Microsavings, The Unbanked, and what are financial services anyway?

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If you have some spare time on your hands this week, I strongly suggest that you have a look at this 3 minute clip about (what is essentially) a Vietnamese stokvel.

I’m a big fan of savings groups. I’ve written about them before (check out “Susus and Stokvels: They’re For Rich People too“).

But I think it’s important that we bring this kind of program back into our communities.

Why?

Because I think that we underestimate what a gross social travesty the financial services industry has become.

For example:

  1. No one can register for tax, or savings products, or investment products, or almost anything really, without a bank account.
  2. Registering for a bank account requires proof of residence, initial deposits, initiation fees, and so on.
  3. And because we’re toeing the IMF line and trying to implement first world compliance in a third world setting, there’s is plenty of paperwork.
  4. All the paperwork requires compliance officers to be hired to check all the paperwork.
  5. So the charge gets passed on as bank fees.
  6. But in a developing economy such as ours, the bulk of the population don’t really have proof of residence. They don’t get utility bills, or have telephone accounts. They don’t sign lease agreements. Which doesn’t mean that they’re tax evaders or money launderers. But, you know, tough luck.
  7. Also, they don’t have a spare R50 to put into the bank account to be thrifted off in bank charges.
  8. Meaning that the bulk of the population are locked out.

It’s the economic version of a caste system: where the unbanked are the untouchables.

So as I see it, the unbanked should self-bank.

After all, that’s how it all started.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.

Risk Diversification Often Means Taking The Biggest Risk You Can

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When I shared yesterday’s post about listed property on Linkedin (see here), there were many comments along the lines of “A well-balanced and well-diversified portfolio is best”. There were also many supportive comments for said comments.

But being the contrarian soul that I am – I wanted to point out that, for me, “diversified” and “well-balanced” are not the simple truisms that they appear to be.

So let me start with the general idea behind being diversified and balanced:

  1. Life is full of risks.
  2. Some risks are specific (like: “there is a risk that this company could fail because of its bad hiring decisions”) and some risks are more general (like: “global downturns make life difficult for everyone”).
  3. When investing your money, you want to minimise your risks.
  4. The total risk of any company can be broken down into specific risk (bad management decisions, etc) and general/market risk (bad global economy, etc).
  5. But it’s important to recognise that risks aren’t just one-directional. For example, one company can score on its hiring decisions, and do a lot better than expected; or the economy can benefit generally from a boom in investment.
  6. So if you split your investment amongst enough companies, then the good specific risk outcomes will offset the bad specific risk outcomes, and you’ll just be exposed to the market risk.
  7. Thus: risk minimised.
  8. Then you can do even more exciting risk diversification by saying that there are actually different market risks for different asset classes (bonds, equities, derivatives, property, commodities, etc) – so you can split your risk amongst asset classes.
  9. Then you can diversify out country risk by buying asset classes on multiple international exchanges.
  10. And pretty soon, you can diversify out everything but the general risk of a global economy.

And of course, there are many long-term studies to show that this kind of investment strategy regularly outperforms non-diversified investment strategies and it all gets a bit statistical.

I have two main observations.

Less Important Observation: Methodology and Relevance

Long-term studies in investment strategies are…problematic.

The market today is not the same market as it was 30 years ago. Or 20 years ago. Or 10 years ago. The financial wizards are constantly giving us new forms of asset class. The technology wizards are constantly giving us new ways to trade. Economic policies are in a constant state of flux. Economic fundamentals are still ineffable in all the ways that matter. Market tastes have changed. Savings cultures have shifted. The amount of money flowing around the world is larger than it has ever been.

I’m just not convinced that you can say “the empirical evidence here says…” because the empirical evidence refers to a completely different market reality.

But even if you disagree with me there…

More Important Observation: What Is Your Greatest Investment?

I’m about to sound like a self-help nut, but for most of your earning life, you are your biggest asset.

I’m not really saying that in the spiritualistic sense (although I believe that as well). Let me give you an example:

  1. I have a friend – let’s call him John.
  2. Like myself, he’s a 29 year old Chartered Accountant.
  3. Let’s assume that he earns a market-related salary of R550,000 a year.
  4. He can reasonably expect that to step up by around 15% per year in real terms until he’s 38 or so (through promotions and bonuses, etc), at which point he’s finished climbing the corporate ladder and now sits as parter/director/board member.
  5. Thereafter, his earnings growth will slow to, say, the 2% real growth rate, until he retires at 70.
  6. Up to this point, he’s managed to save R400,000 (it’s mostly locked into a bond on the 2-bedroomed apartment that he bought with his fiancée, with some of it sitting in a Retirement Annuity Fund and the residual in a small Satrix ETF investment).

