What is rationality? For the purpose of this article, we’ll define it as “the ability to make intelligent decisions based upon objective observation of your own psychology, the facts surrounding a particular investment, and the specifics of your financial situation”. It can mean the difference between retiring to your vacation home in Palm Beach and spending your days working multiple low-paying jobs into your golden years. Perhaps more importantly, it can mean the difference between a peaceful night’s sleep and agonizing hours of tossing and turning as a result of worrying about your pocketbook.
Rationality Key 1: Know Thyself (Understand Your Own Psychology)
In each and every life decision there are ordinarily two distinctive choices: the one that makes the most sense in terms of financial or physical well-being, and the one that lets you sleep at night.Imagine, for example, that you have $500K in a diversified portfolio. Your banker approaches you and offers to loan you $300K in a long-term, fixed rate personal loan with semi-annual payments that you estimate can easily be made based upon your expected rate of return. This additional leverage will magnify your return on equity, causing you to generate far more profit for each dollar of your own you have invested. Should you take the deal?
From a practical standpoint, it makes sense to accept the terms of the agreement and borrow the funds. Your investments are conservative, you are not moved by market fluctuations, and you don’t have any need for the capital already in your account. Over the next twenty years, the incremental return that is generated by the borrowed money will result in many times the wealth you would otherwise have owned.
On the other hand, your personality may simply lean toward a desire to be debt-free. Regardless of the additional profit you could earn by utilizing the bank’s resources, you are already financially independent and have no desire to introduce any repayment risk whatsoever. You are going to sleep easier knowing that everything you possess is legally yours with no claims against it. If the Stock Exchange closes for years due some horrific accident or natural disaster, you won’t be affected because there is no need to make payments or sell assets.
Which course of action would rationality seem to dictate? If an objective observation of your own personality reveals that you are likely to fret about owing money – regardless of it is makes good financial sense to do so – it is probably unintelligent for you to take the cash. In other words, as odd as it seems, one of the most rational things you can do is accept your irrationalities that are unlikely to change and compensate for them accordingly.
