Brett Romero

Data Inspired Insights

Month: May 2015

Labor Statistics Part IV – The Employed

Previously in Parts II and III, we focused on two subsets of the population that are not employed – non-participants and the unemployed. In Part IV, we finally move on to looking at the population of employed people. However, in a slight change of tack, instead of focusing on the characteristics of these people, we are going to look at the changes in the employment market in general and more specifically at the changes at the industry level.

Declining Industries

Chart 1 – Industries with Declining Shares of the Employment Market 1939 to 2015

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Decline in Manufacturing

Looking at the data, the big story since the end of World War II (1945 for those who skipped History class) is the decline of the manufacturing industry. Manufacturing was far and away the biggest sector in the US in terms of employment at the end of the war, but has seen its share of the employment market decline to less than 9% as of 2015. The reasons for this have been the subject of a lot of discussion (see here for example), but if we look at the number of manufacturing jobs (see Chart 2), as opposed to the percentage of the non-farm employment market, we see there are two phases to this decline.

Chart 2 – US Manufacturing Jobs 1939 to 2015

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As Chart 2 makes clearer, manufacturing in the US was actually still adding jobs from 1945 through to the late 70s, it was just that the other sectors were adding more jobs, causing the manufacturing sector’s share of the employment market to decline.

From the mid 80s onwards though, the manufacturing sector started declining in both percentage and absolute terms. Increasing automation and the shift of jobs to low cost manufacturing countries such as China, India and other developing nations started what would be a long decline for the industry. There is one ray of light though, and that is that the US has actually been adding manufacturing jobs for the past 6 years. Although this looks like a positive change, it is hard to say whether this is the start of a new trend or just an aberration representing the recovery of jobs lost in the last downturn. The 90s boom saw similar gains before they were reversed very quickly in the new century.

Where is the Tech Boom?

The sector that you may be surprised to see in the declining chart is the Information sector. Information Technology (“tech”) seems to be the only sector that anyone is talking about right now – glitzy product launches, podcasts (the excellent Startup) and TV shows (Silicon Valley is fantastic if you haven’t seen it). So why don’t we see it in the employment data? To explain that, it helps to break the sector down into its component industries (see Chart 3).

Chart 3 – Information Sub Industries, All Employees 1990 to 2015

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The finer level data only goes back to 1990, but this is the key period we are interested in anyway. What we see is that despite the hype, the two tech related sub industries (Data processing, hosting and related services, and Other information services) are still very small, even within the Information sector. In terms of the number of people employed, these two sectors are drowned out by the traditional publishing industry and the telecommunications sector. So even though the two tech sub industries have been adding jobs, it has simply not been enough to outweigh the job losses in the larger sub industries.

The Telecommunication Boom

The other interesting point on Chart 3 is how much the tech boom in the late 90s impacted on the telecommunications sector. Despite the popular perception that this boom was a tech boom (it is called the dot com bubble after all), the boom led to far greater increases in job numbers (and job losses after the bust) in the telecommunications sector than in the tech sectors. The boom in telecommunications was primarily driven by telecom companies rushing to upgrade networks and infrastructure in response to exploding demand for the two hot new products of the time: the internet and mobile phones. After the bubble popped, some large companies went bust, others consolidated, but the net result was a lot of job losses.

Expanding Industries

Chart 4 – Industries with Expanding Shares of the Employment Market 1939 to 2015

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Moving on from declining industries, let’s look at the industries that have grown their share of the employment market over the past half a century. The clear winners here are the Education and Health sector, and the Professional and Business Services sector.

Professional and Business Services

Professional and Business Services cover a range of services that have gone from non-existent, or the domain of niche firms, to being the domain of some of the world’s largest firms. Additionally, being employed to provide services within this sector has become very prestigious (legal services and management consulting are good examples), allowing these firms to attract some of the top talent in the market place.

Overall, the growth in the number of people employed to provide these services is largely explained by the increasing complexity of doing business. Increasing complexity creates demand in several ways, including the need for:

  • People who are experts in one or a small subset of specific business functions
  • People who are experienced in navigating an increasingly complex regulatory environment, and/or
  • Agility to quickly respond to certain business needs that preclude hiring and training staff internally

In recent times there has been talk about larger businesses attempting to ‘in-house’ some of the services that professional services firms typically provide, particularly legal services and various compliance functions. As of yet, this does not appear to be impacting the employment growth of professional services firms.