Here’s his asset breakdown at age 29:

John's Assets: Age 29

John’s Assets: Age 29

So when we say “29 year old John should diversify his portfolio”, I’d be saying: “Yes, but 99% of his assets are one risky asset”.

In fact, when you consider that risk diversification means “investing in multiple risky assets so that the risks of one offset the risks of the other”, then risk diversification for John actually means “investing in the most risky asset he can find that moves in the opposite direction to the risk that he faces as an earner”. In other words – forget a balanced portfolio for the R400,000 savings – John needs to take the big risks with his savings now.

And in terms of risk management, John needs to make damned sure that he invests in some insurance protection for his biggest asset (himself) in the forms of income protection and disability insurance.

But then consider what happens over time (and for the sake of argument, I’m going to assume that John manages to transfer 30% of his earnings into some form of savings – taking into account RAF contributions, mortgage payments, and some discretionary savings – and these manage to grow at 4% in real terms each year):

John's Assets Age 38

John’s Assets Age 38

John's Assets Age 55

John’s Assets Age 55

John's Assets Age 70

John’s Assets Age 70

I guess what I’m saying is this: risk diversification is a sound strategy for an individual.

However.

You have to bear in mind, in all of this, that “risk diversification” does not apply simply to your savings. It has to take into account the fact that you, as an income generator, are an asset.

And the best time for your savings to be fully diversified is when you’re no longer earning an income.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.

Listed Property: Cometh The Crash?

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People are very bullish about listed property in South Africa. Even I have been a bit bullish in some ways – talking about how REITs* seem to be the best option for the new Tax Free Savings Accounts (see here).
*Real Estate Investment Trusts – listed property vehicles on the JSE and other exchanges.

But I have some concerns.

Even if some of them are a bit anecdotal.

Firstly, a graph, showing how money is pouring into the listed property market:

Market Capitalisation of Listed Property in SA (thanks sareit.com

Market Capitalisation of Listed Property in SA (thanks sareit.com)

Even though this:

SA REIT yields versus SA Bond Yields

SA REIT yields versus SA Bond Yields (thanks sareit.com again)

SA Listed property is now consistently generating rental yields below that of long term bonds.

And I find that deeply concerning, as it seems to suggest that we’re on the tail end of a feedback loop.

The Listed Property Feedback Loop

  1. The initial listed property funds are very successful, generating high rental yields.
  2. These attract in more capital – which is used to go in search of similar properties that generate similarly high yields.
  3. This, in turn, attracts more capital.
  4. If this cycle continues, the market inevitably reaches a point where it has more money than there are high-yielding properties to invest in.
  5. Especially as all the money chasing the same properties will just as inevitably drive up property prices.
  6. So the funds start to invest in lower-yielding properties. And they develop on free land. And they go in search of higher-risk properties that might generate higher yields. And the risk is acceptable because the portfolio is now well-diversified and can cope with more risk, and so on and self-justified.
  7. Meaning that property prices continue to rise.
  8. But the increased demand is not driven by need or usage – it’s driven by an over-availability of capital chasing return.
  9. And you can’t escape the market fundamentals indefinitely, because the whole premise of this investment is the rental yield.
  10. With this oversupply of property space, despite the rising property prices, you start to see a drop off in rentals.
  11. This is now a renter’s market.
  12. And here is where it all gets a bit sticky: because people start to say things like “We’re concerned about the dropping rental yields – but there are strong prospects for capital appreciation with the growing investor appetite for listed property investments.”
  13. Pardon?
  14. Question: what drives long term capital appreciation in property markets?
  15. Answer: mostly rental yields. The nominal kind. So one part inflation, one part economic growth. The rest is mostly speculation.
  16. And when you have nominal rents falling (as in, not just drop offs in real return – but deflation in the rental market), that has one highly probable outcome: falling property prices.

The Anecdotal Concerns

As I drive around Johannesburg, I see “To Let” signs everywhere. They’re on highways and in shopping centres and around the perimeters of office parks. And I’m talking about the popular areas: Sandton and Illovo and Melrose.

