000 mistake. It was the difference between having $11,000 at the end of the year instead of $7,000.
Even though inflation will eat away at their purchasing power, the impact will be far less than the impact of poor decisions during turbulent times.
Holding “too much cash” may not be the best economic decision each year, but for this person, it was actually one of the best emotional decisions they could make, which in turn resulted in one of the best financial decisions they could make. They understood how much cash they needed to feel comfortable staying invested and that made the difference.
Although generic guidelines say 16 months’ worth of living expenses in cash is too much, you can see how for some people, it may be the right amount. It is not purely an economic decision. The emotional side of it must be weighed, which factors into the ultimate financial outcome.
Low-Interest Rate Debt vs. Investing
A common question most people have is, “Should I pay off my debt or invest?”
Depending on the scenario, it is usually a fairly easy answer. Historical stock market returns are well documented for any given time frame, such as 5, 10, or 30 years. It is easy to find the range of outcomes that have occurred, which can be used as a guide in the future.
For example, imagine a couple who have a 30 year fixed rate mortgage at 3%. They are wondering if they should pay more on their mortgage each month to pay it off sooner than 30 years. They hate the idea of paying interest to the bank, but they are also aware that historical stock market returns have been far above 3% for 30 year periods.
Economically speaking, there are very good odds if they invest any excess money each month into the stock market instead of paying off their mortgage, they will have a much higher net worth in 30 years.
However, this makes many simplifying assumptions. It assumes they will invest any excess money into the stock market or a balanced investment portfolio. It assumes future market returns will look something like the past. It assumes they can stay invested for the entire 30 year period.
These assumptions may not play out.
For example, it is highly unlikely they will invest all excess money into the stock market each month until the loan is paid off. Lifestyle inflation happens and budgeting can become more challenging. It takes an incredible amount of discipline to invest excess money each month over many decades. Sometimes it is easier to pay down debt.
Market returns may or may not look like the past. Given where the valuations are in US markets, it’s reasonable to plan on market returns being lower than in the past, which is another great reason to be diversified in international and emerging markets. Normally, higher valuations lead to lower future returns, but you never know. Perhaps market returns are even higher than the historical average in the coming decades.
Lastly, they may decide to sell all or a portion of their investments during volatile markets at a loss, which would mean lower returns. There are very good odds that over a 30 year time period, they will see multiple recessions and periods where market returns drop more than 20%, possibly more than 40%.
They will need to understand how important it is to stay invested during those times, which is exactly when they may feel like paying down their debt. When investments are not earning high rates of return, they tend to say, “My investments are not earning 3%, perhaps I should pay off my mortgage.” Unfortunately, these are usually the worst times to sell because markets normally recover and have higher returns after periods of lower returns.
Economically speaking, there are very good odds that not paying extra towards the mortgage and investing excess money into the stock market or a balanced portfolio over time will beat the current mortgage interest rates of around 3% on a 30 year fixed mortgage. If mortgage interest rates were higher, such as 15%, the answer may change because now there is a higher hurdle rate. There is a lower likelihood the stock market will earn a higher return than 15% over a 30 year period than there is it will earn a higher return than 3%. Historically, markets have returned 7-12% depending on the time period, which means a mortgage rate in that zone would be a grey zone and a more difficult question to answer.
The other option is to pay any excess money each month towards the mortgage loan balance. By paying it down, they are receiving a guaranteed 3% return and increasing their net worth. It is not a bad deal to get a 3% return.
For many people, paying down debt can increase their motivation and excitement around money. Sometimes, setting a goal of paying down debt can increase the amount they save towards the goal. It becomes a game to see how much they can save.
For instance, while someone might have $1,000 extra per month to invest, they may only invest $600 of it and spend the other $400, whereas, with debt, they may put the full $1,000 towards debt and possibly find other ways to reduce expenses, which allows them to put $1,200 towards debt. Many people are debt-averse, which means they are more committed to paying off debt and will make sacrifices to pay it off faster than investing.
Sometimes, these lifestyle changes put people in a better financial place than choosing the “best economic decision.”
While the best economic decision may be to invest the money instead of paying off a mortgage at 3%, it may not be the best emotional decision.
I know this firsthand. I have made extra payments towards my mortgage. When I refinanced, I even put a large lump sum into the mortgage balance to reduce the monthly payment. Economically, I feel confident I would be wealthier investing the money, but I also understand a smaller monthly payment gives me peace of mind.
Having a mortgage paid off provides peace of mind. Lower expenses provide greater freedom and flexibility. It is tough to put a price tag on a debt-free home.
Sometimes, you do not need to make the most economically sound decision. Sometimes, the most economically sound decision is not the smartest financial decision for you.
My Decision to Buy Life Insurance When I Did Not Need It
I bought life insurance when I did not need it. I was not married. I did not have kids. My parents were not dependent on me. If I died, my assets would have covered final expenses.
Economically speaking, it was a terrible decision to buy life insurance.
Emotionally speaking, it was one of the best financial decisions I made that year.
Why? Why did I buy life insurance when I did not need it? Why did I voluntarily pay money for coverage without an immediate need?
Peace of mind.
I had a family member who was diagnosed at a very young age with melanoma, a type of skin cancer. Thankfully, they survived. I also know people who have experienced major health problems at a young age.
Many of these health problems make it very difficult, expensive, or impossible to qualify for life insurance later. Knowing this, I was concerned that while I did not have a need today for life insurance, I may one day and may be unable to qualify for coverage or it would be extremely expensive.
That stressed me out.
There was an easy solution to relieve the stress: buy life insurance.
And after a few years of thinking about it, I bought a 30-year term policy. I felt relieved after buying it. Knowing I was covered for the next 30 years regardless of what happened to my health felt amazing.
The life insurance could help provide for family, friends, a partner, or charities. It was a protection nobody could take away as long as I paid the premium.
From an economic perspective, I did not need life insurance when I bought it. Now, I have more of a need and instead of going through the application process, I simply needed to change the beneficiaries of my policy.
I share this story because very few people would have said it was a “smart” financial decision to buy life insurance when I did, but it is one of the best purchases of the past few years.
Summary – Final Thoughts
Personal finance is personal.
Be wary of accepting suggestions from strangers (yours truly included – nothing I write should be thought of as advice – only information) because nobody knows your personal situation better than you. Blanket advice or the “smartest” financial decision may not be the best decision for you.
Whether it is holding extra cash, paying off debt, or buying something you do not need, consider the economic and emotional side of your decisions.
Sometimes, the best economic decision is not the best emotional decision, and no amount of return matters. At times, the best emotional decision can transform into the best financial decision.
In a world where people want clear answers, I am here to remind you that very few questions have simple answers. Our emotions play into our financial decisions, and it is wise to be mindful of how they influence them in order to make better decisions for ourselves.