Inexorable Rise of Education and Health

The Education and Health sector has shown the strongest and most consistent growth of any industry over the last 50 years. But what explains this strong growth? Chart 5 provides a breakdown of the subsectors within this industry.

Chart 5 – Education and Health Sub Industries, All Employees 1990 to 2015

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The first thing to note is that all the sub sectors have been adding a large number of jobs over the past 25 years, but there are two standouts:

  • Social Assistance (child care workers, personal and home care aides, social and human service assistants) has gone from easily the smallest sub-sector in 1990 to employing as many people as the Education sub-sector, tripling the number of people employed.
  • Ambulatory Health Care Services (outpatient medical services like dentists, GPs, diagnostic centers and so on) has become easily the largest sub-sector over the past 25 years, adding over 4 million jobs.

Generally this provides further confirmation of what we saw in Part II of this series – that there are larger numbers of Americans retiring and as they do, the demand for certain services, particularly health care is also growing.

Childcare Catch 22

One additional point to make on this subject is regarding the growth in childcare services, a key component of the overall growth of the sector. As the model of the family has changed to one with two parents in full-time employment, there has been a corresponding growth in demand for childcare services. For a lot of families this has presented a question – is it worth paying for childcare (does the parent earning the least still earn more than the cost of childcare?).

This causes a catch 22 for the childcare industry in most countries – childcare typically struggles to attract enough suitable employees due to a combination of parents’ (understandably) high expectations and generally low pay. However, if businesses in the childcare industry were to offer higher pay to childcare workers to attract more candidates, they would need to raise the cost of the childcare to parents, leading to more parents simply dropping out of the workforce to stay home and raise their children instead. Because of a parent’s ability to provide their own childcare services, without Government intervention, it will be difficult for the wages of childcare workers to ever significantly exceed the average income for parents in the area they service.

The Financial Sector Reflects the Market

The last sector I want to spend some time on in this section is the financial sector. One of the noticeable things from Chart 4 is, as a percentage of the total non-farm employment market, the financial sector hasn’t grown since the late 80s. This would seem to contrast with the general notion of an ever-expanding financial sector that is taking over the US economy. Again, the fact that we are looking at the data in terms of the percentage of total non-farm employees can be deceptive. Chart 6 shows the total financial sector employees from 1990 to 2015.

Chart 6 – Financial Sector, All Employees 1990 to 2015

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Looking at this chart, we see the Financial sector did add a significant number of jobs between 1990 and 2015, but the number of jobs in the financial sector is still relatively small compared to the economy as a whole. Additionally, the number of jobs in the Finance sector appears to change in line with with the economy as a whole. Does that mean the Financial sector doesn’t need to be reigned in or that it isn’t sucking talent out of the US economy into relatively unproductive industry? That is a topic for a separate article, but the one thing that can be said is that in terms of the number of people being employed by the Financial sector, everything looks very much like business as usual.

Stable Industries

Chart 7 – Industries with Stable Shares of the Employment Market 1939 to 2015

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The Government Sector

Despite there being observations we could make about both the other two industries on this chart, I am going to focus on the most interesting story on this chart – the Government sector. The basic story in the chart is the build up in the percentage of non-farm employees in the Government sector from 1945 to the mid 70s, and then a slow decline through to 2015. Again looking at the percentages can be deceiving, so let’s look at the number of employees in the Government sector (Chart 8):

Chart 8 – Government Sector, All Employees 1955 to 2015

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The period from 1955 to 2009 saw a pretty consistent build up in the Government sector – close to 15 million jobs were added in this time. But since 2009, ignoring census hiring in 2010 (you can also see corresponding spikes in all years ending with ‘0’ for the same reason), the number of people employed by the Government had its biggest decline since the early 80s. To help determine what is happening, let’s look at the Government sector broken down into its three sub-sectors, Local, State and Federal (see Chart 9):

Chart 9 – Government Sub Sectors, All Employees 1955 to 2015

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At first this would seem to show a slightly confusing picture. This decline from early 2009 through to late 2014 represents almost 6 years right in the middle of Barrack Obama’s presidency, but for all the noise about political stalemate in Washington, the sequester and the Government shutdown, there appears to have been minimal impact on the number of Federal Government employees. At the same time, Local Governments have been slashing payrolls and State Governments have essentially been in a hiring freeze. The explanation for this is largely due to:

  1. The nature of Local and State Government revenue sources – the three main types of taxes that Local and State Governments collect are income tax, forms of sales tax, and property tax. All three sources took sharp downturns in the recession, with property tax continuing to decline even as income and sales tax collections were recovering.
  2. Balanced budget requirements – many State and Local Governments have balanced budget requirements, which meant in the face of sharply falling revenues, they were forced to slash expenditures. In many cases this meant cutting payrolls, which unfortunately only exacerbated the effects of the recession locally.

