Sunday, July 10, 2011

The Only Truth About Finance.

It really is the only universal truth, but that didn’t seem as catchy.

One can learn a lot about finance simply by looking at what is true by definition. Ultimately, definitions provide the only true axioms in finance. Everything else is behavioral. So, what axiom is universal, always and everywhere true? Surprisingly, it’s a truth that’s often overlooked. If you always spend all the money you get on consumption, you will always be broke. A corollary of the axiom is that if you spend everything you have, you will achieve broke.

If you’re broke, it isn’t that you earn (are given, win, etc.) too little, and it isn’t that you spend too much. Those are just excuses for ignoring the only axiom in finance. Being broke may be justified, and there shouldn’t be any stigma attached to it. Most people are broke at one time or another in their life. The Hedged Economist was very broke at one time, but I had one asset many people refuse to accept. I accepted the truth of the axiom.

However, many people view being broke as an objective, as in: “I want to spend as much as I can,” or “I want to get as many things and experiences as I can,” or the most insane variation, “I want to spend it all before I die.” Egad, don’t they realize that once they’re dead, they won’t regret not spending it all? Really now! Being broke may be a legitimate goal while living, but to aspire to it as a corpse seems a bit weird. It’s equally silly to aspire to consuming all you can, and then to complain about being broke. Not being broke inherently involves consuming less than you could consume.

If one dislikes “broke” enough, two other behaviors that economists often view as axioms become a little less absolute. They are: (1) wants, desires, needs, or whatever you call them, are unlimited, and (2) resources / incomes are limited. The implication is that one can never have everything one wants / needs. In the long run, that implication is probably true, but it ignores a number of important considerations.

First, the adjustment to changes in either resources (income) or tastes (wants) is not instantaneous. There can be temporary periods at what economists call "local satiation points" where one exists in a state of contentment. The “never have everything one wants” implication gets particularly awkward since research seems to indicate that contentment isn’t related to levels of resources. In fact, without reference to resources, it isn’t related to wants. Furthermore, other than in the short run, contentment doesn’t seem to be related to changes in either.

Second, “wants” has to be so broadly defined that the statement loses any operational implication. People save so “wants” has to include anticipated future wants. People may want leisure. That’s one explanation economists use to explain why at higher wages people may work less (the backward bending labor supply curve when it occurs at a society level). People may want security, and security can be achieved in many ways, some of which are only marginally related to resources.

Most importantly, people confuse the statement “one can never have everything one wants” with the statement “you can never have enough.” The two statements have very different implications. Confusing the two statements can be the difference between being content and being unhappy.

So, let’s stick to one universal truth.

No comments:

Post a Comment