Posted by Tim Stobbs on November 21, 2012
Ok, I’m a little weird. I know this since I actually enjoy creating and tuning mathematical models. While this makes me good at my day job it also causes me to tend to use the idea that every in the world can be reduced down to a model. Of course this never really works out for all sorts of reasons, but today I wanted to focus on just one reason: oversimplification.
In a nut shell, reality is brutally complex even for the simple things in life. For example, when you fill up a water glass, in a model you would tend to treat the glass as a perfect cylinder in shape when in fact a lot of glassware is not that shape. In the worse case scenario there is a slight angle making the glass wider at the top than the bottom so to model it properly you should use a series of conic section calculations. Yet that is a lot of work, so most people would use a perfect cylinder as an assumption and accept an error into their model. This is a classic example of oversimplification, the more you use it the further you get from reality.
Yet often when we make financial decisions we like to use calculators or models to help us sort through our options: should I rent or buy, how much do I need to save to retire early, can I afford a new car this year, should I pay off my mortgage or invest…you get the idea. So over the years I’ve developed or used various calculators to help me in my decision making. But with my background in working with models I tend to look carefully at the assumptions and don’t accept a lot of the results at face value. I know about oversimplification so I tend to watch out for it.
Yet the biggest mistake I see other people making regarding their financial choices is they treat them as rational decisions that can be resolved by models, when in fact a good portion of our decisions in life are emotionally or irrational. Every financial decision has an impact to your life beyond the numbers and you can’t model that. From a pure number situation I should have a much higher savings rate than I already have, since I don’t need to have fun or buy things that I want, but don’t need. Yet I refuse to oversimplify my life to mere survival status in order to retire a year or two sooner. I would much rather have some fun in life while I’m working towards my goal.
So then what is the point of financial models? Well I find them fun to run “what if” scenarios like what if I lost my job today, what if I won some money, what if I wanted to leave work a year earlier…you get the idea. A good model won’t reflect reality entirely due to oversimplification, but it gives you a feeling of the impact of these events in your life. Knowing I would have to give up our annual tickets to the theatre and all my drinking in order to retire six months early is more helpful than looking at some numbers. It provides some context to frame my emotional decisions.
So how often do you run numbers to make decisions in your life? Do you ever worry about the results or take them at face value?