And it’s not just the office space market. I’ve been looking for a new place to live – and I don’t even have to negotiate rentals down. They’re dropping all on their own – great big 20% drops from what they were yielding in December 2014. And they’re going to drop further – because those places aren’t moving. I’m strolling in to view them, two months after their adverts first went up, getting all picky about finishings and noise and whether it’s close enough to a highway.

There is real desperation in the air.

And so, for all the talk of how 2015 is going to be a seller’s market and all the investment potential in the listed property space, I have to wonder just how realistic that is. Particularly because, thinking about the last Big Crash, I’m just not sure that there’s such a big difference between REITs and mortgage-backed securities.

Isn’t the line: “I don’t like paying rent because it means paying someone else’s mortgage?”

In both scenarios, the investor is ultimately both bank and owner of the property.

So not really too much of a difference at all…

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.

Net Neutrality. Without the lingo.

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During my University years, I’d return to Zimbabwe for quick visits to see my parents and not spend any more money. At the time, Harare was a dearth of reasonable internet access. The telecoms infrastructure would barely allow you to make calls between a landline and a cellphone, never mind cater for broadband. But the need for internet access was there – so small ISPs sprang up offering satellite wifi and the like.

For a period of time, we were using an Internet Service Provider that was owned by the sort of unethical Christian that I deeply despise. He’d pepper his conversations with “Praise be”s and hallelujahs, declare himself “blessed” in response to the obligatory “How are you?” greeting, and generally bewail the godlessness of the world while pitifully looking at you, the unsaved, in all your sinful squalor. But then he’d charge you an extortion for a given level of internet speed, deliver a tenth of it if you were lucky, and even that would only work for two weeks of the month because his shoddy infrastructure spent more days offline than anything else.

But no credit notes for you. Because what’s immoral about under-delivering and over-charging?

Anyway – the reason I mention it is that, at some point, said gentleman was clearly struck in his heart during one of those rousing electric guitar services, and he felt compelled to slam a safety gate over his internet connection to prevent anyone accessing any site that he deemed un-Christian. And I’m not just talking about the porn sites. Any web address or search term that included the terms “sex” or “homosexual” or “Marcia Gay Harden” would cause your internet connection to drop. As would any attempt to download songs or movies (although God knows that there was no need to block that – his service delivery was deterrent enough).

Curiously, this individual is still in operation. And he continues to under-deliver.

Anyway.

How This Links To Net Neutrality

Net Neutrality means that supposedly “Christian” gentlemen and their ilk cannot block or slowdown your internet connection for certain sites (except for the torrenting sites, of course). They also cannot prioritise internet connection for certain other sites (to me, that sounds like I’m saying the same thing – but apparently, those are two different things in the world of net neutrality).

To backtrack a second:

  1. Internet Service Providers charge you for the privilege of having the internet in your house.
  2. But Internet Service Providers would also like to charge websites for the privilege of of having your house connected to the internet.
  3. Or: ISPs allow web-users to download and upload indiscriminately (and you pay for that privilege); but they would prefer to charge web-users to download and then charge extra to upload the information that you’re downloading.

This would hypothetically lead to more competition and therefore better internet connection for all. Something like this:

  1. If ISPs were allowed to charge Netflix extra to have more bandwidth;
  2. Then the ISPs would be incentivised to upgrade their infrastructure in order to have more bandwidth to sell to Netflix.
  3. This is good for Netflix, because they’ll have happier customers.
  4. And this is good for internet users, because they’ll have snappier movies.
  5. Everybody wins.

Well, not quite everyone. Because if Netflix can afford to pay for more bandwidth, what about all the poor internet entrepreneurs and start-ups who can’t?

What The Anti Net Neutrality Guys Are Saying

The CEO of AT&T, Edward Whitacre:

Now what they would like to do is use my pipes free, but I ain’t going to let them do that because we have spent this capital and we have to have a return on it. So there’s going to have to be some mechanism for these people who use these pipes to pay for the portion they’re using. Why should they be allowed to use my pipes? The Internet can’t be free in that sense, because we and the cable companies have made an investment and for a Google or Yahoo! or Vonage or anybody to expect to use these pipes [for] free is nuts!

That is: Google should be able to pay to get its page to load quicker than Yahoo.

