DISCLAIMER: I am not a financial advisor and this should not be taken to be financial advice. You should consult a financial professional for advice. I am a financial amateur. These are my thoughts and opinions on money that I have recorded here for my children, with the hope that my thoughts might help them. They are responsible for the results of the advice they choose to follow. Always worth keeping in mind: Past performance is no guarantee of future results. Your mileage may vary. The map is not the territory. Keep your eyes open. Smell it before you take a bite.
To my children:
There’s an old saying, “Never ask a barber if you need a haircut.” This is because the barber makes his money by cutting people’s hair. So the barber will always want everyone to get their hair cut, because then he’ll make money. Whenever you enter a transaction or are thinking about entering a transaction involving money, it’s important to know the money story.
Here are things you should ask yourself and try to figure out:
- Who is making money and how?
- What am I getting? What are they getting?
- Where are the incentives? Are the buyer’s and seller’s incentives aligned?
- Why does this sort of transaction exist?
- What other pieces of the puzzle might there be?
Who is making money and how?
You should know who is making money and how. Why is food so much more expensive at the airport? Because they know the normal priced meals are all far away from the airport and inconvenient to get to if you’re at the airport. Unless you planned ahead and brought your own sandwich. When you pay more for the same food at an airport, you’re paying for convenience. Knowing the money story means knowing what you’re getting out of the exchange and what the other party is getting out of the exchange. Why does the discount retailer Ross carry name brand products at deeply discounted prices? Because those goods didn’t sell at the normal retailers at normal prices. They are leftover inventory. At that point, the brand name companies just want to sell the goods and are willing to offer a discount, and so you can get a discount—but you also have a limited selection. Maybe there’s only one style or all of the sizes are very small or very large.
What am I getting? What are they getting?
If you know how a business makes their money, then it should be fairly straightforward to figure out what you’re getting and what they’re getting. You should always know what you’re getting and what they’re getting. Here are some examples.
- Distressed Inventory: Yesterday’s Muffin’s, 50% off – You get a discount, they get to sell a muffin. – Bakeries might sell muffins at half price, but they’re not as fresh as the ones baked today. The bakery is getting some money rather than no money, and probably still making a profit. Why do they do it? Because they know that if they sell today’s muffins right next to yesterday’s muffins and they’re the same price, then everyone will choose today’s muffins because they’re fresher and they will be left not being able to sell any of yesterday’s muffins. This is called distressed inventory. It has a shelf life and the business owner wants to sell it before its value expires.
- Gaining a Customer: 20% off first purchase when you sign up for our newsletter – You get a discount, they gain a customer and permission to keep in touch with you. – Companies value having your email address so that they can send you promotions in the future, so it’s worth it to them to offer you a discount on your first purchase in order to gain you as a customer. For you, you might want 20% off your first order enough to sign up for a newsletter and receive emails from the company.
- Bulk Discounts: 1 for $10, 2 for $15 – You get a discount, they get to sell more products. – Why is the super extra large soda only slightly more expensive than the size smaller than it? Because they are still making money at that point. If soda costs them 1 cent per ounce, and they sell 8 ounce, 16 ounce, and 32 ounce sizes, then they don’t need to charge twice as much for each size to make money even though they are giving the customer twice as much soda. If their cost is 8 cents, 16 cents, and 32 cents for each drink, then they don’t need to charge $2, $4, and $8 for each drink—they can charge $2, $4, and $5 for their drinks. When the customer sees that the 16 ounce drink is $4 but the 32 ounce drink is only $5, they might think that’s a deal, because the cost per ounce is less (they’re getting double the soda but paying much less than double the price), and the restaurant is still happy because even though they are lowering their profit per ounce, they are still making a profit. With these numbers, they would make $3.84 on a 16 ounce soda and $4.68 on a 32 ounce soda. Making more money is always attractive to a business so they may price their sizes in this way. I remember my mom used to buy very large bags of potato chips because they were cheaper per ounce and then she would put them into smaller Ziploc bags and we took them to school in our lunches.
- Expertise and Time: You’re (probably) not a plumber. – You get to avoid the time and headache of trying to fix your toilet yourself, and your plumber gets to charge a fee for their time and expertise. – It’s often worth hiring an expert. The world’s too complex and life’s too short to learn how to become a doctor, a lawyer, a plumber, and an electrician. When you need electrical work done on your house and you pay an electrician, you’re paying for her expertise, the quality of the job she would do compared to you, and for time—even if you took the time to learn how to do the job yourself, she would be able to do it much more quickly, saving you precious time.
