(or at the very least, this is an explanation of how I rationalize my own irrational behavior)
At Clever, we have ‘Clever Talks’, where we learn from one another about exoplanets or Magic the Gathering or bike maintenance – anything that someone at the company knows about which others find interesting. This week we had a guest, Amil Bera. Amil is a Registered Investment Advisor and was going over basic personal finance – a great talk. I would definitely recommend him as a resource! However, I disagreed with one section of the talk in particular. This section discussed the irrationality of people paying off debts with very low interest rates when they could get a better rate of return elsewhere.
The logic here is sound. If you can slowly pay off your subsidized student loan and put the rest of your savings in something that earns you much more, you are certainly better off in the long run. And yet…… when I got my first job out of college, what I started on right away was repaying student loans as quickly as possible! According to Amil, I’m not the only one, especially amongst Millennials.
Why are all of these rational people making irrational financial decisions? I’d argue that it’s not just human nature, and that there are some factors that make this at least more of a close call than the financial advisors would suggest.
First off, while I’ve heard a similar argument about investing instead of paying down debt from other people, all of those people have been well-off themselves, or have extensive support networks. Essentially, being in a financially privileged position allows you to take these kinds of risks – if the stock market crashes and you lose your job, no big deal – you can just ask your dad to help you out until you get back on your feet. Yes, the advisors say that you should have a 4-6 month window of cash savings to be able to do this yourself, but then you are battling your own psychology daily to prevent from spending any extra cash when you could be paying down liabilities which you’re still on the hook for if your career does go south. Even if right after college you didn’t have these support networks, it’s easy to look back and say that your past self was irrational. Yet this is easy knowing how the next few years played out! As always, hindsight is 20/20.
Second, I find being in debt to be very mentally challenging. The Millennials became financially aware in times where playing with debt was seen as safe (Buy a house on credit in Phoenix, AZ – You can flip it in 6 months for a guaranteed 30% gain!) but many people ultimately got burned. Similar to those who lived during the Great Depression, we’re going to have a wary relationship with debt and credit for some time, if not for life. I think this is healthy – generally credit is dangled in front of Americans as a way to pay for consumption we don’t need. If we have an aversion to that debt, we will consume less and hardly miss out as a result. This aversion to debt also weighs down on you when you have loans, even if you have a steady job. How much is it worth to release a nagging worry at the back of your mind: The worry that there is a virtually unshakable debt with your name on it which you might be paying it off for decades? Stress-wise, I’d prefer the slight regret of a missed percentage point over the daily specter of indebtedness.
Thirdly, I think that the effect of debt is to significantly chill honest self-realization. I’ve already talked about how positive financial incentives can affect your decisions in ways you might not expect and debt is a flip side to this with respect to self expression and ‘rocking the boat’. If you want to be able to think for yourself and decide who you are as a person, having debt is terrible. Having regular debt payments means that choosing to be a ‘free spirit’ is a financially suicidal decision. Jack Kerouac can’t afford to spend his paycheck on gas for cross-country trips and jazz, for instance, if he has student loans due every month. If he forgets to pay his phone bill, no big deal. If he forgets to pay his loan payments, that’s another month of compounded interest tacked on. While someone paying off student loans instead of investing still has the same problem, paying off the loans immediately gives the person freedom to choose their own way sooner instead of having to schlep to the cubicle every day.
Finally, (and this is the argument that will be most persuasive to the financial analysts), being in debt keeps you from properly exploiting opportunities that come up. Having wealth tied up in investments that may be unavailable for long stretches of time (perhaps the stock market is in a temporary downturn, for instance) means that there is little liquidity in your life’s financial structure. This liquidity matters a great deal, especially amongst those just starting their careers. Imagine someone a year out of college gets an offer to join Twitter, working for living expenses and equity. They’ve been an investment banker for a year, so they have been able to save an amount equal to the principal on the loan, which they’ve rationally invested in the stock market. Now, this would be a great career move, but unfortunately it’s 2008 and the Global Financial Crisis has just happened; the money which was supposed to be earning above loan interest is waiting on the markets to rebound. Now, over time the investment will rebound and earn more than the interest rate on the loan, but this is little consolation to our protagonist. Being a little ‘irrational’ and paying off the loans early would have wildly paid off in the long term. I have not read ‘Antifragile’, but paying off the loans early seems to match Taleb’s attitude. You are trading a few percentage points of reasonably sure gains for massive potential upsides coming from unpredictable serendipity. It is, I believe, ultimately the rational choice.
Have I convinced you? Or have I just rationalized my own irrational decisions? Let me know!