On the face of it, Mr Whitacre sounds reasonable. But actually, I think he’s being greedy. Because:

  1. Internet users pay the cable companies to have access to the internet.
  2. That includes Google.
  3. Does Google pay to have a great connection to the internet?
  4. I’m pretty sure they do.
  5. But according to Mr Whitacre, that’s not enough.
  6. They shouldn’t be allowed to use the pipes just because they’ve paid to access the pipes.
  7. They should also pay to access you on the other end of the pipe.
  8. Even though we have already covered our end of the pipe.
  9. Isn’t that double-charging? To charge Google or whoever for what I’ve already paid for?
  10. Seems completely like a monopolist who demands the right to charge everyone for everything, twice.

And that makes a lot of sense when you look at this kind of thing:

What we forget is that “competition” is a bit of a misnomer when it comes to cable companies. Because there are whole areas of coverage where there is only one service provider. And that, I’m afraid, is the very definition of a monopoly. Because if I live in a house that only has connectivity to one cable company – then I’m locked in. Regardless of the service offering. Regardless of the price.

It’s why it’s curious to me that so many libertarians are against net neutrality rules. Allowing ISPs to apportion bandwidth is not very free-market of them – it’s more anti-competitive and special-interest than anything else. But perhaps that’s just me.

The Big Problem Of A World Without Net Neutrality

If I have a regional monopoly, then that changes the way that I respond to demand. Where there is competition, more money on the table means that I’m likely to do more, provide more, innovate more to access it. But if I have a monopoly, more money on the table means that I just access it. I don’t need to do anything more to get it.

In fact, if anything, I can restrict supply in order to maximise my profit extraction.

Cable companies won’t necessarily provide more bandwidth to create fast lines. They’ll just create really slow lanes (the so-called “bus lanes”) for the “everyone else” that can’t pay for the existing bandwidth. Because that maximises the return. And any additional bandwidth will only go to paying websites – irrespective of what the web-user wants.

Which brings me to my bigger issue. As I see it, the real problem here is not all the start-ups and entrepreneurs that might face higher barriers to entry without net neutrality. Or about the anti-competitiveness of no net neutrality.

The bigger issue is more like my problem with the hypocritical Christian up top.

Because say the ISP gets paid by the rich Republican voters for more bandwidth for pro-Republican websites and news stories. What happens to the voice of dissent?

It either gets paid for, or it gets lost in the bus lane.

Without Net Neutrality rules, you risk losing the democracy of information.

And what’s the payoff for that risk? More money for Cable companies?

So it’s probably a great thing that the FCC has ruled in favour of strong net neutrality rules. Even though it’s a regulation.

For more on this, I strongly suggest that you have a look at this cartoon strip.

Happy weekend!

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.

South Africa’s Budget: Not That Bad, Really

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By now, I’m sure everyone knows the bad-ish news:

  • Higher fuel levies
  • Higher electricity levies
  • Higher sin taxes
  • Higher transfer duties for the rich
  • Higher tax rates for the big earners (by 1%)

And the other stuff:

  • Inflation-adjusted rebates, tax credits, etc (leaving the less-big earners either tax neutral or better off)
  • A one-year UIF break
  • Much higher tax savings for small businesses (although it’s quite a chore to register as a small business – so this feels more token than anything else)
  • Higher social welfare grants
  • More government spending (although it’s only planned to be 2.1% higher a year until 2018 – well below inflation – so in real terms, the government is planning to spend less).
  • No change in VAT
  • Fun new Tax Free Savings Accounts (see here).

Some thoughts:

  1. It’s not necessarily a fair budget – but it is a progressive one.
  2. The middle class are going to be paying less tax in general (except on their fuel, electricity, alcohol and cigarettes); and the poor are going to be receiving more money overall (much lower UIF contributions; higher tax rebates; and all the social grants).
  3. The adjustment in the fuel levy seems (to me) to be a much cleaner alternative to raising the VAT. The VAT system is more reliant on general compliance than we perhaps realise – because how easy is it for a vendor to start accepting cash and forgoing an invoice? The answer is: very easy. It’s risky and it will drive an accountant crazy – but the higher the VAT rate, the stronger the incentive to do something to reduce it.
  4. The other thing is: a higher fuel levy probably has a smaller impact on the low income classes than an increase in VAT would have. While the middle and upper class cruise around in one person per vehicle, the poor travel by commuter taxi. And the taxis cram, what, 20 people into a vehicle? That’s quite a cost-share.
  5. And then you have the larger social grants. Putting more money into the hands of the lower and middle classes is not such a bad thing for the rich. After all, it’s stimulative. And the data shows that the social grant money tends to be well used rather than being “blown on beer and whores” as the trolls would have it.