- Interest-Free Loans: 0% interest for 4 years – You get to pay off a big purchase slowly rather than all at once, and they get to sell you something you might not be able to afford otherwise. – People who sell cars and other expensive items like mattresses, TVs, and sofas know that not everyone can afford to pay for something that costs hundreds or thousands of dollars in one day, so they let them buy it slowly by offering a loan at a low percentage interest rate, sometimes as low as 0%. This can be a good deal for both parties. The customer gets to buy something they might not be able to afford otherwise, and the seller gets to sell something that they might not be able to sell otherwise.
What are the incentives? Are the buyer’s and seller’s incentives aligned?
A good part of the money story to think about is incentives. Once you know how someone is paid, then you can figure out their incentives. If someone is paid to paint a house by the hour, they don’t have an incentive to work fast. They have an incentive to work more hours. If someone is paid by the project to paint a house, then they have an incentive to work fast. They have an incentive to work more projects, and for each project to take as little of their time as necessary.
If you walk into a store where the sales team is paid by commission, a certain percentage of their sales, then they want you to buy the whole store and might do their best to try to talk you into that. If they’re not paid on commission, then you don’t have to worry about that as much.
Financial advisors sometimes charge a percentage of a person’s portfolio to manage the money. This incentivizes them to have clients with a lot of money. They have some incentive for your money to grow under their management, because 1% of $20,000 is more than 1% of $10,000 but if your money doesn’t grow at all, they still get paid.
Ideally, you want to be in win-win situations, where both sides are benefitting from the transaction. If the financial advisor was paid a percentage of the amount that your account rose in value, and only if it rose, then that would be a great situation where incentives are aligned but it’s very difficult to make money in the stock market every year, so what would they do during the bad years? They still need to eat.
Why does this sort of transaction exist? What role does it play?
Whenever you come across a product or service for sale, know that it didn’t always exist and that someone created it for a reason. Knowing the reason that it exists will help you figure out if you want it or not. It may also give you an idea of what else could exist. Take insurance as an example. Before insurance existed, stuff just broke and you just suffered. Then someone invented insurance and said, “For $1, I’ll insure that $100 thing you just bought for a year.” $1 is reasonable so some people buy it rather than risk it breaking and not having the thing or having to pay another $100 if it breaks. And the insurer has done the math and knows that the chances of these things breaking in the first year is only 1 in 200. So for every $200 insurance policy he collects, he expects to have to pay out $100 to replace an item that broke. So everyone’s happy.
If you have enough money or could live without the thing without kicking yourself if it broke in the first year, then you might decide against purchasing this insurance policy. Because typically, 199 times out of 200, you will lose your $1. 1 time in 200, your $1 will turn into $100. So overall, you expect to put in $1 and receive half of it back, on average. But with insurance comes peace of mind, and you might decide that peace of mind is worth $1. That’s fine. But just notice that the situation changes as the price of insurance goes higher (and the odds of it breaking remain the same) and that it changes as you have more money to replace the thing with. If the insurance cost $50, then it’s much less worth its price. If you have plenty of money to buy another if it breaks, then you definitely shouldn’t buy the insurance, even when it costs $1.
What other pieces of the puzzle might there be?
Once you understand that insurance exists to protect people against bad things like products breaking, and things being lost or stolen, then you’re in a better position to think of things related to this. For example, at some point someone realized that insurance companies themselves might be interested in protecting themselves from catastrophes, like when there’s a big fire or earthquake and many people who bought insurance lose things and then are going to ask the insurance company to replace their things. This will be a huge expense for the insurance company and if they’re not prepared for it, they could go bankrupt. So someone invented reinsurance, which is insurance for insurance companies, to protect them against these rare but possible catastrophes. Once you know how insurance works, it’s easier to see that there might be another piece to the puzzle, like reinsurance. There are other pieces to the puzzle too, like unscrupulous people who make fraudulent insurance claims, claiming they lost something when they didn’t.
Bottom Line: It’s worth it to take the time to figure out the money story behind any financial transaction that you’re involved in. Ask yourself: What am I getting? What are they getting? How are incentives aligned? Are you okay with the deal?