plonkee money an english-er's thoughts on personal finance

March 27, 2009

sunk cost fallacy

Filed under: banking and economics — Tags: — plonkee @ 1:57 pm

Once you’ve irrevocably paid for something you should take that into account when considering what to do next.

Err. No.

Once the money (or time or effort) is gone, then it’s gone. There’s no point in worrying about this.

I was on a great forum the other day for people who are interested in playing classical music. In the UK, you can take exams in playing instruments, the most commonly know are the grade exams. Distinction at grade 8 is the minimum standard required for acceptance at a conservatoire (don’t need the exam, just the standard). They aren’t free to take, and there was a post on the forum from a girl stating that she didn’t want to take her Grade 7 Flute exam, but was concerned because if she didn’t the entry money her parents paid would be wasted. The right way to think of it is that whether she takes the exam or not, the money is gone. She may as well do whatever is best for her in the long run.

If you’ve spent money on something that you regret, one way to get over sunk cost fallacy is to consider what you would do now, if you were given (or won) that same object for free.

If you buy a delightful pair of shoes that turn out not to fit, instead of bemoaning the money that was spent on them, ask yourself whether you would wear them if you had been given them for free. If not, don’t wear them just because you spent money on them. If prettiness is more important to you, then by all means, ruin your feet. (I stole this example from blunt money, but it’s good! and I admit that I’ve done it myself.)

If you have an investment that you think was a mistake. Ask yourself what you would do with it if you say, inherited it now (imagine the mistake was someone else’s). Woud you keep it, or sell it?

My buying a house that has dropped in value might have been a mistake. But if I were given the house plus mortgage now, I would just keep paying out on the mortgage, rather than sell and take the loss that I can’t afford. But if I couldn’t afford the mortgage payments, it would be a different matter.

The only time you should take into account sunk costs, is when you’re learning from previous mistakes. Then it’s ok to remember that you spent a fortune on shoes that didn’t fit when you’re in the shoe shop choosing a new pair, and to take that into account by trying them out more carefully. Similarly, if your investment picking was rubbish then bear that in mind when it comes to pick new investments. Or if your house dropped in price a lot, take that possiblity more explicitly into account when you next buy (or firmly resolve never to move again, whichever).

Don’t make the mistake of considering money that’s been spent and can’t be got back when you make your decisions.

February 13, 2009

historic returns: looking back more than a century

Filed under: banking and economics — Tags: , , — plonkee @ 12:46 pm

JD @ Get Rich Slowly highlighted a municipal bond issued in the mid-Victorian era in New York state that is just now coming to completion. It was paying out annually at 7% per year, which is a very respectable rate of return, even though inflation has seriously ravaged away the purchasing power of the original sum of $1000.

a good book teaches a lot

It reminded me that nearly everything I know about pre-20th century finance, I know from reading literature. In Jane Austen’s Pride and Prejudice, Mr Bingley and Mr Darcy are extremely wealthy men – with incomes of several thousand pounds a year. Of course, nowadays several thousand pounds will go nowhere. I have also surmised that trade (business) was looked down upon, and that investors were fairly cautious in the early nineteenth century – investing in joint stock companies was considered speculative.

A bit more of my knowledge comes from Jayne Eyre (the wealth of Mr. Rochester was built on the work of freed slaves) and North and South (which covers the cotton mill recession of the mid nineteenth century).

inflation is omnipresent?

When I read about incomes and prices from one or two centuries ago, the long term effects of inflation become very clear. If Miss Darcy’s £20,000 had been solely used to generate an income for her to live on, and none of it reinvested that money would still be providing around say £1,000 a year, but that’s not enough to live on, let alone enough to be considered a catch by a fortune hunter.

It’s interesting to read, then, that inflation was not a major factor during the nineteenth century. A report by the House of Commons into the value of the pound since the beginning of the Georgian era in 1750 (pre-dating the American Revolution) shows that although during the Napoleonic Wars, inflation was high, and this was then followed by a period of deflation, for much of the nineteenth century when Britain was the most industrialised nation (and certainly the major superpower) inflation didn’t really exist. Prices in 1870 were not very much different from prices in 1830, compare that to the twentieth century where inflation is an important influence and prices have tended upwards throughout as a result.

stocks and shares

Although inflation wasn’t of great importance to the Victorians, they did still invest in equity, but they generally looked for preservation of capital and provision of an income, rather than capital growth. Stocks and shares didn’t experience all that much capital growth in this period – this table of historic FTSE index returns from 1800 onwards doesn’t show much in the way of share price increases during the nineteenth century. However, dividend income was much more important – making up around twice as much of returns as they have done in the twentieth century (more than 60% down to around 30%). Returns in the UK were higher than the US at this time.