I guess what I’m saying is: we all knew this was going to be a difficult budget. It’s balancing a lot of awkwardness: high deficits, high unemployment, high inequality, growing debt, falling credit ratings, low growth, bad infrastructure, appalling morale, EFF vitriol, evaporated investor confidence…

And given all of that, I thought that the budget was impressively balanced. Ironically.

I also really liked this article from Matthew Lester, which I think is worth some of your time.

And you can find the full budget speech here.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.

Tax Free Savings and such. With graphs.

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While I was taking a long weekend, looking at things like this:

IMG_2916.JPG

Kariba Sun

And this:

IMG_2890.JPG

Kariba Sunset

And this:

IMG_3090-0.JPG

Kariba Sunset, With Storm

South Africa’s National Treasury announced the final details of its Tax Free Savings Accounts (TFSA).

Exciting stuff, eh?

The Basic Background

  • National Treasury is concerned about the lack of savings amongst middle class South Africans.
  • National Treasury is particularly concerned about middle class South Africans cashing in their pension and provident funds early.
  • So National Treasury is throwing out a tax bone.

How TFSAs will work

  • You get to contribute a maximum of R30,000 a year into an investment product (fixed deposits, unit trusts, and from what I can tell, REITs – subject to some restrictions);
  • You can contribute a maximum of R500,000 in your lifetime;
  • Your contributions are not tax deductible (boo);
  • But all your proceeds and gains are.

The critics are concerned that the limits are a bit paltry.

But this type of savings scheme is not for people that would find these limits immaterial. TFSAs are intended for those of us that aren’t doing much saving in the first place – in which case, anything is better than nothing.

I do have some other concerns:

  • I’m not entirely sure why you would choose to encourage the middle class to consume less when the economy is already under pressure. That said, I’m sure that people will generally continue to consume what they consume – and just change their already-existing investing strategies to include some sort of TFSA for themselves and their children.
  • I don’t think that the middle class thinks along the lines of “Oh my. A tax incentive that I don’t understand! I must save more to take advantage of it.” or “You know, what’s always held me back before is the taxes on my investments.”
  • But you know what is a much bigger obstacle to the saving/investing process? FICA. And FATCA. And all those Big Brotherly things that turn your bank account into a massive exercise of constantly searching for proofs of address.

That aside, I’m certainly not going to say “Don’t take advantage of this on principle”.

I’m a pragmatist. National Treasury is serving up small punnets of fruit. It won’t solve the famine, but we can still make jams and puddings and pastries.

How I Will Run My TFSA

Some principles:

  1. The sooner it goes in, the better.
  2. The higher taxed the return, the even more better.
  3. The bigger my immediate family, the very best.

So the first one is clear: if I save R30,000 on 1 March 2015, it gets to earn a year of tax-free return. If I save R30,000 on 28 February 2016, it doesn’t get to earn a year of tax-free return.

And I think that the third one is also clear: why save R30,000 for myself tax-free and the rest elsewhere when my spouse and children are also eligible for R30,000 worth of tax free savings each.

But the second principle is the interesting one: because what’s the point of tax savings if you’re not going to be subject to very much tax?

Some points:

  • Investment returns are generally limited to: dividends, interest, capital gains and distributions (in the case of REITs).
  • Tax on Interest? Your first R23,800 of interest is tax-free. And assuming a 5% interest yield, you’d need to have R476,000 invested before you’re going to be taxed on any interest. So for the most part, you’re not going to have a tax benefit there for quite some time.
  • Capital gains? You get R30,000 of capital gains excluded (ie. tax free) each year. So again, probably not the best tax benefit in the short term.
  • Dividend tax? Well, companies won’t withhold the 15% withholding tax on dividends for any investments held in a TFSA. So that’s quite a nice saving right there – as it translates into a 18%* boost in your return.
    *15% (tax saving) ÷ 85% (after tax dividend) = 17.6% higher return
  • Tax on distributions? Well, distributions from REITs are included in your normal income tax calculation – so they can be taxed at the highest marginal tax rate (40%) depending on your tax bracket. And if they’re taxed at 40%, then that translates into a 67%* boost in your return.
    *40% (tax saving) ÷ 60% (after tax distribution) = 67% higher return.

