On Why Good Financial Decisions Are Often Wrong

While beginning my day some time ago, a local news station played on the television in the background. As I sipped my coffee and discussed the day with my wife, I overheard a story begin to play with a title similar to "home renovations that pay off now." This story, which on the surface seemed to make perfect sense, presented a clear opportunity to discuss why good financial decisions are often wrong.

The premise of the story was pretty straight-forward. It was the type of story media outlets recycle often and seem to use as filler when they are short on news. The newscaster discussed the amount someone could expect to pay for a certain home renovation (e.g. kitchen remodel, home expansion, etc.) and the amount that each renovation might increase the value of the home. Finally, the story was wrapped up with a comment about which renovations returned the most money for your investment and then concluded by listing which renovations were the best to make.

I have found when talking to people that often financial decisions are approached in this manner. They are reviewed primarily from a "maximize return" perspective and the highest expected return equals the "good" financial decision. There is good reason to consider the return to expect from some financial decisions, but it is my opinion that generally this is not the best way to make decisions. Far more important is the value you receive by choosing either side of the decision. What is important to you? How much are you willing to pay or give up to choose a certain path?

Take the home renovation example, a kitchen remodel may return more than an in-ground swimming pool addition, but if your goal is to swim in your backyard every day and you never cook, the kitchen really does not make much sense. You may get more money back if you choose to sell the house in the future, but you get no return from the kitchen while you still own the home. The kitchen remodel might be the good financial decision but entirely wrong for you.

Other examples of this type of decision-making include maintaining a mortgage for a tax deduction when you could pay it off and you are debt-averse or taking more investment risk to maximize return at the expense of sleeping well at night.

Don't forget yourself and what is important and valuable to you when making financial decisions. Don't allow someone to convince you to make a choice that does not represent your values simply because it has the highest expected return. Well-considered financial decision are made by considering the expected return, long-term impact and what is important to you, then balancing those factors to reach the decision. A good financial decision according to the experts could be entirely wrong for you.


Chad said...

Nate, well put. I'd also add that sometimes the best financial decision can be doing nothing different than you're already doing. Problem is, too many financial "advisors" are afraid to tell their prospective clients to stand up, and walk away, because they are doing well on their own and don't need an advisor right now.

I had a daughter and son-in-law of a client in last week, and did my usual "get ta know ya" meeting. They were so squared away financially it was almost unbelievable...I told them they didn't need me. They'd been to see three other advisers all who wanted to make changes. Did I get paid for the engagement? Nope. But I've already received a referral from them for someone that does need the help.

Sometimes doing nothing is the totally appropriate thing!

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