Emotions are information

I recently received a letter from a reader who was incensed that I, a financial professional, would announce on social media that I had refinanced my home from a 30- to a 15-year mortgage. Given the low interest rates for lending and the opportunity for growth in the stock market, I was clearly wrong to prioritize putting my money toward my debt rather than toward growth. How could I support such nonsense, especially when I’m supposed to know all about how emotions poison pure financial reasoning?

The reader made a good financial argument, but it was off base. My decision was based in a desire to pay down my debt for emotional and psychological reasons that — to me — outweigh the increased ROI that I could achieve in the stock market. This interaction illuminated for me a misunderstanding that I think is rampant among finance professionals and enthusiasts: that maximizing ROI is the end-all financial goal, and that emotions are anathema to financial decisions.

I disagree with this reasoning both as a professional and as a living human with a nonfinancial life that happens to intersect with financial concerns. Emotions are not the enemy. Emotions are valuable human experiences and teach us about what we want and don’t want in our lives. Emotional trade-offs are real in financial decisions, and emotions are valuable information that must be weighed properly in our mental calculus so as to ensure that they inform but do not hijack the decision-making process.

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MAXIMIZING VALUE

The goal of financial planning is to maximize a client’s quality of life while keeping them within the constraints of their limited resources. In economics, we call this a utility maximization problem, and we have a host of complex mathematical procedures to predict what trade-offs will lead to the highest utility under different circumstances.

Based on these equations, if option A makes more money than option B, you should choose A, right? Wrong. Or at least, not completely right. Because we aren’t trying to maximize dollars. We’re trying to maximize utility, and utility is only partly about the dollars. For all the mathematical complexity and striving for precision that we do in finance and economics, we have to remember one very important thing: Utility is subjective, ill-defined and hard to measure.

EMOTIONAL UTILITY

Utility is just a catch-all term that basically means the value or benefit derived from a trade-off decision. The financial outcomes of a decision are part of the utility we experience, but other, nonpecuniary factors may be involved as well. Weddings, vacations and philanthropy are examples of expensive undertakings that nonetheless bring a lot of utility! You can run all the equations you like, but people will still insist on giving gifts, paying off debts (even when they could gain more from investing), and doing other “foolish” things with their money because maximizing ROI is not the goal — maximizing utility is the goal.

Emotional outcomes are a real factor in many financial decisions, and failing to account for them does not make you a more disciplined investor or planner. It means, rather, that you’ve ignored important information in estimating the utility of the outcome.

DON’T WASTE INFORMATION

Ignoring emotional aspects of financial decisions leads to wrong quality-of-life estimates. To really help your clients make sound long-term decisions they can live with and thrive with, don’t try to minimize or negate that valuable emotional information! Instead, help them to think through options that will harmonize their financial and emotional lives, allowing them to live well today while planning for a great tomorrow.

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Sarah Newcomb is a behavioral economist at Morningstar Inc.

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