
Mathematically correct but psychologically wrong - fogus
http://www.johndcook.com/blog/2010/11/02/snowball-strategy/
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wisty
Here's another strategy: break all your debts up into similar sized chunks.
Draw a grid with all those chunks on a big sheet of paper, and post it up on
the wall. Cross off the chunks as you pay them off (highest interest rate
first). It's mathematically and psychologically correct!

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kscaldef
Crossing off a chunk on your grid does not reduce the number of nasty letters
and phone calls you get from creditors.

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trustfundbaby
You only get those phone calls if you're not paying anything at all to the
creditors and or/ignoring their phonecalls. If you talk to your creditors
explain your situation and are making payments, the phone calls and letters
stop.

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greendestiny
If you've fully paid off a debt then even if you fail to make payments in
future its not coming back to haunt you. Also even apart from psychological
considerations there is how soon until a creditor is likely to institute
proceedings against you - it's probably sooner for smaller debts.

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aycangulez
I think the real gem is at the end of the article:

"Many things that don’t look optimal are in fact optimal once you take the
necessary constraints into account. For example, software that seems poorly
designed may in fact have been brilliantly designed when you consider its
economic and historical constraints. (This may even be the norm. Nobody
complains about how badly obscure software was designed. We complain about
software that has been successful enough to criticize.)"

~~~
jdp23
i thought this was a great point too.

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dkokelley
The thing is, to me (and the HN community), this seems blatantly wrong. Why do
we need a psychological hack to motivate us, when we know what the optimal
solution is?

However, the majority of people who are drowning in debt got there because
they weren't looking for the optimal solutions to their cash flow problems.
Seeing their debt snowball shrink (or grow, I guess) in measurable steps is
what provides the motivation to proceed. And in reality, the difference
between your highest and lowest interest rate is probably 15-20% or so. Not
enough to make or break you (and if it is too much of a difference, you are
probably on your way to bankruptcy anyways).

P.S. Think of the variable cost savings of stamps and bill paying time!
</sarcasm>

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j_baker
Psychology is the science of the mind. I don't know about you, but I have a
mind. Therefore psychology affects me.

I know, I know. My being a member of HN should make me _above_ psychology. But
apparently it affects _every_ human being. Annoying isn't it?

~~~
dkokelley
Nobody is above psychology, although it affects people differently. However,
as a member of HN I would expect that you would be above psychological hacks
(as in, you can think beyond them, and make decisions based on your own
reasoning, rather than relying on them as a crutch).

~~~
eru
At least in terms of finance. People here may need tricks against
procrastination, though.

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keltex
Fortunately (in this example) the smallest debt usually has the highest
interest rates. Usually people's smallest debt is their credit cards, the next
smallest their car loans, their next smallest their student loans and their
least smallest the home loan.

~~~
joshuacc
Except that most people I know of have multiple debts on most of these
categories.

\- 4 credit cards \- 2 car loans \- 2 student loans \- 1 mortgage

Individual debts don't follow the same distribution as the categories.

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corin_
_Most_ people you know have 9 loans?

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philwelch
9 semesters of college on loans is 9 loans. Sometimes 18.

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corin_
Ah, in the UK you just pick up a single student loan to cover all your
tuition.

Thinking of most people I know whose finances I roughly know about... I'd say
the average is one credit card (probably just $500-$1000 limit, not
neccesarily maxed out, often paid off in full each month), no general loans,
and a mortage and/or student loan depending on their need for them.

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sdz
From an economics point of view, it's basically another way of saying that
wealth maximization is different from utility maximization. While the two are
frequently correlated, it's not necessarily so.

The snowball strategy could be perfectly rational for people who gain more
utility from the small but frequent accomplishments of paying off debt earlier
than they do from maximizing their overall lifetime wealth.

