Monday, September 21, 2009

A Pearl of Great Price

My wife and I have been house shopping for most of this year. It's an interesting experience. How many things in your life do you buy that cost over $100,000 and take over a decade to pay for? The process is exactly what you'd expect of a six digit purchase-- exciting, intense, stressful, and a bit scary. The whole thing is making me rethink my basic economic mindset.

If you go to a store to buy something you think will cost $100 and it actually costs $110, more likely than not you'll buy it anyway. Presumably you went there because you needed it. Driving around hoping to save $10 probably isn't worth the time. And even if an economist's equations state the value of time is worth it, most people just won't bother.

But think in terms of a house. If you plan on spending $200,000 and the house you want actually costs $220,000, what do you do? $20,000 is a lot of money, and even if you're willing to pay it, you might not qualify for the higher mortgage.

There was an interesting study done on how price changes affects willingness to buy things. In an experiment, they presented some people with this situation:
You have decided to buy a full package vacation to Hawaii. The price is $2000. But when you sign up to pay, the price has dropped to $1600. Do you still buy it?
Obviously everyone still does. Keep in mind that $1600 is a pretty good deal for a full package vacation. Then they gave people a different situation, with only the prices changed:
You have decided to buy a full package vacation to Hawaii. The price is $900. But when you sign up to pay, the price has increased to $1200. Do you still buy it?
Overwhelmingly people in this situation will not buy the vacation, despite $1200 still being an amazingly cheap price. For some reason, we as humans get fixated on the relative differences between prices. We approach the situation as, "If I buy the $1200 vacation, I will have to give up $300 in other things I wanted to get." It doesn't matter that we can't think of what those things are, nor that $1200 is still a great deal. It's just that by comparison, the option that is no longer available is superior. People would rather choose nothing than accept the feeling of a loss.

Note that this is distinctly different from the traditional economic view of humans as rational consumers. Economics is on the assumption that humans rationally choose things that maximize utility, the benefit the consumer gets from consumption.

Suppose someone values a vacation to Hawaii as being worth up to $2000. That is, if given the choice between gaining $2000 and gaining a vacation to Hawaii, they would have no preference between them. For any value above $2000, they would prefer the money, and for values below $2000, they would prefer the vacation. According to economic theory, this person would have bought both the $1200 and the $1600 vacation in the experiments above. But the experiments prove that this is not how humans operate. At best, humans act semi-rationally. And the extent of "semi" is up for debate.

For me, this is the hardest thing about house shopping. I realize it's in my best interest to act like the rational economic consumer. I want to act that way, but my brain isn't wired like that. There is this concept of "fair market value" for a house, which essentially means, "what everyone else thinks someone else will pay". But as what prices people will pay depends on the relative context of other prices, the fair market value is at best a hazy estimate.

What I'm learning is that while fair market value might affect whether a bank will give you a mortgage, it shouldn't affect your buying decisions one bit. Yet it's human nature to think it matters. Buying a house for $200,000 with a fair market value of $220,000 doesn't make sense if the house doesn't provide $200,000 worth of value to you. If it isn't the right size, in the right neighborhood, and so on, don't buy it even if it's theoretically a good deal.

Fair market value doesn't tell you whether you'll enjoy your purchase. At best it tells you what kind of bargaining the seller might accept. When you compare prices to fair market value, you are making the same mistake that vacationers face with the $1200 Hawaii vacation. You are comparing an option available to you ($1200 or the seller's asking price) to an unavailable option ($900 or the "fair market value"). That's not a good basis for making financial decisions.

The rational choice is to compare the seller's asking price to prices from other sellers. Suppose you like a place but the seller wants $240,000 for it. Compare it to other available homes with similar features. If the next best option costs $260k, then $240k is good deal, fair market price be damned. And that's doubly true if you haven't found any suitable alternatives.

It's easy to fall into the trap of thinking of financial success means maximizing your money. Money is only as useful as the things it can buy. It's better to make decisions that maximize the number of things you want to have. It's true that saving money is the best financial decision the vast majority of the time. But when you find what you're looking for, be willing to pay whatever you can afford to get it.

