Economics Dilemma

[aggle-rithm]

My wife and I were having a discussion yesterday about friends of ours who are up to their eyeballs in debt and are frantically trying to sell their house before it gets foreclosed upon. They are hoping to make a $6000 profit on the sale, after which they intend to go on a "spending spree" to celebrate.

They have $40,000 in credit card debt.

The conversation turned to the fact that people in general do not have much sense when it comes to money, and often make irrational decisions. I told her about the study that demonstrated that if people were given the choice between $100 today and $101 tomorrow, most people would wait a day. However, if they were offered the choice between $100 today and $101 NEXT YEAR, they would take the lesser amount. This, I told her, is an irrational decision because the amount of time elapsed is irrelevant. It's MORE MONEY. MORE MONEY is worth more.

She disagreed, saying that the dollar might be devalued in that year. "Assume the dollar stays stable," I suggested. She said she could put the money in a savings account and earn more interest that $1.00. "Really?" I said. "You get a $100 windfall and you're going to put it in savings? That would be somewhat out of character for you."

Finally, she said she would want more than one dollar as compensation for having to wait a year. I pointed out that "waiting a year" isn't really a chore; that year is going to elapse whether she gets the money or not. She insisted that it WAS relevant, because a year is a long time to wait to get the money.

I can see that she SOMEWHAT has a point, since banks do compensate people for using their money, since they do not have the use of that money while the interest is accruing. However, the reason this system works may be that people are irrational in the first place and believe that not spending money over time should garner some kind of reward.

So who is being irrational here?

 

[The Don]

IMO neither of you are being irrational so long as you've stipulated that the $100 becomes $101 in real terms in a year (otherwise inflation may wipe out the gain and the thing you could buy for $100 today will cost $102 in a year).

You're certainly not being irrational, waiting a year for $101 (or with U.K inflation it's $104) does represent more money.

Then again the $101 may not properly compensate you for the opportunity cost. If you has a super-duper investment which would yield a 100% return in a year, clearly you;d be better off worth the $100 now - clearly a ridiculous example. Another view of opportunity cost would be that if I had the $100 now I could go out and buy a new guitar which I could enjoy for the next year, $1 would not compensate me for that lack of enjoyment.

 

[Doubt]

Money has a time value. Given a choice between 100 today and 101 in a year I would take the 100 now because I am pretty sure I can beat a 1% yearly ROI.

Also, it is not irrational to think that not spending money should garner a reward. But only if you do something to make the money work for you.

 

[Tippit]

The conversation turned to the fact that people in general do not have much sense when it comes to money, and often make irrational decisions. I told her about the study that demonstrated that if people were given the choice between $100 today and $101 tomorrow, most people would wait a day. However, if they were offered the choice between $100 today and $101 NEXT YEAR, they would take the lesser amount. This, I told her, is an irrational decision because the amount of time elapsed is irrelevant. It's MORE MONEY. MORE MONEY is worth more.

She disagreed, saying that the dollar might be devalued in that year. "Assume the dollar stays stable," I suggested. She said she could put the money in a savings account and earn more interest that $1.00. "Really?" I said. "You get a $100 windfall and you're going to put it in savings? That would be somewhat out of character for you."

Finally, she said she would want more than one dollar as compensation for having to wait a year. I pointed out that "waiting a year" isn't really a chore; that year is going to elapse whether she gets the money or not. She insisted that it WAS relevant, because a year is a long time to wait to get the money.

I can see that she SOMEWHAT has a point, since banks do compensate people for using their money, since they do not have the use of that money while the interest is accruing. However, the reason this system works may be that people are irrational in the first place and believe that not spending money over time should garner some kind of reward.

So who is being irrational here?

You are. Time preference is one of the most basic economic concepts. Most rational people would prefer to consume or acquire goods now rather than later. The decision of whether to spend or invest (or "save") money depends on a given rate of return associated with the investment or savings. A 1% nominal rate of return, as described in your example, isn't nearly enough to compensate you for your loss of purchasing power by actually saving dollars, so not only would you be forgoing the enjoyment of a purchase not made, but you would be ending up with less purchasing power in the future. Not a good deal, to say the least.

