Financial decisions are about balancing risk and return

The point of considering all of your debts and assets in a single portfolio is so that you can more easily make decisions around financial tradeoffs.

For example, are you better off:

– Paying off your student loan or putting more to your retirement?

– Selling your savings bonds to pay off your student loans?

– Renting an apartment or taking a loan to buy a house?

– Putting your bonus towards retirement or in your savings account?

There are many considerations in these decisions besides financial, but from a financial perspective they all come down to risk and return.

Comparing assets is usually fairly straightforward. If the stock market is high risk but pays 11% a year on average, and your savings account is very low risk but pays 1% a year on average; you can compare these two options in the context of how much risk you are willing to take on; how much risk you already have in the portfolio; and how long you have until you need the money (because the longer the time frame, the more time you have to recover if the return goes south).

It’s less intuitive, but you can also compare debts and assets in the same way. Most of your debt will likely have a fixed interest rate, in which case it effectively has zero risk – the rate is the rate is the rate. Some debt instruments are variable and do have a risk associated with the rate going up. Either way, comparing assets and debts is the same as comparing assets to assets.

Consider this. What is the difference in putting $100 towards an investment that returns 2% a year vs putting $100 towards a loan with an interest rate of 2% a year? Of course the financial impact is exactly the same. In the first case you earn $2.00 and in the second case you save $2.00. Either way, you are better off by two dollars. When you make financial decisions, it is wise to always anchor back to the fundamental concepts of risk and return.

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