Advanced Personal Finance

I caught myself in an interesting bit of economic behavior a couple of days ago.  It’s an experience I’m sure many people are having about now.

I got my quarterly statement for our taxable mutual fund account and I was in no hurry to open it.  Not like these statements are like Christmas day even in an up market, but I just had no interest in looking at it.  Because I already knew it was going to be ugly. 

Naturally it was.  It’s an S&P index fund, so you can figure out the losses.

Funny.  I never minded opening the statement or looking up performance online while the market was going up.  Hmmm.

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Moving to a lower cost of living location is a popularly advocated means to cut expenses and live below your means.  But does moving to a cheaper area really save the kind of money most people would need to save to make such a dislocation worthwhile? 

Maybe not.

People interested in personal finance advocate lots of different methods to either increase income or decrease expenses.  There has been a plethora of stuff (too much) written about the ever-ellusive ‘alternative income streams’ to do the former.  The latter garners an even greater amount of attention.  Free Money Finance has written several times about the idea of moving to another city to cut expenses.  My family just did it earlier this year.  Now David at My Two Dollars is planning on moving to a much cheaper area this summer.  But there’s excellent evidence from behavioral economics research that this isn’t the money-saving move people think it is.

One of the basic principles of the new field of behavioral economics is something called ‘anchoring.’  Basically, anchoring means once you’ve gotten used to the cost of something, you compare similar things to that cost.

Anchoring is relevant in this context because when people move to a lower cost of living area, they’re expectation of the cost of housing (among other things, I suppose) is anchored to their previous (more expensive) location.  So it’s been shown that when people move to a place with cheaper housing, they keep sinking the same amount of money into where they live.  A family moving from Dallas to Des Moines spends what they used to pay for their old house; they buy more house in Des Moines because they’re used to a certain mortgage payment.

Interestingly, it also works the other way.  If they move from a cheaper area to an expensive one, people typically just squeeze themselves into a smaller house and keep roughly the same size mortgage payment.

So maybe the advice to move to a lower cost of living city isn’t as automatically beneficial as I thought.  I can tell you, though, that in our case we did cut our payment by a third for a similar house when we moved.  Of course, everyone thinks they’re the exception to the rule, don’t they?

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The Senate recently passed a bill to essentially bail out people involved in the housing crisis.  Builders, buyers, local governments, future buyers, they all get a piece of the pie.  This on top of the taxpayer funded bailout of Bear Stearns. 

I say let’s just go ahead and bail everyone out…of everything.  Did you buy a car you’re having trouble making the payments on?  Here’s some money.  Lots of credit card debt you can’t service?  Here ya go.  Small business facing financial difficulty?  It’s all yours.

Why are those any less worthy than people involved in the current housing and lending trouble?  After all, each made decisions, presumably after considering their own self interest, that turned out to be bad ones.  A good number people in all these groups really didn’t do anything wrong at all.  In an economy like ours, sometimes you lose even when you do everything right.  Fortune doesn’t always favor the prudent.  Why is it, then, that those hurt by housing get special treatment?

This is coming from a guy who is a homeowner.  That means my house has probably decreased in value, too, just like millions all over the country.  But I’m also a faithful taxpayer (one of the just 60% of Americans who pay into the federal treasury on April 15th).  So that’s my money going to JPMorgan/Bear Stearns, Toll Brothers, and Joe Downthestreet.  And it’s real money.  That has to be paid for.

So if we’re going to make those people whole, why not everyone else struggling with their debt?  Are they any less deserving?

If you ask me, the people most hurt by this aren’t even directly involved.  It’s those people who are trying to do the right thing.  Savers have suffered with plummeting interest rates.  Paradoxically, those trying to borrow that money in the form of an auto loan are facing higher interest rates, too.  And it’s making attending and paying for college harder.

Situations like this teach people, if only subtlely or subconsciously, that it doesn’t pay to be prudent and do the right thing.  Feedback like this changes economic behavior for the worse.  People learn recklessness isn’t as dangerous as they thought.  Savers and investors begin to look like suckers. 

That’s a problem because of basic economics.  An economy that wishes to grow must have citizens who invest and save.  And that investment cannot come from outside the country, as is the case in the US today.  That’s just selling the country, bit by bit.