I suggest you let your wife handle the finances.

 

[Spindrift]

If you don't do anything with the $100 then yes wait a year otherwise it's very rational to take the money now.

There are lot of things that you can do with the $100 that will be more beneficial than waiting a year to get an additional dollar.

Buy something. The price might be higher next year.

Put towards credit card debt.

Put towards mortgage principal.

Add it to an investment account.

Even if you're going to piss it away, why wait a year? Another dollar isn't going to make much difference in what you piss it away on.

 

[aggle-rithm]

I suggest you let your wife handle the finances.

This suggestion would really make her day.

 

[aggle-rithm]

Money has a time value. Given a choice between 100 today and 101 in a year I would take the 100 now because I am pretty sure I can beat a 1% yearly ROI.

Also, it is not irrational to think that not spending money should garner a reward. But only if you do something to make the money work for you.

I'll have to look up that study and see how the question was phrased. It could be there were conditions that ensured that there was no real difference between waiting a day and waiting a year.

 

[Pup]

I can see that she SOMEWHAT has a point, since banks do compensate people for using their money, since they do not have the use of that money while the interest is accruing. However, the reason this system works may be that people are irrational in the first place and believe that not spending money over time should garner some kind of reward.

As others have noted, it's all about the time value of money, based on risk vs. reward.

It would be irrational to put my money in a hypothetically perfectly safe hiding place, come back in a year, and expect to be rewarded. I might even be willing to pay to have my money guaranteed safe--hire an armed guard, buy a fire-proof safe, etc. Safety has value.

But people are usually a little more ambitious than that, because they can use money to make more money. In general, the higher the risk they take with the money, plus the more effort they invest, the higher the reward.

Somebody might want to take the risk of investing their money in a small business, running it, and hoping to turn it into the next Microsoft. High risk, high potential reward. That's a potential option for anyone with money.

But let's say someone doesn't want to put in that much risk or work. So they just loan their money to an entrepreneur, agreeing to a fixed interest rate (less potential reward) and a contract that they can repossess all his office equipment if he doesn't pay (less work--just write up a contract and come back to collect in a year--and less risk because they've got first dibs on his stuff even if he goes bankrupt).

Let's say someone doesn't want to take even that much risk or effort, because they don't want to find this entrepreneur, pay a lawyer to draw up the contract, sell a bunch of office equipment to get their money back if he fails, etc. So instead, they give their money to a bank which offers a lower interest rate (less reward) but FDIC insurance and a safe reputation (less work--just make a deposit--and less risk). the bank then takes the risk of loaning to the entrepreneur.

It's rational to expect some compensation for not using your money if you're taking the risk of letting someone else use it.

 

[Ziggurat]

So who is being irrational here?

You're both being rational. It's just that you're wrong and she's right.

Well, more accurately, she's more right than you. There's a concept often referred to as a "discount rate", basically the idea that the value to you now of something that will happen in the future is discounted based on how far in the future that event is. The rate indicates how fast that value should change with time.

You're basically assuming a discount rate of zero, and your wife is not. You can assign whatever discount rate you want for yourself, but 1) a zero discount rate is not how most humans behave, and 2) there are logical reasons for choosing a nonzero discount rate.

For example, there's a nonzero chance that you will not be alive in one year's time. So the present value of $100 in a year should be reduced to account for that risk, since if you die, that $100 becomes worthless. Then there's the fact that, as your wife points out, money today can be invested, so it's illogical to set a discount rate lower than the interest you can get on a treasury bill. And then there's the fact that we aren't quite the same people over time. Although it's based upon subjective feelings, it's still logical to take into account that the present you may value the comfort of the present you more than the comfort of the future you. So this can also contribute to a discount rate.

Now, it's true that many people are illogical about the topic in the sense that they will forgo future returns for immediate payoffs even if the returns are higher than the discount rate they would accept . And we also tend to think that people who demand exceptionally high discount rates are irrational as well. But the basic idea of a discount rate? It's both logical and sensible.