The combination of sharply falling revenues and the inability to use debt financing led to large job losses at the State and Local Government level. On the other hand, it is well known that Federal Government does not have a balanced budget requirement (much to the chagrin to some on Capitol Hill) and, in contrast to the State and Local Governments, significantly increased spending going into the recession (the American Recovery and Reinvestment Act of 2009). The merits and impact of Government financed stimulus may be debated, but the impact on employment within the Government sector is pretty obvious.

A Strange Observation

The other surprising observation from Chart 9 is that the Federal Government has employed more or less the same number of people since the late 1960s – all the growth in the Government sector has come from the Local and State Government sectors. The growth in Local Government makes sense, the population of the US has increased significantly in that period and providing Governance for that population requires more employees. We also see growth in State Government for the same reasons – but nothing at the Federal level.

Technology and other efficiency gains should allow fewer people to do the same amount of work over time, and the productivity gains between now the 1960s have been huge. Additionally, the impact of these efficiencies would be greatest at the Federal level where the scale of the work is typically bigger and there is less need to maintain a physical presence all over the country/state in the same way that Local or State Government has to. But the efficiencies wouldn’t apply everywhere:

  • To audit the same percentage of businesses over time, the IRS would need to continually hire additional auditors to keep up with the growing number of people and businesses
  • For Social Security to continue to service a growing population, the number of locations (and the staff to keep them running) would also need to expand significantly

Even allowing for a more efficient work force, it seems unlikely that the Federal Government has been able to maintain the same levels of service, regulatory effectiveness and Government advisory when the country has grown so much in population and complexity.

From here it would be easy to launch into a diatribe about an understaffed Federal Government leading to issues like the financial crisis, the failure to detect various huge frauds (Enron, Bernie Madoff), and the generally poor quality of Government services (the torturous immigration process comes to mind[1]). I could then also go on to talk about how using the points above to argue for further reductions in the Federal Government seems crazily wrong-headed. However, linking all these events to a shortage of Federal Government employees is far too simplistic. These events were caused by a range of factors and simply adding more Federal public servants would not have solved the problem on its own.

All that said, not increasing staffing levels for 50+ years does have an impact. The next time you are forced to suffer through some unnecessarily archaic (Federal) Government process, read about another fraud that the SEC and/or FinCEN failed to pick up, or lament that lobbyists are writing a significant amount of legislation that gets put before congress, keep in mind that collectively the Government agencies providing these functions are today operating with the same number of people as they were when Neil Armstrong took his first steps on the moon.

 

[1] Please don’t tell me that this is done intentionally to discourage applicants – there are plenty of ways to discourage applicants without wasting huge amounts of time and money.

 

Have any thoughts on what impact constant levels of Federal Government staffing since the 1960s might have had? Please leave them in the comments!

Why You Probably Don’t Need a Financial Advisor

I recently had an interesting series of conversations with my parents around investing and the world of financial advice, which encouraged me to outlay some thoughts on the subject. First things first – I am not a financial advisor, and none of this should be taken as specific investment advice. My only aim is to highlight some common mistakes people make when it comes investing. If after reading this you feel you may not be getting the best advice, your next step should be to do your own further research and/or have a more informed conversation with your current financial advisor.

Why You Probably Don’t Need a Financial Advisor

Generally speaking, financial advisors are people who provide a service to investors, helping them build, balance, manage and adjust a portfolio of assets, taking into account the prevailing economic conditions and the expectations and needs of the client. There are a multitude of scenarios where financial advisors and asset managers provide a valuable service to their clients, unfortunately, however, as Matt Yglesias points out, this is almost never for small “retail investors”, like you or me.

