Issue time 9:48 am, by CTreit
Category:personal finance
Spend now, save money later. Finance Theory versus Personal Finance Bloggers
June 29th, 2010A few famous economists proposed the life cycle income hypothesis – it’s that people design their spending around the income they earn during their lifetimes. That is, economists believe that people behave as if they figure out how much it would be if they had in their hands today the total amount of income they’ll earn over all the years they live (also called the present value of their life’s income) and each year they spend the percentage that is the equivalent of one year’s worth of all that money. This thinking explains why young people do not save money but incur debt instead – they expect higher incomes later in life, and expect to pay back the debt then. It makes perfect rational sense, right? Yeah, maybe – but how many young graduates are drowning in student loans with this strategy? I mean, it’s just a theory! It’s not reality, and certainly it’s not reality for everyone!
This theory also (presumably) explains why people save money during their working years. They need some funds when they retire – that will be their income when they stop working. However, savings is a sticky point with the life cycle hypothesis, for a couple of reasons. First, why bother to save if your income is constantly going up? Second, the data about saving concludes that we’re actually not even saving enough! Three out of four Americans have under-funded retirement savings. I guess Americans have not yet gotten the memo about the life cycle hypothesis – they are stuck in the excessive spending pattern!
So, maybe, just maybe this hypothesis is not right after all. Well it’s sensible to think that people don’t work this way. First, think about the calculations that are involved in figuring out the present value of future income streams. Who can even assign a good enough number to his or her income 20 years down the road, forget about every single point in the future? Who can tell what discount rate or interest rate you should use when you want to know what the income 20 years from now is actually worth in today’s dollars? How about what estimate one should use to figure out how long you’ll live? If you end up putting funny numbers into your calculations, your result will necessarily be a funny number and not very reliable. Do you know the mathematical “rule” that says “garbage in(to an equation), garbage out”?
Economists are used to working with such formulas and applying them to human behavior, so they are not very bothered by a problem like this one. They assume that we behave as if we knew the discounted value of our future income even if we don’t know the actual number. For the sake of argument, let’s go along with this assumption, no matter how far fetched it is. Imagine you somehow know that the present value of your average income is $60,000 even when you are making $45,000 right now. Somebody tells you that it is okay to think of yourself as somebody who makes $60,000, because you will, eventually. So, let’s say you are “prudent” – that means you “save” 10% of your average income, or $6,000 and you spend the rest ($54,000). It also means that today, you will be short $9,000 considering your current income $45,000. You obviously have not saved anything. You incurred debt. And since you only actually make $45,000, it’s not going to be easy to pay that off. I mean, that’s one fifth of your income! And if you behave that way every year until you actually make $60,000 or more, you will certainly end up in deep financial troubles. So much for us behaving as if we knew the present value of our life’s income.
I find it amazing that a theory like that became prominent enough that I had to study it in school decades after it was proposed. I remember when the professor was talking about this hypothesis in all seriousness way before I knew anything about personal finances. It was ludicrous to me. My wife, who also has a graduate degree in economics, after a lecture about another theory once exclaimed to her professor, “But you can’t possibly really believe that people actually behave this way!” The professor said, “No, but it doesn’t matter. Economists believe that if these theories well enough approximate how people behave, it’s good enough, whether or not people actually think this way.”
This kind of thinking makes me question other expert advice or opinion, which may very well be based on theories like this life cycle hypothesis. Maybe the experts don’t know so much – maybe the people struggling day to day, just like we are, are the ones who know more. Like personal finance bloggers who are themselves trying to make good decisions without academic theories to guide them!
Okay, I’m going to end here because I now must go and read a few posts from my favorite personal finance bloggers…..
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Issue time 11:01 am, by CTreit
Category:setting up a budget
How to really save money when you spend it
June 24th, 2010Have you heard this one before? “I can save money if I go to the mall during the 4th of July sale.” If you can save money in the mall, you’ve got to explain to me how you do that. Savings, in my book, is putting money away – and the mall is very good at taking your money from you, not holding it for you. While I see a bunch of ATMs in the mall, I don’t think that there are many savings banks. I am sure the ATMs accept deposits, but I have the feeling that this is not the primary activity going on there. Okay, I’m being sarcastic, but it’s obvious that you don’t actually save money if you buy something at the mall. You are spending money there even if you get an enormous discount – so the best you can say is that you spend less, not save. There’s no way you add to your wealth when you spend money.
