There is a popular saying or a story that goes something like this – If Bill Gates found a 100$ bill on the street, he would not bend down to pick it up because in the time it takes to pick it up he could have earned more.
I am sure like most of us, I would be more than happy to pick it up. This leads to the question of perceived value of money.
Perceived and not Actual
A 100$s is always a 100$s the actual value does not change in any way. But, the perceived value of money is not a constant. It keeps on changing. In this post I would like to explore the perceived value of money in a little more detail.
How much you already have
Firstly, the obvious. For a billionaire an opportunity to earn 100$s an hour is silly if not a downright joke. But for most people it is almost ten times the minimum wage in most countries.
Perceived value of money depends a lot on how much money you already have. The more money you already have the less valuable that extra money feels like.
Do you remember the first paycheck that you ever received?
Remember the time when you graduated out of school and got a real full-time job? After the first few weeks you get a paycheck for the first time. Do you remember how you felt?
The feeling cannot be repeated ever again. Going from almost 0 to any amount makes you feel like a billionaire! This feeling would seldom be felt once again unless you win a lottery or something spectacular happened.
Marginal Value
Conceptually this is referred as the Marginal Value. Marginal Value is something that is a concept that often pops-up in Micro-Economics.
A very simple example of marginal value is eating a Pizza. Imagine you are very hungry and you order a Pizza. The pizza arrives within 30 minutes and you are so hungry that you don’t even sit down and begin eating the pizza right out of the box.
After the first slice you move on to the second slice and wolf it down once again. By the time you are down to the fourth slice, you are kind of full and start checking your phone, watching TV and almost forget about the Pizza.
What happened? What is the value of that next slice of Pizza? It is the same slice from the same Pizza but it is less desirable compared to the first slice.
This is the concept of Marginal Value. In this case, it is the reduced perceived value or demand for the next unit of consumption after consuming several units.
Marginal Value in Income
Going back to our previous example. A 5000$ raise for a new grad who is earning 50,000$ a year is substantial. However, for someone earning 250,000$ a year, a 5000$ raise seems trivial.
It is the same amount but the perceived value is different.
Not the amount but the Ratios
Mathematically speaking, this can be modeled using a simple concept of ratios.
5000$ divided by 50,000$ is 0.1 or 10% whereas 5000$ divided by 250,000$ is 0.02 or 2%.
Comparison now becomes easier, 10% is larger than 2%, hence the difference in perceived value.
By extension, in the scenario of the first pay-check the denominator is 0 which means any amount divided by 0 yields a ratio of infinity. Which explains the feeling of being infinitely rich!
Implications to FIRE
As human beings, we are more sensitive to ratios than absolutes. The perception of sound, brightness etc is based on relative scales rather than absolute measures.
This might have been an evolutionary advantage that seems to have served us well.
However, when it comes to finance, and more importantly on the journey of FIRE. This could be a very big disadvantage.
An Example
In the beginning of your FIRE journey let’s assume your FIRE portfolio is 10,000$. At this time, spending an amount like a 1000$s for example makes you question it and look for alternatives as it is a significant proportion of your current portfolio. To be more precise, it is 10% of your portfolio.
Fast forward to 5 years later, your FIRE portfolio is now worth 250,000$. Now the same 1000$s is only 0.4% of your portfolio.
There is a real danger of becoming negligent towards this 1000$s as the perceived value is lower.
How do you escape this trap?
One way to escape this fallacy is through the use of the same mathematical model that we used to explain the concept of perceived value.
We saw that as the denominator (networth or the money you already have) increases, the ratio becomes smaller and smaller for the same amount in the numerator.
One way to combat this is to use a constant denominator.
Instead of dividing any amount by the money that you already have, use your target FIRE portfolio.
Applying this to the same example, let’s assume the target FIRE portfolio is 1Million $s. Then the ratio of 1000$s to 1Million$s is always going to be 0.1% no matter how much money you have.
Takes time to adapt
This is a new way of thinking and it takes time to adapt to this. When you first start, 0.1% seems trivial but it also pushes you to think differently. Like, a 1Million $s is a one thousand 1000$s. So, every 1000$s counts.
It also allows you to make consistent spending and earning decisions as the ratios that you use are comparable all along your FIRE journey.
Do let me know in the comments as to what your thoughts are.