And considering that these investments will be indefinitely tax free, you’re looking at compounding impacts.

Let me illustrate that. Let’s say that you’re a top tax bracket man who needs to pick between three different investments, all earning the same after-tax return currently (let’s call it 6% for ease of convenience):

  • A Fixed Deposit
  • A Unit Trust of low-risk, high-dividend-yielding stocks (let’s say that all gains come from dividends)
  • A REIT (let’s say that all gains come from distributions of rental income after expenses)

If you’re going to invest R30,000 a year until you hit the R500,000 cap (in the middle of year 17), then your investment options look like this, after you take into account the tax bonus:

All investments earning the same return

All investments earning the same return. Although, disclaimer, I’ve not gone into the semantics of interest saving – that fixed deposit will get some tax savings in later years, so it should be a bit higher.

And that’s assuming the same return. Which isn’t really that accurate, because you’d expect:

  1. Capital growth in both the REIT and the unit trust, which will also be tax-free; and
  2. Higher yields for those two because of higher risk.

So if we say that the after-tax return of equities is about 10%, and the after-tax return of the REIT is about 8%, then you get this:

Investments earning risk-adjusted returns

Investments earning risk-adjusted returns, with the same disclaimer for the interest savings

It’s part of the trouble with taxes and tax breaks: you get unnatural distortion in the way that markets are meant to work to be efficient and reward risk. In this case, REITs are probably lower risk in a lot of ways – but the tax methods involved are going to reward the investment. It’s the kind of tax construction that results in property bubbles.

But Ignoring The Potential Market Distortions

Let me thoroughly disclaim something else here: this isn’t financial advice. I’m just observing the range of outcomes.

But for my money, I’ll certainly have a tax free savings account. And I’ll be maxing out that allowance each year.

PS: as a final aside, SARS is going to heavily penalise over-contributions, even if it’s by accident. If you put more than R30,000 into the account in a year, then the excess gets you a 40% penalty. Probably for two reasons:

  1. They don’t want too much saving; but also
  2. It’s going to be hard to administer (how will they know if you’ve put R30,000 into two different TFSAs? Or more? That kind of things needs to be nipped in the bud by making it hugely punitive if you get caught).

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.

The Economic Theory of Relativity [Repost]

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This is not a post about Einstein.

I briefly attempted to wiki Einstein’s General Theory; and realised, from the second line, that even the phrase “out of my depth” would be inappropriate – because it implies that I may have “some” depth when it comes to physics.

If anything, I have anti-depth.

We’re not rational

But yes – what this post is actually about is irrationality.

The “Rational Man” and the “Rational Investor” are the very foundation of traditional economic theory. They are the approximate assumption – meaning that even if we exhibit short-term irrationality, we are rational over time. And also, if we’re not rational by choice, then we’re made rational by force – because the rest of the market will sweep in and persuade us otherwise, or dwarf us into becoming insignificant outliers.

I present these:

Most of us have seen these and know that the orange ball, the line and the monster are all the same size.

But if you’re honest, when you say “I know they’re the same size“, what you actually mean is “My eyes are telling me otherwise, but I’ve been told that they’re the same size so I have to believe it even though I can’t see it.”

And we should probably all stop for a moment and reflect on that, because:

  1. If a simple optical illusion can continue to cause consternation even when we know that it’s just an illusion (ie. knowing that it’s an optical illusion doesn’t mean that we see clearly once it’s been pointed out),
  2. And optical illusions are just tricks played by the brain,
  3. And rationality is dependent on the brain’s ability to “see” clearly,
  4. Then is it such a leap to suggest that irrationality, or logic blindness, might be the long-term status quo?

Irrationality Number 1: Our Truth Is Always Relative

Obviously, you get the hipsters that sit around and swill cheap brandy while reflecting on the vagaries of life and the subjectivity of truth. But deep down, for most of us, truth is absolute. Or, at least, we believe it is. Truth such as “I like ribs” and “Taxi drivers are malicious and selfish on the road” and “You’re an idiot”.