It's not what I would do, but as they say, there's no accounting for taste.

~~~
sudont
I've had this argument with my parents on saving for retirement vs paying off
loans.

It would seem like one would prioritize savings, but due to the variance in
interest, the net gain is in favor of paying off high interest loans vs
building low interest savings.

~~~
dkokelley
It is better mathematically to pay off debt than to save (since debt is
usually costing you more than the opportunity cost of not saving).

Still, from a practical standpoint, you shouldn't put ALL of your disposable
income towards debt, as you will want some sort of emergency fund to keep you
afloat when your car breaks down. Otherwise, you go rely on more debt.
Spending saved money is cheaper than spending borrowed money.

~~~
xenophanes
Assuming you have a credit card, you should pay off all debts worse than
credit card debt, and all credit card debt, saving no money. If your car
breaks down, charge it. It's only if you have a source of debt that's more
pleasant than credit card debt, and which you can't easily get back in case of
a car-breakdown-forcing-credit-card-use that you'd want to save some debt to
keep cash around for emergencies. And even then you'd want to look at the
extra interest you're paying compared with the risk of emergency and the
difference between the interest rates of that debt and your credit card, and a
lot of the time it'll be like (IF i have a car breakdown, which is 5% likely,
then I'll end up paying 5% higher interest on the repair money for a few
months ... this is NOT worth failing to repay some debt immediately which will
cost in interest a lot more than the expected loss of that incident)

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dododo
you can make the snowball strategy be the optimal strategy by simply picking
the right cost function.

optimality entirely depends upon your cost function. so pick the right one and
optimise. the author clearly has one in mind---paying out the least money to
eliminate the debt. but this doesn't seem the right one to me.

for example, i would much rather pay off small debts to friends (which
typically have 0% interest) over larger, higher interest rates to banks,
simply because there's a social cost owing money to friends, whilst it's kind
of the purpose of a bank.

~~~
eru
Also getting phone calls and letters from your creditors are a psychological
cost to most people. The snowball system minimizes the number of outstanding
debts (and thus probably also the number of creditors) the fastest.

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mwexler
Am I only one who was surprised to see not one reference to any research or
proof of his claim? That is, anything that shows a situation where people in,
say, equal debt situations, 1/2 were given snowball, half given pay big ones
first, then measure debt reduction, satisfaction, perception of
accomplishment, etc? Or even just a survey? Anything?

I've heard snowball as a great approach... but without some proof, I wonder if
it truly is "...a problem with an obvious but naive solution". Behavioral
Economics theorizing aside, even one example from a simple survey or academic
study would do much to support his overall point.

Otherwise, his "Many things that don’t look optimal are in fact optimal" comes
into question, and I don't want my silly need for proof to get in the way of
that essential point, which, come to think of it, I firmly believe even
without much proof. But still...

~~~
koepked
I can't offer technical proof, but the snowball method saved me.
Psychologically, getting rid of the easier debts wasn't the biggest factor
though. The increased cash flow from the lack of those payments allowed me to
make payments on larger debts that actually felt like they were making a dent.
That was an awesome feeling.

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xenophanes
The mathematically (but not morally) correct way to deal with big debts is to
figure out how many cents on the dollar they can get back from you with a debt
collection agency and offer them slightly more than that.

~~~
j_baker
If we're ruling out ethics, the optimal approach would be to simply not pay
the debt back.

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amelim
I always find it fascinating how poorly the brain conceptualises various
problem spaces, specifically in math related fields. The Monty Hall problem is
an excellent illustration and just shows how irrationally our minds operate.

~~~
JoeAltmaier
And the lottery. We misestimate probabilities, particularly when they are
extreme (near-certainty and near-impossibility). That gap between how likely
an event 'seems' and its real probability explains the lottery, not wearing
seatbelts, smoking, witchcraft, the monty hall problem...

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seles
Possibly but then you must also consider the psychological effect of
consciously making an illogical decision... which results in habitually
justifying irrational behavior

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JoachimSchipper
I think the people giving this advice know enough psychology to know it works
(defined as: likely to get people out of debt), and enough mathematics to know
it's not optimal.

As to the people in debt: if they always consciously made (suboptimal)
decisions, most of them wouldn't be in debt.

