The argument was complex and worth reviewing those posts for more detail, here’s the shortest version I give. Because many people simply put a percentage of their salary (say 6%) in a retirement account, it is better to got with a Roth 401(k) over a traditional one… you’ll end up with more money in most scenarios.
Mathematically, I still don’t fully grasp it. However, at the time it was explained to me, it made sense.
The reason it turns out better is “behavioral finance.” Investopedia explains behavioral finance as:
“According to conventional financial theory, the world and its participants are, for the most part, rational ‘wealth maximizers’. However, there are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways.
Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.”
Maybe that definition isn’t exactly fitting of the situation, but it seemed like the idea was to tell people to go with Roth 401(k) because in general circumstances it will turn out better.
I’ve never been a fan of such financial generalizations. At the time, I cited people who give the advice, “Cut up all credit cards.” It makes me cringe because I use credit cards to save thousands of dollars a year and never pay a finance charge. I also don’t spend more money, because it is “less painful” then spending cash. To me it is exactly the same.
On one hand, I want to say this behavioral finance stuff is terrible. Instead let’s just educate people so that they can be ideal “wealth maximizers” (love that term). If we show people how to make great financial decisions, they’ll be better served in the long run.
On the other hand, I want to say, behavioral finance could be useful. It’s easy for me as someone who blogs about personal finance on a daily basis to say, “let’s teach people.” However, I think there are a lot of people who are ummm, well too Lazy (in the bad sense), to learn. Maybe they are preoccupied with some of life’s other problems. So for those people, maybe just telling them what to do is the right thing?
You may be able to tell that I’m leaning towards behavioral finance being bad. I think people should learn all they can about how their money works from a mathematical view. It’s okay to point out the psychological pitfalls, but I don’t think that should be the horse that pulls the wagon.
What do you say? Let me know in the comments.