Monday, April 17, 2006

Reference points, and their relevance to personal finance

A lot of my friends work on Wall Street, and often get ridiculed for casually saying stuff like "My bonus was only X, but Biff got 3X!" (Actually, that's an utter lie -- my friends on Wall Street are far more likely to be named Adil, or Moishe.) They, and people like them, get pilloried in the press for making such claims on 6, 7, 8 or even 9 figure amounts when there are millions of people barely able to subsist on their limited incomes. Sadly, their anger and unhappiness are probably attributable to core psychological issues that lock in everyone from hedge fund traders in NY to poor students in CA to small farmers in IA.

A caveat about Wall Street -- the very nature of trading jobs argues for either picking someone else off, or being picked off yourself on virtually every trade -- the signal sent by smaller bonuses is basically your boss telling you, we're paying you just enough to make you somewhat unhappy, but we know you're not good enough to go elsewhere. In fact, I would suspect that the equilibrium bonus strategy is just that -- pay enough so the trader is somewhat unhappy, but unwilling to take on the switching costs of looking for a new job. Thus, the complaint is not so much that compensation is inadequate for one's lifestyle (well, actually, there are a lot of spendthrift traders making trades, like buying cartel-ized, obnoxiously large diamonds rings that lose 95% of value immediately after purchase, in essence doing trades that they'd kill themselves for making on the job -- unless girls that materialistic are still someone worthy of partnering with/they're thinking of it as a blatantly mercenary trade to get access to her trust fund/she needs it as a signal for the bitchy, elitist people she has to interact with at work, etc), but that one is getting picked off on a huge trade (basically, most of one's personal PNL -- profit and loss -- for that year).

But back to reference points -- there was a survey of college students that basically demonstrated that the vast majority would rather make $50,000 when everyone else working with them made $25,000, than make $100,000 when everyone else made $200,000. (Implicitly, the rest of the economy, purchasable goods per $ of your money, stayed the same, though I'm not sure if all interviewees realized this.) Also, multiply all those numbers by some factor 1/X to get the actual survey. (For more on behavioral economics in a relatively easy-to-read format, check out Colin Camerer's paper, page 16 for reference points in particular.)

Before you lambaste these Ivy-degreed idiots, think about it -- do you measure your happiness by comparing your lot to that of your ancestors 500 years ago, or people living without electricity and telephones in rural 19th century America? Do you actively think about how much better off you are than people starving in Biafra? If people on average did so, then also on average, people's happiness should be rising roughly proportional to pre capita GDP growth (which is ex-growth via population increases), deducting some amount for how much more hurried their lives are due to work, knocking some more off for greater income inequality levels, number of hours worked on average (which in many countries, has gone down significantly over the last few hundred years), etc. Nope -- surveys demonstrate that without fail, people instead seem to look at coworkers, neighbors, friends, when judging personal happiness levels. This applies across history, ethnic groups, countries, even different zip codes w/radically different median income levels. Even if they resist trying to keep up w/the Joneses, people still feel worse for not doing so, whether the Joneses are Park avenue socialites, or mobile home dwellers.

Consumption creep is made even more difficult to resist because the average person also references himself or herself for comparison -- that is, we examine recent consumption levels when internally deciding how happy we should be. How many people, after getting out of college and getting a good job, still gorged themselves on free food every chance they got (not realizing that given their income levels, they should have been considering the health effects/maybe even the poor quality of most catered food)? And how many of that set of people, end up spending the bulk of their salary on fast cars, cool gadgets, and expensive food just a few months later?

Some people do resist reference-point based consumption, and I commend them for it. As much as possible, I try to do so by deliberately not ratcheting up my spending, trying to ignore conspicuous consumption, even avoiding knowledge of certain categories of consumption that I'd never previously known about or considered, and so on -- I may have it easier than most people, since I've always been an appreciated of iconoclasm (at least w/regards to consumption and common wisdom, and not necessarily broad social norms -- well, OK, maybe a fair number of social norms as well). Either that, or as my girlfriend puts it, while I may appreciate many luxury goods and many of the nicer things in life if they were free/cheap, I have insanely low minimum thresholds for almost anything (optimization along the lines of 1.Is it healthy 2.Is it tolerable physically 3.Is there anything cheaper that satisfies 1 and 2?).

Perhaps my only luxury is food, but even there, I avoid alcohol (which greatly caps total restaurant spending unless one is a sumo wrestler), I focus on tastiness rather than trendiness, and deliberately and gradually dole out visits over long timeframes to the famous, expensive restaurants that I could afford to go to, and instead go to what in my opinion are equally good, occasionally even better, but underrated restaurants. I add value, or at the very least, self-perceived value by becoming a quasi-regular at the least flashy/most welcoming restaurants that are above a high threshold of quality, and reap the benefits in the form of tasting menus that feature things not even remotely hinted at on the menu (or else, this strategy might also suffer from lack of novelty).

Short of radical steps, like
-moving to Buffalo County in South Dakota, home of the Crow Creek Indian Reservation, which had the lowest median income in the US (at $17,003)
-telecommuting to your original job since a)jobs in that zip code are clearly limited, and b)you want to avoid seeing the consumption of your coworkers
-from time to time, resetting your references by deliberately eating very bland/disgusting but healthy food for several weeks at a time (not that high end restaurants will be very relevant if you're living in the poorest area in the country)
one can still take less radical, but effective steps to limit consumption creep.

Sure, every blogger always says, you should just save more money and spend less, and so on and so forth. The behavioral economist would probably ask people to come up with actions today that bind your future self to such actions -- that is, make it very difficult to spend, even if you wanted to do so at some point in the future. Such innovations in the field of retirement accounts, for instance, will probably make a huge difference in total welfare of numerous individuals over the next 50 years.

I think the essential evaluation is frank and hardheaded evaluation of just how forward looking you are, how disciplined you are, and how overall, how much delayed/discarded gratification you're willing to take on. One person might be able to get 0% APR for 12 months credit cards, remember all the fine print, spend no more than s/he would otherwise, and eke out a nice implied 5% return on the money. Another person might get the same deal, spend crazily, forget a payment, not realize that this rachets his/her APR up to 20%, and also forget that the card doesn't provide free money -- just a roughly 5% implicit return (depending on how quickly it gets maxed out). Whenever you see a cool idea or gimmick, make sure to think about the net effect of that object on your entire finances, and not just think about it in isolation. If coupons end up making you buy far more perishable foods than you should, they're not saving you money. Overall, if you do things that make it more difficult to spend (eg, keep credit cards for your credit score, but always leave them at home unless there's a special promotion you need one for), you'll probably win out over the long run (unless your response to temporary deprivation is consumerist binging thereafter...).

1 Comments:

At 4/21/2006 7:12 AM, Blogger Miserly Bastard said...

I find the comment somewhat off-putting, but recently I heard "$1M is the new $100,000", and there is some truth to this. But NYC money values are totally screwed up.

 

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