 

[The Central Scrutinizer]

My wife and I were having a discussion yesterday about friends of ours who are up to their eyeballs in debt and are frantically trying to sell their house before it gets foreclosed upon. They are hoping to make a $6000 profit on the sale, after which they intend to go on a "spending spree" to celebrate.

They have $40,000 in credit card debt.

The conversation turned to the fact that people in general do not have much sense when it comes to money, and often make irrational decisions. I told her about the study that demonstrated that if people were given the choice between $100 today and $101 tomorrow, most people would wait a day. However, if they were offered the choice between $100 today and $101 NEXT YEAR, they would take the lesser amount. This, I told her, is an irrational decision because the amount of time elapsed is irrelevant. It's MORE MONEY. MORE MONEY is worth more.

She disagreed, saying that the dollar might be devalued in that year. "Assume the dollar stays stable," I suggested. She said she could put the money in a savings account and earn more interest that $1.00. "Really?" I said. "You get a $100 windfall and you're going to put it in savings? That would be somewhat out of character for you."

Finally, she said she would want more than one dollar as compensation for having to wait a year. I pointed out that "waiting a year" isn't really a chore; that year is going to elapse whether she gets the money or not. She insisted that it WAS relevant, because a year is a long time to wait to get the money.

I can see that she SOMEWHAT has a point, since banks do compensate people for using their money, since they do not have the use of that money while the interest is accruing. However, the reason this system works may be that people are irrational in the first place and believe that not spending money over time should garner some kind of reward.

So who is being irrational here?

You.

 

[The Central Scrutinizer]

Well, more accurately, she's more right than you. There's a concept often referred to as a "discount rate", basically the idea that the value to you now of something that will happen in the future is discounted based on how far in the future that event is. The rate indicates how fast that value should change with time.

This is basically the foundation of successful investing.

 

[aggle-rithm]

I'll have to look up that study and see how the question was phrased. It could be there were conditions that ensured that there was no real difference between waiting a day and waiting a year.

Ugh, here's the problem: I got the experiment totally wrong. Here is how it was worded:

"Would you prefer a dollar today or three dollars tomorrow?" or "Would you prefer a dollar in one year or three dollars in one year and one day?"

More people would take the dollar today than would take the dollar in one year. The waiting time makes us see ourselves as being some different person that has more patience. It's called present-bias.

So, I got it completely wrong. The irrationality was mine in believing that my faulty memory of the study represented some lofty truth, then sticking with that belief in spite of myself.

 

[The Don]

Looking at the anecdote in the first part of the OP....

My wife and I were having a discussion yesterday about friends of ours who are up to their eyeballs in debt and are frantically trying to sell their house before it gets foreclosed upon. They are hoping to make a $6000 profit on the sale, after which they intend to go on a "spending spree" to celebrate.

They have $40,000 in credit card debt.

Different people have radically different approaches to spending and investment.

We have very good friends who have lived in their house for 15 years, have an interest only mortgage and yet have never paid a penny off the principal on that mortgage preferring instead to live an extravagant (to us) lifestyle.

About 3 years ago he (who accounted for 80-85% of the earning power) was laid off in his mid 50s. They were of having to sell their house (due to house price inflation, the mortgage which was 100% is now maybe 30% of the value of the property) and downsizing so they could be mortgage free. As it turned out he managed to start a spectacularly successful business which is currently generating profits of £200k+ a year. His response after the first year was not to pay off the mortgage but to buy himself an £50k Audi R8.

We, on the other hand have always striven to pay off any outstanding debt and save, save, save. As a consequence we have relatively cruddy old cars and a comparatively modest (although by any normal standards very comfortable) lifestyle. We have enough ready cash to last maybe 10 years at our current spending rate (though if there was no income from the business we could economise and stretch that to 15-20 years) plus we could afford to pay ourselves at our current rate for around 10 years from the cash surplus in the business.