If this is the case, why are financial advisors still in such demand when it comes to retail investors? I believe it comes down to four factors:

  1. Unrealistic expectations on the part of retail investors
  2. Fear of complexity
  3. The belief that your financial advisor’s incentives align completely with your own, and/or
  4. A lack of understanding of compounding.

Adjusting Expectations

Your expectations may seem pretty straightforward – you want to maximize the returns on your assets. But let’s dig a little deeper – what level of returns are you looking for? For most people, the prospect of 5-7% per annum returns seems underwhelming – that’s pretty much the average for the market right? What if I want to beat the market – half the investing world is beating the market average in a given year – surely I can be one of those guys?

Unfortunately, there is no shortage of people who will tell you they can help you do exactly that. From stock pickers in your local newspaper to highly paid active fund managers on Wall St, there is an endless line of people who want to help you discover the secret of obtaining above average returns. More often than not, it is even sold as quite a reasonable thing, an opportunity that others have overlooked for some plausible sounding reason, or something that is only available to a tiny subset of investors that you happen to a part of.

The problem is not the salesmen – salesmen are gonna sell – the problem is we keep buying into the promises of above average returns, despite our own better judgment. The reality is beating the market is extremely difficult to do, particularly over any multi-year period. Even if there are advisors and money managers that have found a way to consistently beat the market, they are running a hedge fund with billions in assets, or providing advice to people and/or companies with a lot more money than you or I. They are almost certainly not working 9 to 5 at your local branch of ABC Bank.

To start thinking like an investor, instead of a gambler, the first step is to readjust your expectations. There are no shortcuts to wealth – average market returns should be your expectation. Once that is your expectation, your view on the best way to invest your money fundamentally changes. Now the question changes from “How big is the return I can get?” to “What is the lowest cost way to match the average market returns?” That is the right question to be asking.

Fear of Complexity

Fear is a tool that has been used by professionals in most fields essentially since the beginning of people doing things for money. From lawyers to auto mechanics to management consultants, they have a vested interest in making any job they do seem more complicated than it is to ensure that a) you don’t learn how to do it yourself; and b) they can charge as much as possible for their services. People working in the financial industry are no different.

That’s not to say there aren’t extremely complicated products and concepts in the financial world, but now that we have adjusted our expectations – all we want is to match average market returns – why do we need to understand these complicated products? Do you have a large exposure to Chinese Yuan that you need to hedge? Have you been creating short positions on European junk bonds that you need to cover? You can probably stop reading this if you do.

If we accept that matching the average market return is in fact a perfectly acceptable result, then there are a range of simple, understandable options available to retail investors that are only a regular brokerage account away.

The Incentive Misalignment

Despite the platitudes, a financial advisor’s primary incentive is to maximize the amount of money they make from you as a client. There is some alignment in incentives in the sense that their fees increase as your assets grow (fees are typically structured as a percentage of total assets), but the difference to your advisor between your assets growing at 5% or 7% is minimal. The real money is in finding additional pools of assets to manage. Because of this, it is much more economical for them to spend their time finding additional clients than it is for them to spend that time trying to squeeze an extra percent or two out of your portfolio. Confused? Similar incentives apply for Real Estate agents (I’m just picking fights with everyone today) as is explained very well in the following short clip.

The above misalignment is actually one of the more innocent ways in which an advisor’s incentives can diverge from your best interests. The more disturbing divergence occurs due to the opaque world of incentives and commissions. This varies widely between countries, states and even the specific type of advisor you have, but these payments can lead an advisor to recommend products and strategies that aren’t actually the best option for you[1]. This could include recommending unnecessarily complex portfolio structures, advising you to take on too little or too much risk, or even recommending funds and/or securities that the advisor actually receives commission for selling. Most people have heard about this happening in the US, but don’t believe it doesn’t happen elsewhere – take this excerpt from the Financial Services Guide for Colonial First State, an Australian Wealth Management Group (emphasis mine):

“You may receive advice in relation to the products we offer from financial advisers who do not work for Colonial First State or may be representatives of other licensees in the Bank. These advisers may receive some benefits from us. The adviser’s remuneration is included in the fees you pay when investing in our products.”

The issue here isn’t that these products are being marketed, but there is a blurring of the lines between advisor and salesman that is particularly bad in the financial industry. Again referring to Matt Yglesias – compare buying securities recommended by your advisor to buying a car: “we understand that the car salesman works for the dealership — he’s not your car advisor.”