An article from Vox (an economic thinktank) suggests that the reasons that returns were higher in the UK were the relative hegemony that the British Empire possessed during the first phase of the industrial revolution, and barriers to entry for companies at this time – particularly illiquidity (much money was tied up in land, and financial institutions were more local).

Sometimes it’s interesting to take the very long term view, and see what can be learned from the lessons of history. It’s definitely true that past performance is no indicator of future performance, but also I think that some things don’t change so much. Innovation drives business and wealth, and humans being what they are, I’m fairly certain that ingenuity will continue long into the distant future. It’s hard to tell what’s likely to be the dominant factor in twenty-first century financially, but sensible investing probably isn’t going to hurt.

January 26, 2009

thinking about deflation

Filed under: banking and economics — Tags: , , — plonkee @ 7:41 pm

Ack. The company I work for has just announced that a pay freeze for April. The argument is that this recession is really, really serious and there’s wage deflation in our sector. It’s a big company and covers lots of sectors, some of which are almost certainly in big trouble. My particular area is probably better off than most as it has excellent long term prospects but only just. There’s also an unofficial recruitment freeze, and most discretionary spending (like training courses or staff entertainment) has been cancelled.

My response is that boy am I glad that I spend less than I earn. I imagine that there will be some redundancies, somewhere in the company although I should be safe until at least October, probably April 2010 by which times things will have lightened up somewhat we all hope. My emergency fund is in place, and I’ve worked out (including statutory redundancy pay) that I could go nearly 12 months without having earning any money at all before being bankrupt – I’d have to cut expenses very close to the bone though. Fairly scary stuff, but I have to keep telling myself that it will probably be ok, and if it’s not, it’s not – it’s certainly not the end of the world.

I’ve been spending a bit of my mental effort trying to work out whether we’re heading towards deflation or not. Because I’m the sort of geek that finds it interesting you understand. According to our CEO there is some wage deflation. Meh. It’s in his interests to say that, and I’m not really sure that it’s true exactly, more a function of supply and demand. I know most manufacturing companies are operating on partial weeks. I guess it’s a sort of wage deflation.

Also, when you look at *stuff* pretty much everything is on sale at the minute. Full prices haven’t shifted, but not many people are going to be paying them. I’m sure that’s more than the regular January sales and is basically deflation by another name – it’s the price you pay that’s important, isn’t it? Not the sticker price. On the other hand, 500ml of Pepsi Max went up 11.5% over the weekend. Food prices have been really jumpy for the last few months. I don’t know if they’re always like that though, I only notice the prices of things that I buy regularly (cheese, orange squash, pepsi/coke, fruit, sausage rolls – yes I know that’s a really weird mix, I have no excuses).

The next set of council tax increases is going to average 3.5% – that’s really quite low. But public transport fares have gone up quite a bit more than inflation (as usual), catching the bus costs me 13% more than it did a month ago. Gas and electricity prices are going up, but I’m not sure by how much.

I guess that estimating deflation is pretty hard, and it’s not going to be uniform, just like inflation isn’t normally uniform. As my increase in net pay is going to be around the £10 mark for the 2009-2010 financial year (new tax and NI bands), it’d be helpful to me if inflation was low. I’m guessing that there’s going to be a £50 per month increase in my costs this year, which I could attempt to mitigate for with my discretionary spending. I’m planning on putting spare money into my short term savings anyway because I can, and upping my charitable donations slightly because I should.

If there’s deflation, then that’s definitely a bad thing. Particularly for suckers like me with a mortgage. It’s a negative spiral, and generally means a deeper recession, more job losses, and greater insecurity. It’s normally considered to be worse than high inflation (although I bet it’s a wash with hyperinflation) because there’s very little central banks can do about deflation – they can’t reduce interest rates below 0%.

Anyway, what do you think? Do you think we’re in deflation yet, or am I just not paying attention to some price increases?

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