The global pandemic has prompted a massive re-examination of personal priorities. The big quit along with the growing number of people moving from cities to suburbs and small towns are just a few examples of how people seem to be changing the way they value compromise in their work, family, and financial lives.
These case studies involve money, but money is not the only factor. People choose retirement or more fulfilling or balanced jobs. They move to places that offer more space, natural beauty or simply quietness. Everywhere you look, it seems people are increasingly focused on maximizing their overall quality of life.
These trends illustrate an aspect often overlooked by finance professionals: major financial decisions involve both monetary and non-monetary trade-offs.
When the economy gets emotional
Let’s go back for a moment to Economics 101 and the fundamental concept of utility. In finance, we think a lot about optimizing utility, but what is utility? Utility is a measure of value, but it’s not just pounds and pence. Utility is defined as the total satisfaction that can be derived from the consumption of a good or service.
It’s tempting to take the mental shortcut of assuming that more money = more satisfaction. After all, money is much easier to measure than satisfaction. But maximizing utility is not the same as maximizing returns. Usefulness is subjective and includes many factors. Ignoring emotional costs and benefits leads us to incorrectly assess the total utility of trade-offs.
No amount of money is worth THAT
When we evaluate the trade-offs, we perform mental cost-benefit analyses. Which option has the highest value when all is said and done? Which will give us the best total return on our initial investment? Some of the costs and benefits we consider are financial. Some are emotional. Some are psychological.
I was once offered a position in a big company which would have meant a significant pay rise, but the job would have required a lot more travel and the work didn’t interest me much. I declined this offer because when I did the cost-benefit analysis, the emotional and psychological costs of daily work and time away from my family outweighed the extra money.
I know I’m not alone in this, and I don’t see this as irrational or suboptimal. I was not focused on maximizing my financial returns, but on maximizing total utility.
Many of us can think of actions so heinous that no amount of money could induce us to participate in them. When we weigh the costs and benefits of compromise, the psychological and emotional costs outweigh the financial benefits, and the overall utility of compromise is unattractive. Likewise, some trade-offs offer benefits beyond the financial.
Price /= Value
We have already said it. We will say it again. Price is not the same as value. Price is what you pay for something, value is what you get. We equate these things at our peril.
Here it is important to note that the main guideline in most people’s lives is not to maximize the market price of their assets. As complex beings, we have goals in life that go far beyond financial security and freedom. Yes, these things are important and laudable goals, but if financial advisors focus only on maximizing financial returns from investments, they are missing the main goal of financial planning.
Personal finance is not about maximizing the amount of dollars a person raises over their lifetime. It’s about making good choices with our limited resources so that we can live the life we want to live. Dr. Brian Portnoy of Shaping Wealth says it best, I think, when he says the real goal of financial planning is “funded satisfaction”.
I know some of the purists will say that the purpose of financial management is to maximize the pounds and pennies, so the customer can use that money to create the life they want. More money means more ability to create that life, so maximizing the pounds and pennies is the CFO’s goal.
To these cynics, I would say that many financial trade-offs come with emotional costs and benefits that cannot be separated from the transaction.
In these cases, ignoring the emotions leads us to evaluate the results incorrectly. I know dozens of people who would turn down even triple-digit returns if it meant directly harming others or significantly depleting the planet of natural resources. For the purist who only thinks in terms of numbers, this is irrational, but for these decision-makers the trade-off is clear and there is no sense of loss or failure in not pursuing such actions.
More than a feeling
Consider, for example, a person who is thinking of selling their house after a painful divorce. The house is an asset with a specific financial value, and you can easily estimate the financial return they can realize from the sale. However, the emotions they associate with the house will affect the total utility of the trade.
In this example, Person A associates the house with the negative emotional and psychological aspects of the broken relationship, and therefore selling the house and moving to a new location would provide an additional benefit above the financial one.
Person B associates home with the family she nurtured and the roots she established. It gives them a much-needed sense of continuity and stability in an otherwise tumultuous and uncertain time. For Person B, selling the house would require an emotional cost, reducing the overall utility of the transaction.
Thinking about financial trade-offs through the lens of maximization utility allows us to easily explain many human behaviors that do not make sense through the prism of finance alone. It may also help explain how two people can have wildly different experiences of similar financial transactions.
Personal finance is more personal than financial
Crises reveal, and COVID is no exception. This long period of uncertainty, stress and isolation has prompted a major re-examination of priorities for many, and macro-socio-economic trends suggest that people are placing more weight on the non-financial aspects of their work and family life than before the pandemic.
These trends highlight the non-financial aspects of financial trade-offs, and savvy finance professionals will take note. Thinking about financial trade-offs in terms of maximizing utility rather than dollars can help explain why numbers alone aren’t always compelling to customers.
Counselors who learn to incorporate the emotional and psychological aspects of decisions into their thinking will find that they are better equipped to work side-by-side with clients to develop strategies that maximize quality of life. Helping customers achieve the ultimate goal of “funded satisfaction” is indeed a valuable service.