Back in the 1950s, economists Franco Modigliani and Merton Miller developed a theory that, even today, is taught in virtually every finance class. To understand this theory, suppose you’re running a company and want to build a new factory. To raise money for this project, you generally have two options: You can sell shares to investors or you can borrow the money. No one disputes that basic framework, but Modigliani and Miller added a twist: They argued that it doesn’t make a difference which option the company chooses. Whether it issues shares or it takes on debt, investors shouldn’t value the company any differently.
That’s the theory. But in reality, most people raise an eyebrow when they hear this. That’s because debt always carries risks. Should something go wrong, an unhappy lender can, at the extreme, force a company into bankruptcy. These risks might not be quantifiable, but they’re real nonetheless. This sort of thing occurs frequently in economics—where the formula says one thing, but the reality is more nuanced.
It’s the same in personal finance. I often say that there are two answers to every financial question: what the numbers say, and how you feel about it. That, in fact, is a big part of what makes personal finance so tricky. Few questions are purely mathematical. Many—maybe even most—lie at the intersection of factors that can be quantified and those that cannot. Examples include:
Spending. Spending represents a tradeoff between enjoyment today—something which is real but hard to quantify—and financial security tomorrow—which is much easier to quantify. We all intuitively understand this and try to strike the right balance. But it isn’t always easy. According to the book Happy Money, there are more than seventeen thousand academic articles that examine the relationship between happiness and money.
The Happy Money authors do identify certain rules of thumb that can help. Among the most well known: Buy experiences rather than things. And buy time. But at the end of the day, even these rules are subject to interpretation. If you buy a convertible or a vacation home, do those count as things or as experiences? I’d argue they count as experiences—and are thus money well spent. But others might see them as frivolous. So even these well accepted guidelines aren’t hard and fast rules.
My advice: The best thing we can do when it comes to spending decisions is to simply be intentional about them. Most of us are busy, so our financial lives run on autopilot. And especially today, with so many companies quietly billing our credit cards each month, it’s more important than ever to be intentional about spending. An approach I recommend is to hold an annual financial review. Some people do this on January 1st of each year so they don’t forget. However you structure it, the key is to review your spending and to ask this basic question about each significant line item: Even if we can afford it, do we need this item? Will it make us happier—or make our lives easier—or would we instead be happier having those dollars in the bank?
Charitable giving. Like spending, charitable giving represents a tradeoff between today and tomorrow. But it involves two additional dimensions, one quantifiable, the other not. The quantifiable dimension is, of course, the tax benefit. The unquantifiable dimension is the satisfaction that giving can provide.
How can you balance all these factors? As I described a few weeks back, the first step in making a giving plan is to understand your “why” for giving, and the goals you are trying to accomplish. This question is itself multidimensional, but just like day-to-day spending, I think it’s important to be intentional about it.
Investments. How should you invest your savings? This question gets a lot of attention, but it’s mostly focused on the numbers: risk, return, liquidity, expenses, and so forth. To be sure, those are important. But there are additional dimensions to the investment choices we make.
For starters, though it might seem like an obvious question, it’s important to be clear about your objective. As one client put it, know your definition of “winning.” Is there some number that you define as enough? Or are you trying to grow your investments to as large a number as possible?
Beyond that, do you view investments simply as a vehicle to support your goals? Or, do you derive enjoyment from the investment process itself—whether it’s reading through the literature, picking stocks or making angel investments? The reality is that there are many ways to manage your money successfully. You shouldn’t let anyone else tell you what’s right or wrong. It’s important, though, to be clear in your own mind about your objectives.
Tuition. College tuition is a component of spending. But it’s significant enough to warrant its own category. Suppose your child gets into Harvard or a school with a similarly sky-high price tag. If you don’t qualify for financial aid, it’s going to cost a bundle. On the surface, you might immediately rule out such a luxury. But it’s tricky.
In one respect, tuition is a spending decision. But it’s also an investment decision—because a college education should deliver a positive return on investment. The challenge for many families, though, is that this investment in their children comes at the expense of their own financial security. Compounding this challenge: Ideally, college also delivers unquantifiable benefits outside the classroom. It’s nearly impossible, though, to know how to factor these benefits, which are potentially significant but totally intangible, into a financial decision.
How should you approach this decision? Step one is to recognize that U.S. News & World Report is not the only and final judge of schools’ quality. There are other measures, including the Money Magazine rankings, which evaluate schools along many more dimensions than U.S. News. As a result, the Money rankings highlight a much more diverse list of schools.
Housing. In many ways, housing decisions are like tuition decisions. Both carry enormous price tags. And just like college, housing is partly an expense and partly an investment. But housing has other dimensions as well. If it’s a comfortable place, it may cross over into the “experience” category of expense that the researchers recommend.
Housing, however, does differ from tuition in one crucial respect: If a house ends up being too much of a burden, you can almost always sell it. Unfortunately, there’s no way to get a refund for a poor college tuition. For that reason, I’d worry less about housing decisions than about college choices.
These are just a few examples. Other topics that lie at the intersection of quantifiable and unquantifiable include Social Security, life insurance and estate planning. There is no magic bullet for addressing any of these topics. Still, a useful starting point in decision making is to simply recognize that these intersections exist.