So let’s just bail everyone out.  After all, we all deserve it.

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For those of you not aware, we’re currently looking for a new house. We thought we’d have lots of time to look while our house languished in this buyer’s market, but incredibly our house sold in one day and now we’re scrambling for a new place. So after two trips to the prospective new hometown, we’re inching closer to making an offer on a house. Great, right? Some progress at least.

The problem is we’ve succumbed yet again to what I call ‘Price Creep.’

Price creep is the tendency to slowly but steadily increase your threshold amount you’re willing to spend on a major purchase.

I don’t think we’re alone in having this problem judging by the commonality of heated (and now cooled) seats in cars. (Can’t have our American butts getting chilly now can we?)

We started our search with the hopelessly naive intention of having little or no mortgage. We figured with the net profit from our current (now sold) house and a move to a lower cost of living area, we’d be all set. Wrong. It turns out that while the cost of living (specifically housing) is in fact lower in the new place, it’s not that much lower.

We learned this in stages as we looked at houses. This one’s in an undesirable neighborhood. That one has a not-so-good school. Another one looked a lot better on paper.

So the price goes up.

This house has good school’s and a good neighborhood, but it doesn’t have the rooms we’ll need. That one has the right rooms, but they’re all too small.

So the price goes up.

It’s slow and incremental and in the end it can kill you. Before we knew it, we were looking at places with much higher price tags than what we’d started at.

It’s another perfect example of economic behavior - it’s called ‘anchoring.’ Humans adjust their expectations of what is acceptable based on one piece of information. Often the one piece is what was learned most recently. In other words, we’re ratcheting up our expectations for the new house based on the nicest parts of each of the houses we’ve seen.

Where we are now is that we’re preparing to spend about 50% more than what we initially hoped. Now we’re going back to the budget to see how much torturing it can take before it breaks. We know reaching for a house is against all the rules and we’re trying hard to keep things in check.

But like I said, we suffer from price creep.

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In an article in the Wall Street Journal, Jonathan Clements made an offhand comment that I thought had particularly important ramifications.

“All of the above presumes your income rises at the inflation rate between now and retirement. What if your income rises much faster? Ironically, that could make it tougher to retire.”

I’d never thought about it explicitly, but that’s exactly correct. To date I’d always sort of figured that fact into my planning for retirement without stating it outright, but it’s worth stating again.

A rising income can make it harder to save for retirement.

At first this might seem counterintuitive. I mean, who doesn’t want to make more money, right? In a situation like that, you have the ability to save more toward retirement, getting to the level we’re ’supposed’ to save according to personal finance gurus and countless university studies. Or you might be able to retire earlier than you’d planned.

Only, in practice it rarely works that way. Why? Human behavior.  When their income goes up, most families (including ours) experience ‘lifestyle creep.’ As income grows, so too do expenses. Sure some of them are necessary or even the result of that rising income (Mom going to work and earning a nice paycheck but having to put the kids in expensive daycare springs to mind). Regardless of the underlying reason, most of the time increases in income flow right out the door for the most part.

That ‘for the most part’ is keenly important. Obviously, one of the bedrock principles of good personal finance is the old saw ‘keep a portion of everything you make.’ So you dutifully save 10% of your increased income. Or maybe you don’t. It’s really easy to forget to increase savings with an increase in income. Did you increase your 401(k) contribution when and if you got a raise last year? I know I didn’t - my raise was laughably small. So every bit of that small raise went to lifestyle inflation.  We spent it.

What this means for trying to save for retirement

Back to the topic at hand - retirement. We see how increases in income often flow right back out the door. Another way of saying that is when you get an increase in income, your standard of living increases. The core challenge of saving for retirement is to match your sources of income to your expenses. In other words, you need to match your standard of living right before retirement (unless you plan on taking a lifestyle hit).

As your standard of living increases right before retirement, you need that much more retirement income and hence, retirement savings. Thus, increases in income, unless a portion of them are saved, result in increased difficulty in your ability to retire how you want.

I’ll have to keep that in mind the next time our family’s income goes up. It was easy to remember recently since I just accepted a new job with lower pay. But that’s another story…

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