The key point is that the only person who really cares about your money is you and you should spend as much time researching how you invest your money as you would on any other major purchase. Fortunately, there has never been a better time for investing novices to learn some of the basic concepts of investing – CNN, ASIC, Yahoo Finance and many others have beginner’s guides to investing. For those looking for something more in depth, Coursera is a fantastic resource of free courses offered by some of the worlds leading Universities. Two excellent beginners’ finance courses are currently being offered by the University of Michigan and Yale.

So instead of spending all your time online looking up Joe Pesci trivia, watching John Stewart clips on racial inequality, or researching the best toothbrush to buy, invest some time building your financial knowledge. Start with important concepts like the risk-return tradeoff and diversification, and move onto the different types of securities. Let your curiosity take you where you want… after you watch the Joe Pesci clip of course.

Underestimating Compounding

One of the big reasons so many of the injustices in the financial markets occur is because people consistently underestimate the effects of compounding. Let’s look at a simple example – the bank provides you with an asset worth $0.01, but it doubles in value every day (i.e. it would be worth $0.02 on day two, $0.04 on day three and so on) for an entire 31-day month. How much would that asset be worth at the end of the month?

If your guess had less than 7 figures, you are way off. By the end of the month, that asset would be worth over $10 million. That is the impact of compounding. Let’s look at a more relevant example for investors. Anecdotally, you will often hear people say something along the lines of the following:

X was a great investment – it doubled in price over the last 10 years.

What is the average rate of return that would cause an asset to double in value in 10 years? 7.18% per annum. Consistent 7.18% returns is nothing to sneeze at, but it is a lot less impressive than the returns sought by a lot of investors. It is also lower than the long run average return of the S&P500, which is over 9% (see Chart 1).

Chart 1 – Value of $100 Invested in the S&P500 in 1928

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Ok, so leaving relatively small amounts of money invested at low rates results in a lot bigger returns than you might expect. If that is the case, it shouldn’t matter if my advisor is charging me 0.15% or 1.5%, as long as I leave it accumulating for long enough, right? Unfortunately the opposite is true, when it comes to fees, compounding works against you. Those seemingly small fees that financial advisors and intermediaries charge you for their services end up having a much bigger impact than you might expect.

Just as compounding works by exponentially increasing a value by giving us returns on our returns, the money lost through fees grows exponentially by taking away money each year that would be compounded in future years. Chart 2 shows a comparison of two $100,000 investments over 30 years assuming the long run returns of the S&P500 (9%). One investment is made in a low cost market index fund (cost 0.1% of assets) and the other in a high cost managed fund (cost 1.5% of assets).

Chart 2 – $100,000 Investment: High Cost vs. Low Cost Management

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Within 5 years, the high cost fund has cost you over $10,000 more in fees and lost returns than the low cost fund – that’s over 10% of the value of your initial investment gone. The cost reaches over $30,000 by the 10-year mark, and over $135,000 by year 20.

The worst part of this, going back to the first point, is there is almost no chance that your high cost fund managed to outperform the market index fund over the course of those 20 years, and a pretty good shot it did significantly worse. At best you probably just paid $135,000 to match the average market returns… on the plus side, maybe they will take you out on their new yacht for your generosity.

What To Do?

If you understand and agree with the points made above, and if you are currently investing or are planning to invest any significant money, then what you should be looking for is something that will allow you to reproduce the market average performance at a very low cost. There is a growing number of ways to do this, but low cost managed funds and ETFs are the most accessible to most investors.

However, do not simply substitute this advice for your old financial advice. Do your own research – there is so much information out there, and the best advice is often free. Understand what the product options are, what the fees and costs are, and what returns are expected and why. Don’t be afraid to ask questions – the only dumb question is the one asked after you have lost a stack of money.

 

[1] The option recommended might simply be less beneficial than the best option as opposed to an option that is not in your interest at all, which would be a breach of fiduciary obligations.

 

Disagree with any of the above? Feel free to leave a comment below.

4 Economics Concepts to Improve Decision Making

Rightly or wrongly, the reputation of the economics profession has taken a battering over the last 6 years. Largely this is because of the perceived inability of economists to foresee the Global Financial Crisis, and the anemic recovery that occurred afterwards in most countries. Leaving the debates over austerity vs. stimulus, liquidity traps and the zero lower bound for another day, I thought I would go back to some basic economic concepts and how, with a little bit of imagination, they can be useful in situations most people encounter in everyday life.

