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 the theory, suppose you’re running a company and want to build a new factory. To raise money for the project, you generally have two options: You can sell shares to investors or you can borrow money. No one disputes that basic framework, but Modigliani and Miller added a twist: They argued that, whether the company issues shares or it takes on debt, investors shouldn’t value the company any differently.
That’s the theory. 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 can’t. Here are five examples:
1. Spending. This is a tradeoff between enjoyment today—something that’s 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 17,000 academic articles that examine the relationship between happiness and money.
The Happy Money authors identify certain rules of thumb that can help. Among the best known: Buy experiences rather than things. Use your money to buy more time for yourself by, say, paying others to do tasks you dislike.
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 thus are money well spent. But others might see them as frivolous. My advice: The best thing we can do when making spending decisions is to be intentional about them.
Most of us are busy, so our financial lives run on autopilot. But with many companies quietly billing our credit cards each month, it’s more important than ever to be intentional about spending. An approach I recommend: Hold an annual financial review. Some people do this each Jan. 1 so they don’t forget. However you structure it, the key is to review your spending and to ask a basic question about each significant line item: Even if we can afford it, do we need this item? Will it make us happier—or our lives easier—or would we instead be happier having those dollars in the bank?
2. Charitable giving. Like spending, charitable contributions involve a tradeoff between giving today and perhaps saving the money for 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” and the goals you’re 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.
3. 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, 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 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.
4. Tuition. College tuition is a component of spending. But it’s significant enough to warrant its own category. Suppose your child gets into Harvard, Yale or another 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: 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 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 judge of school quality. There are other measures, including Money’s 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.
5. Housing. In many ways, housing decisions are like tuition decisions. Both carry enormous price tags. And like college, housing is partly an expense and partly an investment, and it has other dimensions as well. For instance, for many folks, it crosses over into the “experience” category.
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. By contrast, there’s no way to get a refund for a poor college education. 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’s 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.