A rupee today is worth more than a rupee tomorrow (or at any point in the future)
This is the first, most fundamental lesson you learn as a student of finance. Called Time Value of Money, the idea that any money you have today can earn interest or returns in other forms making it worth more than the same amount of money at a later point in time, is a core principle of finance.
Another way to look at the above statement is that inflation is constantly reducing what a fixed amount of money can buy. Hence you hear statements like “When I was young, we could buy an entire <insert large quantity here> of <insert any commodity> for what it costs for <insert small quantity here> today!” from those who have more than a few decades under their belt.
Yet another slightly non-academic way of summing it up is “We like more money more than we like less money”. Hmm…Not something to exactly stop the presses about.
Given the immutable nature of this principle, it wouldn’t be unfair to expect all our money and wealth-related decision-making to stay true to this idea i.e. given an option of spending less than more, we theoretically should always choose the former. Yet, in real life, we routinely make decisions that do not “maximize” the money we have or will have.
At some level, we know this, and we’re ok with it. After all, being “completely rational about wealth” would mean using a Nokia 3310 in an age of the iPhone, planning meals based on minimum “cost per calorie” than taste, buying clothes only for thermal efficiency than style and so on… Hardly a life worth aspiring for.
It’s easy to see why that outlook of only maximizing wealth makes no sense to us. After all, the joy derived from a refreshingly chilled pitcher of foamy lager brought out and served while lounging on a hot beach is way more than when served in the air conditioned confines of a downtown restaurant. In short whether the utility derived from something is more or less than the price paid is what determines our enjoyment of it. And that mostly works fine.
However, there are lots of decisions we make that are not tied to maximizing our utility but tend to play on our imperfect and biased thought processes. While there are lots of biases we are susceptible to, this post is meant to illustrate a real, prevalent and visible example that highlights how our reasoning is faulty.
The Economist Subscription: Flawed mental processes
This example is from one of Dan Ariely’s books: Predictably Irrational and is one of the best representations I have come across of how flawed our thought processes can get when making decisions.
Many years ago, the author came across this online ad one day, offering the opportunity to subscribe to the well-respected magazine, The Economist. Curious about it, he clicked through to the site.
Here is what he saw on the subscription offer page:
The first option only provides access to the online version of the magazine, the 2nd option is traditional print magazine-only and the 3rd option is option 1 + option 2 combined.
Pause here for a moment to ask yourself, which one would you pick if you were a willing reader of ‘The Economist’? If National Geographic, Filmfare or Hustler are more your speed, picture those in this thought experiment. Continue reading once you’ve made your choice.
If you’re like me, you’re wondering why would anyone pick the 2nd (Print only) option if you get access to Print + online edition for the exact same price?! Of course my choice would be the 3rd option: Print + web for $125
Turns out that the useless looking 2nd option (Print only for $125) plays a big role, which is to distort our mental processes when we choose. And here’s how Prof. Ariely proved it:
He conducted an experiment by displaying the same subscription offers above to a set of students at MIT and asked for their choice.
84% of MIT students picked the ‘Print + Web’ option for $125, and the minority opted for the ‘Web only’ option. Predictably, not a single respondent picked that useless ‘Print only’ option. High-fives all around for thinking like MIT students do!
Now, Prof. Ariely conducted the 2nd half of his experiment. Given not a single respondent picked the 2nd option, he reran the experiment, removing the 2nd (Print only) option. So the two choices presented to respondents were:
- Web only option: $59 / year
- Print + Web option: $125 / year
What would you pick?
In the two-option test, 68% respondents picked the much cheaper “Web only” option, 4x up from the 16% who picked it in the first case.
In a “rational” world, removing the “useless” option shouldn’t have impacted the results at all. We should be picking the option that makes most sense to us irrespective of what extraneous options exist. Turns out, not quite.
Apparently, the presence of the ‘Print Only’ option priced at exactly the same as the ‘Print + Web’ option distorts how we view the latter option and makes it more attractive than the cheaper ‘Web Only’ option.
So the next time you’re making choices about anything, try taking a step back to see how much the other options in the mix are potentially skewing your thought process.
We will probably never be rid of such distortions but maybe pausing to examine them might help us make marginally better decisions.