2 + 2 = 5?
Last week’s blog post I talked about refinancing and used this analogy:
Math ≠ Money
According to Reuben Hersh, an American mathematician and academic, math can defined as follows:
"Mathematics is the subject where answers can definitely be marked right or wrong, either in the classroom or at the research level. Mathematics is the subject where statements are capable in principle of being proved or disproved, and where proof or disproof bring unanimous agreement by all qualified experts—all who understand the concepts and methods involved."
For example, if I told you 2 + 2 = 4, you could not dispute that. This is a fact. If I told you 2 + 2 = 5, you could easily dispute that. And you might question my professional competence!
When it comes to your financial life, I can tell you many things that are fact…based. Here are some facts:
You are 40 years old.
You are able to save $36,000 each year.
You are able to do this for 30 years.
And you are able to earn 6% on that money each and every year.
For simplicity, we are ignoring taxes, tax deferral, etc. If these facts hold true, you will have $3,013,545.13.
Why are these facts? Because we've used math. It's a financial planning formula that looks like this:
Years x Money x Rate of Return = Wealth
In our case it looks like this:
25 x $36,000 x 6% = $3,013,545.13
We have four different factors in our formula. How many of them are variable?
All of them are variable:
Years: you might not work for all 25 years. You might lose a job, get sick/injured, stop working to spend time with kids, etc.
Money: you might not save exactly $36,000 each and every year. You might remodel your home, choose to pay for kids education, aggressively pay off debt, care for parents, etc.
Rate of Return: what are the odds of your investments earning 6% EACH AND EVERY YEAR, without a down market…ever? Yeah, not happening.
Wealth: if any of the first three variables are off the mark, either up or down, then forget about this final factor being exact.
Never mind inflation, taxes, and new technologies that haven't even been invented yet!
So right off the bat we can see how math ≠ money.
Money on the other hand is not exact. Sure, if something costs $10 and I pay with a $20 bill, then I am due $10 in return. But that's not money, it's still math.
Decisions around your money cannot be marked with a right or wrong answer. Your financial decisions cannot be proved or disproved in unanimous agreement. Except maybe in your household.
Money is filled with infinite gray areas. It's definitely NOT an exact science.
In the past I've talked about paying off debt early vs. investing. I've talked about refinancing vs. keeping your original mortgage. In both cases, we can show facts to prove a financial decision should or should not be made…based on the math.
The facts, however, make a lot of assumptions and do so over a pretty long time frame. They are still mathematical facts, though. The flaw? The facts use a formula (see above) that's static and assume life does not and will not change. Ever.
Here's another popular topic: Should I invest in the 401(k) or the Roth(k)?
If you look online for the answers, finance articles ask you to make a few predictions:
Do you want to pay taxes today, or tomorrow when you take the money out?
Will you be in a lower tax bracket in retirement?
Will tax rates be higher or lower when you retire?
You don't know the answers to these questions. I sure as heck don't, either. So this decision is not math. It's money. You have to make a decision based around money, not math.
Other examples in your financial life could include how much life insurance to own, renting vs. buying a home, or the amount of risk you take with your investments.
In the past, I've seen folks ignore the "facts." They made the decision(s) that wasn't the "optimal" choice or the "mainstream" decision based on the "facts" we worked with.
Why? Because math ≠ money. And that’s okay. Because we also know it’s personal.
Another issue at hand is emotion. We often make financial decisions based on emotions and biases. This is not ideal and can destroy the best of intentions. That's money! We're emotional when it comes to our money. We worry about the markets. We worry if we'll be able to put our kids through college. We worry about what people will think of our clothes, our car, our home.
Perhaps more advisable is to make financial decisions based on what we feel is the best decision for us. Or a decision based on your values or a personal goal. That's money.
Stop with the math. Put the calculator away. Start thinking about and making your financial decisions around where your money goes, and why.
Because math ≠ money.