We think that they're very irresponsible to live the way that they do (especially because they have two teenage daughters who need to be provided for) but that's the way they have chosen to live, spend now, worry later (if at all). I'm sure they look at us in bewilderment wondering why we don't have fancier cars, flasher holidays or newer furniture.

Of course if everyone was as spending averse as we are, the economy would grind to a halt.

 

[timhau]

Of course if everyone was as spending averse as we are, the economy would grind to a halt.

I suppose so. Still, I don't understand people who voluntarily live from paycheck to paycheck. We've done that, back in the early 1990s when I graduated right into the worst recession Finland has faced as an independent nation and was happy just to have any job that actually paid a salary while my wife was finishing her MA. We didn't much like it, so we made sure that when our income picked up (my wife eventually got a full-time job and I moved up to a better one), our expenses didn't immediately follow. I much rather have a small 6-year-old car and a degree of financial independence to a new BMW, designer furniture with zero savings and an income that just barely covers my lifestyle.

 

[Pup]

Ugh, here's the problem: I got the experiment totally wrong. Here is how it was worded:

"Would you prefer a dollar today or three dollars tomorrow?" or "Would you prefer a dollar in one year or three dollars in one year and one day?"

More people would take the dollar today than would take the dollar in one year. The waiting time makes us see ourselves as being some different person that has more patience. It's called present-bias.

That's amazing. I'm surprised that most people wouldn't wait one day for three dollars, whether the wait is now or a year from now.

If it were the somewhat tougher choice of $1 today vs. $3 in a year, I'd expect more people to want the dollar today, even though that's tripling your investment. Based on pure economics, you should wait the year and triple your money, but I wouldn't see it as irrational to take the dollar now, because the potential return is only $2.

Is it really worth $2 to remember for a year that you're supposed to get a payment from somebody who might forget or might die or deny he owed it, and if he didn't pay, getting $2 wouldn't be worth the hassle of even a small-claims court suit. I think rationally, for the time and risk, $1 right now would be more rational.

If it were $1,000 today vs. $3,000 in a year, waiting for the $3,000 would be a more rational choice, because you'd be compensated $2000 rather than $2 for the same risk and trouble.

 

[timhau]

If it were the somewhat tougher choice of $1 today vs. $3 in a year, I'd expect more people to want the dollar today, even though that's tripling your investment. Based on pure economics, you should wait the year and triple your money, but I wouldn't see it as irrational to take the dollar now, because the potential return is only $2.

I have to agree with that sentiment. I know a guy who inherited €10,000, decided to save it for now and went through quite a bit of trouble to find the best interest rate for a CD. He then claimed that the trouble was well worth it, because he eventually got a much better rate than the one offered by his regular bank -- the interest rates were generally just above 1%, but one bank offered nearly 1.5%, almost 40% more than the second-best offer which was from the bank where he had his regular account. That sounded pretty nice, until a certain killjoy reminded him that his troubles had actually netted him an after-tax extra income of about €30.

 

[Ziggurat]

That sounded pretty nice, until a certain killjoy reminded him that his troubles had actually netted him an after-tax extra income of about €30.

Reminds me of various "free trial offer" deals. My credit card company would offer me some service for something like two or three months for free, and I could quit any time, no obligation. Hey, it's free, why not take it? Well, my time and effort aren't free, and the hassle of dropping the service before it rolled over automatically to paying for it meant that signing up simply wasn't worthwhile.

 

[blutoski]

If it were the somewhat tougher choice of $1 today vs. $3 in a year, I'd expect more people to want the dollar today, even though that's tripling your investment. Based on pure economics, you should wait the year and triple your money, but I wouldn't see it as irrational to take the dollar now, because the potential return is only $2.

I don't think that's true. ROI is compared in timeframes, usually recalculated for 1yr annualized. In this example, the person has 1% return in one day, they can turn around and reinvest it. In the real world, nobody turns off the investment machine. If this 1% return machine remains functional tomorrow and the next day, they have made over 3% in 3 days instead of 365 days. If it's active every day over the next year, I believe the return from daily reinvestment is $37,683.43 in the same timeframe that sitting on it would have yielded only $3.

