As financial planners, we have a responsibility to give people the best advice to guide them towards achieving their goals. In most cases, it’s very straightforward to develop these recommendations, by applying the technical rules and looking at “the numbers” to calculate what path/route/option is best. Yet ultimately, the solutions don’t count unless they’re implemented correctly, and if you want to take that next step, you have to deal with real world behaviors. Which leads to a fundamental problem: what happens if the “best” solution is one that’s not conducive to human behavior? How do you navigate the intersection between behavior and the numbers? How do you develop rational financial planning recommendations in a world where people don’t always behave rationally?
The inspiration for today’s blog post comes from a tweet posted yesterday by financial planner Rick Kahler on Twitter, where he stated:
On the other hand, we also have the popular advice from author Dave Ramsey, who advocates the nearly opposite approach:
“Myth: I should pay off the debt with the highest interest rate first to get out of debt quickly.
Truth: You should pay off the smallest debt first to create the greatest momentum in your debt snowball” – Dave Ramsey’s “Debt Snowball Plan”
The purpose of this blog post is not to debate whether Rick or Dave is smarter, or even about which is the better approach to debt management. The point is that we have two smart people with some real experience guiding people through debt issues, who seem to have used all of their smarts to come up with two completely opposite conclusions about the “best” way to tackle a serious issue. And the difference between the two ultimately boils down to one single issue: behavior.
After all, there’s no question that quantitatively, Rick’s approach is the best. If $10,000 loan #1 has a 17% interest rate, and $2,000 loan #2 has a 7% interest rate, then you’re racking up $1,840/year of interest. If you spend the next year paying down $2,000 on loan #1, then next year you’ll have an $8,000 balance on loan #1 and a $2,000 balance on loan #2, and your interest in year 2 will be down to $1,500. On the other hand, if you pay down loan #2 first, you’ll carry all $10,000 of high-interest loan #1 into the second year, where you’ll owe $1,700 in interest payments. So the solution is clear: pay down the higher interest loan #1 first, and save yourself a bunch of interest!
Ramsey, on the other hand, would point out that for someone who can only pay down part of their loans and must work things out over a period of months or years, there’s a huge behavioral hurdle. It’s hard to stick with a plan like that for a long period of time if you don’t feel like you’re making any headway. The individual who can only pay down $2,000/year (in addition to the interest) has to tackle these loans for 5 years just to make loan #1 go away, and then quickly will stomp out loan #2 the next year. But facing 5 years to tackle one loan can be pretty daunting! On the other hand, if someone who’s trying to get control of debt tackles loan #2 first, and gets it paid down in a year… what a motivational boost! You’re really getting control of your debt! You made a loan disappear by paying it off! Now that you’ve got some momentum, let that snowball forward. Use your success in paying off loan #2 as the inspiration you need to keep the debt payoff plan going.
Again, the point here is not to debate whether Rick or Dave has the better advice. The point is to note how difficult it is to evaluate what the “right” advice is in the first place, in this context. Dave will make the case that if you follow Rick’s advice, a lot of people will never pay down their debt, because the highest interest rate loan may be so big that it’s too daunting, people won’t have any early successes to celebrate, they’ll lose motivation, and the debt will win. Rick will make the case that if you spend too much time trying to stomp out the smaller debts first, you’ll just have even more to pay off because you’re accumulating more interest in the meantime, and it’ll take longer to pay off because you’re carrying more interest (which, mathematically, is absolutely true). And if it takes too long to pay off your debt because you’re accumulating so much high interest, you may fail to pay off your debt anyway, as it’s also easy to lose motivation if the interest on your debt is accumulating as fast as you can pay it down (which is only exacerbated when you don’t pay off the highest interest debt first).
In truth, these kinds of challenges – the conflict between what is best according to the numbers, and the “theories” about what is best once you account for behavior – is not unique to debt management. It’s true for every individual who plans a steady course of investing, but in practice gets stuck in a fear-greed cycle of buying high and selling low. Or perhaps those who wish to buy a variable annuity with retirement income guarantees to get protection from market declines, even if their portfolio is large enough to withstand the impact of volatility anyway. Of those in prior decades who used Whole Life as a “forced savings” vehicle, even though arguably there were better accounts/ways in which to save (yet the reality is that for many of those individuals, the annual premium notice really DID get them to save, and it’s not clear if their savings behaviors would have been as effective if they just tried to save what was left in the bank account at the end of every month or year). In the end, it’s astounding how many situations there are where quantitatively there is one clear answer, yet in accounting for human behavior, it’s suddenly not so clear what path is best.
Addressing this challenge is something we don’t seem to have figured out very well yet in the financial planning world. After all, we’re talking about uncertain and inconsistent human behaviors, and almost by definition much of it is irrational. Yet that’s the problem. Do you address irrational client behaviors by trying to change their behavior, or changing your recommendation to fit their behaviors? Are there ways to get clients to use their irrational behaviors for the better? Which path should we take as professionals?
So what do you think? How do you handle the conflict between what is suggested by “the numbers” versus the behavior of certain clients? How do YOU develop rational recommendations for clients who don’t always behave rationally?