1. Opportunity Costs

Opportunity cost is a concept used in economics to help determine the cost of a particular action or choice. At the most basic level, the opportunity cost of doing something is the cost of NOT doing the most (economically) beneficial alternative.

For example, it is Saturday morning and you are going to drive to your friend’s house for a morning session of Call of Duty. The cost of doing this might appear to simply be the cost of gas to get there and any marginal wear and tear on the car. However, economically the cost is more than that – it also includes the benefit of the most productive activity forgone. Depending on your circumstances, that might have been picking up the breakfast shift at the local café, or putting time into that startup idea you have been working on. Whatever the case may be, you have unconsciously placed a higher value on time spent playing games then the alternative and, in many cases, that is a tangible value (the café example).

This may change nothing in your mind, you may really get a lot out of hanging out and playing games – video games are a huge industry precisely because people place a high value on playing games. But once you start consciously thinking about the cost of your actions in this manner, it tends to have an impact on how and where you spend your time.

2. Incentives

One of the parts of general economic theory that tends to rub people up the wrong way is the idea that everything can be quantified and compared. This is not a particularly romantic way to look at the world, but this line of thinking can be used to help understand and change behaviors.

For example, many people have trouble finding the motivation to go to the gym. Why is it so hard to go consistently? When you hit that sleep button on the alarm, you are making a choice based on the incentives in front of you – and you are valuing an additional hours’ sleep higher than the benefit of a gym session. There can be a range of very rational reasons for that – the benefits of any given gym session are tiny and hard to identify even if the long term benefits of consistent gym work (e.g. improved fitness, a more appealing physique) are highly valued. When you look at it that way, every morning you are faced with a choice between an immeasurably small improvement in health/fitness, or an additional hour of sleep and relaxation.

However, once we realize what the problem is, we can use incentives to reweight the choice to get the desired result. In the gym example, this can be done in a range of ways that will probably sound familiar. You can set a goal like running a half marathon – that provides additional incentive in the form of not letting yourself and/or others down or avoiding embarrassment. It could be a more immediate incentive such as treating yourself to a better lunch if you go to the gym. Organizing a gym or exercise partner will provide incentive in the form of not wanting to let your partner down by cancelling (this only really works if they don’t happen to sleep in the same bed as you). Sometimes, all that is needed is to clearly identify what the benefits will be and remind yourself of them.

Expanding this way of thinking, it can be used to look at a lot of different aspects of your life. If you have a goal to cook at home more regularly, what steps can you take to make that more appealing after a day at work (or make eating out less appealing)? Trying to commit to further study? Perhaps clearly identifying and reminding yourself of how the it will get you closer to that dream job will help provide the needed motivation.

The next logical step for this way of thinking is using it to understand the behaviors of those around you, and then utilizing that understanding to make changes. If you are a manager, how can you rearrange the incentives for the people you are managing to improve productivity or eliminate some unwanted behavior? If you have children, what incentives can you use to motivate them to help with the housework or clean up their room?

One thing to be aware of is that the incentives people are responding to can be complicated and counterintuitive. Understanding your own motivations, never mind the motivations of those around you, is something that takes time. However, the simple act of stopping to consider what may be causing you or someone else to make a choice can often lead to meaningful insights.

3. Sunk Costs

The standard definition of a sunk cost is a cost that has already been paid and is unrecoverable. In economics the concept is usually used in relation to firms (businesses), but we all deal with sunken costs on a pretty regular basis.

The classic example is where you have bought a ticket to a concert but when the day arrives you have come down with a cold (or worse). You spent all that money on the ticket so you should definitely go, right? Actually, to make the economically optimal decision in this situation, you should ignore how much you spent on the ticket (the sunk cost) and simply base your decision to go or not on whether you would still enjoy the concert more than the next best alternative (lying in bed and binge watching season 4 of the Walking Dead). Depending on how bad you are feeling, that decision could go either way.

That sounds simple right? Let’s try a thought experiment to see how difficult this can be in practice. Using the same example from above, let’s first imagine the concert ticket only cost you $10. You probably don’t have to be feeling very sick before The Walking Dead is sounding pretty appealing. Now imagine the ticket cost you $1,000. In your mind, what would it take to stop you going to that concert? Broken leg? Getting stung by an Irukandji jellyfish? If you were being rational (at least in an economic sense), you would be just as willing to forgo the concert regardless of what the ticket cost.