In relative reality, however:

  1. You’ll only like ribs that are cooked properly in a nice basting sauce and provided that you’re hungry and not ill. Take away any of those, and you don’t like ribs (although it’s usually phrased: “Oh no – I just don’t like those ribs”).
  2. Taxi drivers are carrying twenty to thirty people in their minibus, all trying to get to work. If they cut you off, and you end up a few minutes late, then that’s one person late for 30 that are on time. Sounds like a moral imperative to me… Also – if you were a taxi driver, and you drove all day every day, then I think you too would feel some ownership over the roads and resentment toward the thousands of amateur non-working drivers that suddenly emerged onto the road for an hour in the mornings and an hour in the evenings, ruining your peak work time, costing you money, and arrogantly assuming that they should have full right of way over you in your work place.
  3. You’re probably not an idiot. “Idiots”, being a not-very-nice-name for the intellectually-disabled, are biologically incapable of operating at a certain level of thought. You were likely just distracted from the very important task of meeting my expectations.

Because life operates in a relative way, we act in a relative way, and our choices are relative.

But because of above absolutist illusion/delusion (“I’m always rational!”), we believe that we’re making rational and absolute choices.

So Let Me Give You An Example Of A Study

Okay, but first, a confession: this post has been fully inspired by Chapter 1 of Dan Ariely’s book “Predictably Irrational”, which I’m about to plagiarise heavily.

Here’s the opener:

The Print subscription and the Print & Web subscription cost exactly the same price ($125). Which makes it seem pretty obvious that whatever you choose, you’re not going to choose the plain Print subscription, right?

Don’t worry – you’re not about to be surprised. When Mr Ariely handed the subscription out to 100 MIT students (fairly clever and presumably rational individuals), he had the following responses:

  • 16 opted for the Web only subscription
  • 0 opted for the Print only subscription
  • 84 opted for the Print and Web subscription (get the Print subscription, and get the Web one free!).

So far, so rational.

Alright – so seeing as no one wanted the Print only subscription, then it should make no difference at all if it’s removed from the option list. I mean – we’re assuming rationality here. When you made the original decision, you were choosing between web and print editions. The whole bit about Print vs Print & Web is just saying that there was one print option better than the other.

So Dan removed the middle option from the advert, and handed it to another 100 MIT students. This time:

  • 68 people opted for the Web only subscription.
  • 32 people opted for the Print & Web subscription.

IRRATIONAL.

Why though?

Well here’s the theory:

  • The Economist subscription is asking us to make a choice between relative unknowns. We’ve never had a subscription to the Economist before, so we’re not sure what actually constitutes a good deal.
  • ie. is the Web subscription at $59 a better deal than a Print subscription at $125? I mean – how would we know that before we’ve tried out both?
  • But one thing is clear: a Print & Web subscription at $125 is definitely a better deal than a Print only subscription at $125.
  • And that immediately biases our decision-making in favour of the Print & Web subscription.
  • Such clever economists at The Economist.

How That Impacts Real Life

When I go out to eat, I usually forget to buy a bottle of wine before I head out. So I ask for the wine list. Here are my unspoken rules:

  • The most expensive wine is too expensive;
  • The cheapest wine is a bad one, and I don’t want to appear cheap; so
  • Let’s go with middle of the range.

My choice now has nothing to do with the wine in question, or the actual price itself. My choice is thoroughly defined by the price boundaries set by the restaurant owner. And I find myself buying a bottle of wine for $25 that I WOULD NEVER BUY NORMALLY because it costs $6 at the bottle store. But in the restaurant, it seems like a good deal*.
*Or, rather, the least bad of numerous bad deals.

And that irrationality is not just a once-off, it predictably happens every time I buy wine in a restaurant.

Restaurant owners know this.

It’s why you have cheap and expensive dishes and wines on the menu. The ones that the restauranteur want to sell – the ones with the thick profit margins – are always priced to be middle of the range.

And that’s just food!

The same theory can be (and is) applied by estate agents. If they know that you want to buy a two-bedroom place, maybe they’ll show you two apartments (one nice, one less nice) and a relatively cheap house (just to be sure that you’re looking at all the options).

Odds are: you’ll buy the nice apartment.

What To Do About It?

In order to avoid being screwed and/or manipulated by shrewed marketers (and the economists at the Economist), we need to:

  1. Realise that we’re irrational;
  2. Pay attention to those moments when we’re at our most irrational; and
  3. Start questioning the decisions that take place in those moments before we let them be final.

And/or buy wine before you head out. And rent rather than buy.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.