Or can you?
Well, you can get bargains. If you buy essentials like household items, food, gas, etc, and spend less than you expected or budgeted, surely that’s a good thing! (Just don’t call it “savings”!) Perhaps you can use the difference for personal pleasure – a pedicure, or take-out dinner. But if you actually used the difference to put into your savings account, then it’s savings! Say you need toilet paper and find your favorite brand for $2 less. Take the $2 in savings and add them to your savings jar or transfer them to your savings account. If you do this often enough, these little savings will add up before you know it. (Okay – two things here. First, yes, I’m being a stickler on the vocabulary: it’s not “savings” unless some money actually gets put away somewhere! And second, c’mon, you know we all have toilet paper preferences!)
I’m going to let this post be my incentive to set up such a special savings account to track your savings! This is how I am going to do it. I encourage you to follow suit!
1. I will create a new savings account at ING Direct, where I have some of my savings already.
2. One of the supermarkets where I shop tells me on my receipt how much I save on coupons and on my supermarket card. I will add these savings to my savings account.
3. To keep things simple, I will only use the receipts from this one supermarket that already tells me my savings and where my wife and I shop most of the time for grocery and household goods anyway. I may expand the program to other stores later.
4. I will ask my wife to also save her receipts from this supermarket so that I can include her discounts on her spending in our savings account.
5. I will keep you, the readers of this blog, up to date on the progress of this new savings account regularly.
It may not give you the jollies, but let me tell you that I get excited about trying a strategy like this. I am really looking forward to seeing my savings grow just like I enjoy my pennies pile up in my penny jar. It is not much, but over time even these little savings do add up. Maybe I do something spectacular with the duckets once they’re substantial enough.
Will you join me?
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Issue time 9:32 am, by CTreit
Category:setting up a budget
We save money. Shoppers are catching on.
June 22nd, 2010In “How to find cheap airline tickets” we talk about how we save money when we book an airline ticket. We also complained a little bit. It almost seems like it’s the goal of airlines to lose us in the jungle of prices and policies, because we are totally lost when we try to understand how they price airline tickets. But there’s a good reason for that – pricing is not totally clear, and one reason is a behavioral finance concept called “price frames.”
This is how frames work. One frame lets you know the final price right away, another one, much later in the purchasing process, tells you about fees, monthly subscriptions and things like that. Most times when you’re buying airline tickets, you get two different price frames before you learn how much you’re actually going to spend to buy that seat on that plane.
Here are two common ways frames are presented to a consumer. You’ve run across these, haven’t you? “Drip pricing” at first gives you only part of the price, and then, as you proceed with your purchase, you get to find out the final price. For instance, I once saw a flight to Europe that look like it cost only $320 before I found out that I had to add to that price $400 in taxes. These days you also have to consider factoring in extra fees for luggage. Another frame is the “Limited Time offers” that tell you that you must hurry up to book that flight at that price, because “only 4 tickets are left today.” After today, you should expect a price increase.
A recent study conducted by the UK’s Office of Fair Trade tested these frames and a few others. They found out that we make mistakes when we face such price frames. Here’s one example: we usually don’t shop around enough when faced with “drip pricing,” so we accept the additions to the price as we proceed with our purchase as if these additions were inevitable. (Read our post “How to find cheap airline tickets” to avoid getting suckered in by this one.)
The worst thing about these price frames is that nobody wins in this game. We already know that we tend to overpay with the airline tickets offered at “drip prices.” But it doesn’t look like the airlines gain that much – remember how many recent airline industry bankruptcies we’ve seen? It seems to me that their pricing strategies aren’t doing a whole lot to make for a healthy industry. You would imagine that they abandon the practice at some point, but I would not hold my breath. I put my money instead that they spend a lot of time thinking up something even more complicated than “drip pricing.”
Okay, here’s the good news. The experiments presented in this research paper also show that shoppers catch on to different pricing strategies. It may not happen right away, but they start adjusting their shopping behavior. Yep, it’s just like my wife and I – we have our own air travel buying strategy. “Fool me once, shame on you, fool me twice, shame on me.” I don’t want to be shamed. Would you?
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