So it's not just impulsiveness that biases earlier returns - it's the potential for greater long-term returns.

Is it really worth $2 to remember for a year that you're supposed to get a payment from somebody who might forget or might die or deny he owed it, and if he didn't pay, getting $2 wouldn't be worth the hassle of even a small-claims court suit. I think rationally, for the time and risk, $1 right now would be more rational.

If it were $1,000 today vs. $3,000 in a year, waiting for the $3,000 would be a more rational choice, because you'd be compensated $2000 rather than $2 for the same risk and trouble.

I took the dollar values to be more about percentages, but I think it's difficult to interpret the survey anyway. In reality there's very few situations where "all things being equal" conditions take place. Postponed earnings are almost always riskier earnings, so deserve a risk premium. There is also an opportunity cost (what alternative investments are being locked out?) Increasing the yield by 200% while postponing the committment by 36,400% may be too cheap, even an inflation rate of zero.

Because of that, it may be that the survey was detecting people's rational instinct and that a 1% next-day return could be rationally and economically preferable to a 3% annualized return.


Having said that I think that once the mathematical equalization has been worked out, the basic psychological conclusion of the study might still hold... that postponement of reward may devalue it more than raw mathematics dictate. That immediate gratification has enhanced value from an emotional factor.

But it's hard to tell with that particular study, since we don't know the baseline economic risk premium caused by 364 days extra delay.

 

[Pup]

I don't think that's true. ROI is compared in timeframes, usually recalculated for 1yr annualized. In this example, the person has 1% return in one day, they can turn around and reinvest it.

I'm not following. In which example is the person getting a return of 1% a day?

In the two choices in the survey Aggle-rithm quoted, one gives a 300% return in a day and the other gives a strange choice: a 300% return in a day, but only for one day, a year from now.

In the example I gave, $1 becomes $3 in 365 days, about .3% per day.

Assuming the returns were repeatable, either a person could make the astronomical profit of tripling their money every day--clearly not sustainable without soon owning the universe--or else they could triple it every year.

If this 1% return machine remains functional tomorrow and the next day, they have made over 3% in 3 days instead of 365 days. If it's active every day over the next year, I believe the return from daily reinvestment is $37,683.43 in the same timeframe that sitting on it would have yielded only $3

According to my calculations, if a person invested $1 and got a return of 1% a day, and kept reinvesting the profits at the same rate, they'd have $37.78 at the end of the year.

 

[Puppycow]

Looking at the anecdote in the first part of the OP....



Different people have radically different approaches to spending and investment.

We have very good friends who have lived in their house for 15 years, have an interest only mortgage and yet have never paid a penny off the principal on that mortgage preferring instead to live an extravagant (to us) lifestyle.

About 3 years ago he (who accounted for 80-85% of the earning power) was laid off in his mid 50s. They were of having to sell their house (due to house price inflation, the mortgage which was 100% is now maybe 30% of the value of the property) and downsizing so they could be mortgage free. As it turned out he managed to start a spectacularly successful business which is currently generating profits of £200k+ a year. His response after the first year was not to pay off the mortgage but to buy himself an £50k Audi R8.

We, on the other hand have always striven to pay off any outstanding debt and save, save, save. As a consequence we have relatively cruddy old cars and a comparatively modest (although by any normal standards very comfortable) lifestyle. We have enough ready cash to last maybe 10 years at our current spending rate (though if there was no income from the business we could economise and stretch that to 15-20 years) plus we could afford to pay ourselves at our current rate for around 10 years from the cash surplus in the business.

We think that they're very irresponsible to live the way that they do (especially because they have two teenage daughters who need to be provided for) but that's the way they have chosen to live, spend now, worry later (if at all). I'm sure they look at us in bewilderment wondering why we don't have fancier cars, flasher holidays or newer furniture.

Of course if everyone was as spending averse as we are, the economy would grind to a halt.

These friends of yours, are they grasshoppers?