Monday, September 7, 2009

Being Mr. Right

I've been happily married for the past nine years, and we dated over four years before that. Like everyone, we've had ups and downs, but the experience has been overwhelming positive. We have very much grown together. We complement each other well. Not everyone has the same experience, however. I'm conscious that our happy marriage is in large part because of the effort we've put into it, not because "we're so totally in love" or "we're perfect for each other". Those things are true, and they're required for a successful marriage. But neither being in love nor being compatible are sufficient. Contrary to popular opinion, love isn't all you need. If you want your marriage to be a success, or any relationship for that matter, it helps to understand the purpose of that relationship.

When we were teenagers, my brother said something really insightful to me:
Americans don't get divorced when they fall out of love. They get divorced when it's less trouble than staying married.
His point was that many people stay in unhappy marriages because to them, it's better than being alone. But ultimately he's hinting at a rather pragmatic view of marriage. There's so much description of marriage in terms of love and everlasting commitment, but I think that glosses over this simple fact:

People get and stay married because it improves their life.

Simply stated, people think they are happier married than single. The list of common causes for divorce looks strikingly like common causes for depression:
  • Financial trouble
  • Child raising issues
  • Sexual incompatibilities
  • Infidelity
  • Lack of Communication
  • Physical or Mental Abuse
  • Addictions
  • Lack of Compatibility
Really, all these issues boil down to one root cause:
  • Stress
Either the couple disagrees about how to handle an issue and knows it (a disagreement) or they don't know they've disagreed (a miscommunication). Suppose one person wants to spend money on food, housing, and a fancy car. And the other person wants to spend it on food, housing, and travel. If they buy all four things and get into debt, they'll end up in a situation where they can buy neither fancy cars nor nice vacations. Financial stress will tear a marriage apart.

But so can any stress. When parents disagree about how children should be raised, they are likely to blame problems the children create on the other spouse's decisions. If one spouse wants sex once a day and the other wants it once a month, then at least one person will be unhappy, but probably both.

The secret to a successful relationship is using it to reduce life stress rather than create it.

That's why love is necessary but insufficient. Love is merely the motivation that makes you decide the other person is worth the effort. The secret ingredients are solid communication skills and a willingness to compromise.

Good communication prevents small problems from becoming large problems. For example, suppose one partner says, "Lets talk about that later" whenever she's feeling a bit overwhelmed with an issue and needs some time to process alone. But her husband interprets that as, "I don't want to talk about this at all." He might end up feeling emotionally shut out by her. And she might feel neglected because he never initiates the conversation at a later date. This problem is completely avoidable as long as both people take the time to express how they interpret what the other person says and does. The misinterpretation would be immediately clear. Without taking time for that though, these irritations build up into years of needless emotional pain.

Of course, sometimes both people understand each other perfectly well but disagree about what they want to do. In the case of a husband who wants to buy a fancy car and a wife who wants to travel abroad, trying to do both will put them in financial trouble, so that's not an option. Sometimes they just have to compromise on what they want for the sake of the other person. Maybe that means buying a Nissan instead of a BMW, and that they travel to Miami instead of Paris. Or maybe it means they travel to Paris this year, but they buy a BMW in two years. Both people need to realize that their needs can't be the first priority 100% of the time, nor can the same be true of the other person. The overall happiness of the couple needs to be more important than any one particular desire.

There are also situations where couples understand their differences of opinion and are unwilling to compromise. Abusive relationships fall under this category. When the husband believes it's okay to beat up his wife and the wife disagrees, they shouldn't compromise by saying it's only okay to beat her on certain days of the week. If you can't agree to disagree, that's a sign the relationship needs to end. No amount of love or compromise will stop an abusive spouse or convince someone to quit their drugs. They've declared what they want out of life, and it's simply not compatible with what you want.

This is really the category of "irreconcilable differences", and applies to innocuous things as well. For example, desired frequency of sex. If one person is unwilling to have sex more than once a month and the other person wants sex daily, there aren't a lot of options. One person could start having an affair, they can agree to an open relationship (essentially a sanctioned affair), they can "compromise" by only having sex monthly and building long term resentment, or they can break up. Breaking up seems like it causes the least emotional pain in the long run in most cases, which means it's often the best choice. There's no shame in breaking up when you realize things won't work out. You just weren't the right people for each other.