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.

1 comment:

Dave Mark said...

Lots of great examples of this in the book I'm currently reading... "Predictably Irrational".