Tuesday, October 27, 2009

Oh behave!

Good news coming out of Washington! Apparently there is no inflation and things aren't costing more.

What? Does anyone in Washington purchase their own food, gasoline or healthcare? I forgot - those expenses are covered by lobbyists.

On a serious note, the CPI is down about 1.3% compared to a year ago, meaning that goods or services that cost you $10 a year ago now cost about $9.87. So what's the real story?

Behavior finance and economics suggests that most consumers feel pain more vividly than they feel joy. Basically, we like to avoid losing money more than we like making the same amount of money, even though 'old school' economics teaches us that consumers seek to maximize their pleasure, or 'utility.'

Former Wimbledon champion and tennis great Ivan Lendl perhaps said it best when he was quoted saying "I hate losing more than I like winning." Remember, this is coming from a guy who used to win all the time.

We drive around searching for gas that is $2.72 per gallon instead of $2.75, but won't cross the street for cheaper gas that's $2.08 instead of $2.11. Why? It's a better bargain in the second scenario, after all.

The applications for the economy are far-reaching. We see gas prices going up, but forget that they are down 30% from a year ago. That doesn't offset the 29% increase in prices of fuel over the past six months. We have short term memory, and the figures seem to support behavioral theory. Consider the following (yes, I'm keeping the math simple because it's early and my brain isn't working too well yet)

Assume that gas a year ago cost $3.00 per gallon. A 30% drop in fuel would mean that gas costs $2.10. WOW! That's signficiant. Oops. Now gas goes up 29%, resulting in a new cost of $2.71. Yikes! That hurts, even though it's still less than the original starting point of $3.00.

The same calculations can be applied to the stock market. Assume your retirement plan had $50,000 a year ago and the market lost 25%. You'd be down to $37,500. It takes a 35% gain this year to get back to square one. Sadly, this is what's been going on with investments the past two years, creating opposition to something called the wealth-effect. In short, if consumers feel wealthy (good returns on their 401k, appreciating values on their homes, lower unemployment figures, etc.) they are more likely to spend. There hasn't been much good news or even 'paper returns' to allow consumers to feel wealthy - even a nice return in the market the past six months.

To further support this 'behavioral stuff,' as my wife calls it, consider an even-money bet. Let's say I flip a coin and we bet $1. If it comes up heads, I win $1 from you. If it comes up tails, you win $1 from me. Easy enough? We know that most people would take the bet. What if I won two straight times? Three times in a row? How about four or five?

What if I make the bet $10 per flip, or even $50? At what point do you jump off and act out of 'fear' rather than rationality? We allow the dollar amount to skew our ability to judge. Don't worry, I'm guilty of this too. Studies have shown that when the bet goes to $100 per flip, most folks would demand payment of $160 if they win. I'm not about to take the other side of that bet anytime soon, by the way.

See what I mean? We're easily tricked by math and to be frank, it stinks. I fall for it all the time and I study this junk!

So sit back, relax and take consolation in the fact that you are paying less for things today than you were a year ago while you're driving around looking for the cheapest gas station around.

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