In our discussions with economists about personal finance, an interesting topic emerged: the habit of buying things we don’t need. Why do we often buy things we don’t need? Why do we often make unnecessary purchaes? One major reason is the allure of a “deal.” However, it’s important to understand that not everything marketed as a deal is truly beneficial for you.

Understanding Value

Consider this common sales tactic: “Call in the next 10 minutes and get an additional product absolutely free – a $50 value!” This approach aims to trigger impulse buying – unplanned, spur-of-the-moment purchases. But what does a “$50 value” really mean?

In economic terms, a $50 value typically means you could quickly convert the item into $50 cash. However, this isn’t usually what salespeople mean when they use this phrase.

Salespeople’s primary goal is to convince as many people as possible to buy their products, regardless of whether those people actually need them. They craft their sales pitches to achieve this goal. Let’s examine two key aspects of these pitches:

1. The “limited time offer” – Often, these time limits aren’t real. You can usually call later and still get the same deal.
2. The concept of exclusivity – A true deal is usually something available to only a few people. If anyone can get the same offer, how special is it really?

These tactics often work because many people don’t fully understand the concept of “value.” Salespeople and their employers know this and sometimes exaggerate or even misrepresent the value of their products.

While we shouldn’t accuse all salespeople of dishonesty, it’s wise to be skeptical of all value claims. To protect yourself financially, it’s important to develop a critical eye when evaluating sales pitches and to really understand what “value” means to you personally.

The dictionary definition of value – “The worth of something to its owner” – may seem vague, but it highlights an important point: value is subjective. Different people can interpret value in various ways, sometimes drastically so. This is why salespeople often define value more broadly than financially conservative individuals.

For practical purposes, we recommend adopting a more stringent definition of value: the price you pay for something you genuinely need, when you truly need it. Be wary of salespeople who try to persuade you to use a looser definition – they may be exaggerating.

It’s natural to seek out deals when shopping. Salespeople understand this and craft their pitches to make their offerings seem as attractive as possible. Here are some strategies to help you evaluate sales pitches effectively:

1. Avoid Impulse Purchases: Wait at least 24 hours before buying something that catches your eye. This simple step can prevent many unwise purchases.
2. Validate Value Claims: If you still want to make the purchase after waiting, carefully examine all value claims. Determine how the salesperson defines value and consider if this aligns with your needs. In the business world, this process is called “due diligence” – a crucial step in both corporate and personal finance.
3. Consider How You’ll Use the Value: For example, if offered a two-for-one deal, think about what you’ll do with the second item. Will you use it, sell it, or give it away? If you don’t need the second item, you might try negotiating for a single item at half price instead.
4. Trust Your Judgment: If you’re still unsure about the value after considering these points, it’s probably not a good deal for you. Remember, you can always make the purchase later if a genuine deal comes along.

By following these guidelines, you can make more informed purchasing decisions and avoid falling for misleading sales tactics.

Time Preference and Interest Rates: Making Smart Financial Decisions

We all face the question of whether to buy something now or later. While it’s tempting to want nice things immediately, it’s not always financially wise to make purchases right away.

Financially savvy individuals often practice “thrift” – they buy what they truly need at reasonable prices and save the rest for future purchases. This approach is becoming less common, but it’s rooted in the concept of “time preference,” which is crucial to understanding smart financial management.

When you choose to save rather than spend immediately, you’re demonstrating a longer time preference. This patience is rewarded through interest – you earn money on your savings until you decide to spend it. Interest rates play a central role in all financial decisions, whether personal or business-related. Consider these scenarios:

1. Spending all your money now (immediate time preference): You should be aware of the interest you’re giving up by not saving.
2. Buying on credit (also immediate time preference): You’ll be charged interest. It’s crucial to understand this rate and its long-term cost.
3. Saving most of your earnings (long-term time preference): You need to ensure the interest you earn adequately compensates for delaying your purchases.

Many people use credit for purchases but don’t track the interest rates they’re paying. This is a significant oversight. Interest on credit is a cost that can grow substantially if not managed carefully.

If you both use credit and save money, compare the interest rates you pay with those you earn. Aim to lower what you pay and increase what you earn. This isn’t easy – currently, credit card interest rates can exceed 20%, while savings accounts often offer less than 1%.

The reasons for this discrepancy involve complex governmental regulations and policies, which we won’t delve into here. The key takeaway is this: try to minimize the interest you pay while maximizing what you earn, aiming for positive “net interest” (interest earned minus interest paid).

This approach harnesses the power of compound interest, which we’ll explore next. By managing your time preference and interest rates effectively, you can make your money work harder for you in the long run.

The Power of Compounding: Making Your Money Work for You

Investments grow over time, and this is where the concept of “compounding” becomes crucial. Compounding occurs when you earn returns not just on your initial investment, but also on the returns you’ve already earned. It’s like your money making more money for you. Even Albert Einstein recognized the power of compounding, calling it the “eighth wonder of the world.”

To understand compounding, let’s look at the “Rule of 72.” This simple rule helps you estimate how long it will take your money to double. Here’s how it works: divide 72 by the annual interest rate, and you’ll get the approximate number of years it takes for your investment to double.

For example, if you have an interest rate of 50%, most people might think it would take 2 years for $1 to double. However, due to compounding, it actually takes about 1.5 years (72 ÷ 50 = 1.44).

Table 1 illustrates this concept with different interest rates. As you can see, higher interest rates lead to faster doubling times. This naturally leads to the question: How can we earn higher returns to double our money faster?

One way to approach this is by comparing different investment options. Table 2 shows various bond indices as an example. These indices have total returns ranging from 2.5% to 6.0%. Referring back to Table 1, we can see that investments in this range would take between 12 to 29 years to double.

Given these long timeframes, some investors might be tempted to pursue riskier investments for higher returns. However, it’s crucial to consider the “compounding risks” as well. If you lose money in a year, it can take a long time to recover those losses, even with compounding working in your favor.

This is why the first rule of personal investing is to avoid losing money – similar to the medical principle of “first, do no harm.” While this approach might not seem exciting, it helps protect the money you’ve worked hard to earn. This principle is particularly important for older investors and in markets that have reached historically high levels.

Remember, for most people, the primary way to save and invest is through their job. By understanding and harnessing the power of compounding, you can make your hard-earned money work more effectively for you over time.