~~~
seles
So the way to overcome conscious suboptimal decisions is to keep making more
conscious suboptimal decisions? That is what I have been doing wrong... stupid
me for trying to change.

Jokes aside, you are probably correct, I have always been torn between trying
and failing to be perfectly rational versus doing suboptimal emotional things.

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InclinedPlane
No, the way to overcome suboptimal decisions is to make _better_ decisions,
even if they aren't fully optimal.

~~~
seles
But it an optimal decision is even better than a "better decision that isn't
optimal"

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araneae
I had three student loans, and I am doing it the mathematically correct way. I
paid off the second-largest with the highest interest rate before it came out
of deferment, and am currently working on 2 and 3, putting all the spare cash
into the one with the biggest interest rate.

It's really not psychologically difficult at all, except it's slightly more
effort to pay two bills each month instead of one (since I could have afforded
to pay off the smaller but lower interest rate one already had I not put that
money into the higher interest rate one.)

~~~
eru
Can't you instruct your bank to automate the paying?

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araneae
Yes, but I'm usually paying more than the payment amount on the high interest
one. How much has to be done manually, since my income fluctuates.

~~~
eru
It would be nice to tell the bank to just pay anything in your account above a
certain balance.

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pjscott
This is a matter of semantics, but if the "mathematically right" answer is
also the wrong answer, than your math is wrong. Either you messed up the
calculations, or (as is the case here) you started off with invalid
assumptions. In this case, the invalid assumption is that you're
psychologically able to do whatever will pay off your debts in the most money-
maximizing way.

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BCGC
The main conclusion is definitely right. You need to take the constraints into
considerations.

However, imo the optimal strategy to pay off debt is to reduce the total
amount of payments whenever you have money to pay after the necessities of
life are taken care of.

Simple :)

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ajscherer
I believe this principle is central to any successful attempt to lose weight.
The physiologically optimal approach to losing weight will fail for most where
a seemingly less effective approach might succeed.

~~~
eru
Could you elaborate?

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xyzzyz
>Clearly the optimal strategy is to pay off the debt with the highest interest
rate first.

Clearly? This is plainly wrong. Let's say we have two debts: $1000 with 0.7%
interest rate and $40 with 0.8% interest rate (these rates are daily).
Assuming our daily salary is $19, having payed off $40 debt first, we will
never be able to pay off the $1000, as the interest exceeds our salary. The
other way around, we pay off $1000 (then $2546.5) debt after 135 days, and
then a week later we pay off $40 (then $128) debt.

It is not the sole interest rate, but the _ratio_ between interest rate and
debt that matters.

~~~
xenophanes
Your math is wrong, and I don't think it's possible to fix it and get the
conclusion you want (because you should think about your total debt, and how
much it goes up each day, when figuring out if you can keep up or not).

The daily interest on $1000 with 0.7% interest is around $7. Waiting a few
days to pay of the smaller debt will not make it exceed $19.

Edit: Were you banning partial repayments? Most debt (I think) is not like
that, but maybe it makes your math work

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xyzzyz
>Were you banning partial repayments?

Yes, I were. If partial repayments are allowed, it is indeed the best
approach.

>The daily interest on $1000 with 0.7% interest is around $7. Waiting a few
days to pay of the smaller debt will not make it exceed $19.

Of course not, but they will exceed $19 before you will be able to pay it off
as a whole -- it will take more than 130 days.

Maybe I should make my statements clearer, so that next time I do not get
downvoted for being misunderstood.

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stukhomsimdrone
When dealing with people mathematical accuracy requires psychological
ignorance.

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binspace
I get more psychological assurance by paying less overall, thus I feel better
paying off the higher interest loan.