Applying this thinking can be tough in practice (I would have to be close to death to pass up a $1,000 concert ticket), but being conscious of it can help to avoid some poor decision-making. Should you keep pouring time and money into an unsuccessful business because you spent a bunch of money and time getting it started? You probably shouldn’t. Is it acceptable not to drink yourself into a coma after you spent money on an all-you-can-drink pass? Yes, it certainly is. It can even apply to relationships – should you continue dating your current jerk boyfriend because you have already spent 5 years with him? This isn’t a relationship advice blog, so I’ll leave that one to you, but you can see where this is going.

4. Expected Cost/Benefit

Calculating the expected cost or benefit of a set of choices can be a great way to analyze a situation where there are multiple possible outcomes, even if you don’t have specific numbers to attach to certain outcomes. Used in the right situations, it helps to identify, clarify and compare the expected outcomes of different courses of action.

Let’s look at an example where you need to decide whether to apply for a promotion or not. Let’s imagine you are in a work place and a position opens up at the next level that will be filled internally. Here is the scenario:

  • The next level pays $10,000 p.a. more than your current job
  • You are one of two people that can go for the position, but the other candidate is much better qualified and you believe they will get the job if they apply
  • When you speak to the other candidate, they are on the fence as to whether they want the promotion (let’s say there is a 50% chance they will apply)
  • Your current boss is a bit of a possessive jerk and if you apply for the job and don’t get it, you estimate he will cut your bonus by $5,000
  • Your current boss can also be a generous possessive jerk, and if you don’t apply, you estimate he will bump up your bonus by $2,000 for showing loyalty

Should you go for the position? We can calculate the expected benefit/cost of each course of action to help us make the decision. Here are all the possible outcomes:

Candidate 2 Applies

Candidate 2 Doesn’t Apply

You Apply

-$5,000

+$10,000

You Don’t Apply

+$2,000

+$2,000

Given these outcomes, we can now weight the outcomes by the probability of them occurring to determine what the best course of action is:

Expected Benefit of Applying: 50% × -$5,000 + 50% × $10,000 = $2,500

Expected Benefit of Not Applying: 50% × $2,000 + 50% × $2,000 = $2,000

Based on this calculation, you should apply for the job, as the expected benefit is $500 higher than not applying.

Of course this is a stylized example, in reality it is unlikely that you have all the information given above. However, even missing some pieces of information, you can still use this approach to provide a baseline for your thinking. You may not know what the chances of the other person applying are, but by doing this calculation, you can determine that if there is anything more than a 50% chance of them applying, you will be better off not applying. You may not be able to estimate the impact on your bonus of an unsuccessful application, but you can work out how big the cut would have to be to stop you applying (a $6,000 cut in the above case) and then decide whether that is likely to occur. In short, you can use the information you do have to help you make your decision.

Initially it may be difficult to picture many scenarios where this type of thinking may be useful. However, with a little imagination, you may be surprised how often these situations present themselves. Some example scenarios may include:

  • Trying to buy a car knowing someone else is also interested – should I increase my offer, stick to my original low-ball offer, or pull out altogether?
  • Salary negotiations at work – should I accept the first offer or hold out for more money?
  • Deciding who to have lunch with when you are double booked – who would be the most offended and/or who can I most easily make it up to?

BONUS POINT: Getting Over Decisions That Don’t Pan Out

One of the key benefits of approaching your decision-making in a more rational, fact-based manner (aside from hopefully better decision-making) is that there will be less regret when you make a decision that does turn out badly.

Sometimes, even when you make the correct decision based on the information you have on hand, things will turn out badly – and the reverse can also be true. What changes when you start approaching your decision-making in a more calculated way is you provide yourself with an audit trail of assumptions and reasoning used. Now, instead of wondering why you made a particular decision, you can analyze the assumptions and reasoning used and work out what, if anything, went wrong. Did I underestimate how annoyed my current boss would be with me for applying for other jobs? Did I let sunk costs influence my decision? From that point, the only thing left to do is to learn and readjust for next time.

 

Used any other economic concepts in your day to day life? Had any interesting experiences using the ones mentioned above? Please leave a comment and share the story!

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