It’s All Just Commas and Zeroes…Isn’t It? (Part 1)

By Brad Thomason, CPA

 

We’ve all heard it before.  The only difference in this thing or that thing is the size.  When money’s involved, the difference is simply a matter of  “commas and zeroes.”  Simple, right

I actually rather hate that expression.  It’s been my experience that it underscores a way of thinking about finance which leads to misunderstandings and errors of judgment.  In this piece, and one to follow in the near future, I’ll attempt to outline a couple of the ways that this notion can cause problems.

One of the appeals of finance is that it is conducted in terms of numbers, which means that it will often yield to mathematics.  We like math, because it gives us a sense of certainty and precision (this is at times a false confidence, but that’s a rant for another day).  The numbers don’t lie, the wise expostulate.  Just see what the numbers say, and you’ll have the answer.

Oh, really?  To test that assumption, let’s play a quick game.  I’ll give you a choice: you can flip a coin for a shot at $10, or I’ll just give you $1 straight up.  Which do you choose?  This was the base question of what’s become known as the Markowitz experiment, and when it was conducted back in the mid-50s, every one of the participants chose to flip the coin and gamble for the 10 bucks.  But in round 2, they modified the question by adding a comma and three zeroes.  Most people said they would just take the $1,000 instead of gambling for 10x that amount.  And in round three, when they made the adjustment again, every one of the participants said they would take the sure million over the gamble for ten million.  There was a 100% reversal in favored strategy from round 1 to round 3.

This is very interesting, because it refutes the commas-and-zeroes assumption in just about the most direct way possible.  Mathematically speaking, all three propositions are identical.  What the math tells you to do is the same in every case (which, by the way, is flip the coin).  Or stated another way, quantitatively speaking we get a consistent answer; yet in practice the actual decision changed.  Why?  Because there are qualitative factors at work here, too.

A dollar isn’t going to change anyone’s life, so there’s nothing to lose by risking it.  The same can’t be said of a million dollars: there are very few people for whom that would not be a dramatic life change.  So the response to the proposition changes, even though the math doesn’t.  There truly is more going on than just the simple addition of commas and zeroes.

The point here is that the clean lines afforded by the math don’t always give full containment of everything that’s important.  If you only look through the quantitative lens you may miss part of what matters.  Which has clear implications for your chances of making the right decision.

Here’s another quick example to drive the point home.  Jones and Brown are residents of Townville, where it costs $100 a year to live.  Jones makes $200 a year and Brown makes $100 a year.  So Jones is twice as well-off as Brown, right?

Nope.  In fact I would say that Jones is not just twice but infinitely better off than Brown.  The amount that Jones makes beyond what is necessary to cover the cost of living has dramatic implications for the life that Jones can lead relative to what Brown is in for.  Jones will have a cash reserve.  Jones can buy things and pay for experiences that will enhance his enjoyment of life.  Jones can retire one day.  Jones can sleep at night knowing that he’s got some cushion, an all-purpose plan B if life deals him a few bad hands.  What’s that worth?  I would say it’s nearly priceless.  Although mathematically, it is in fact, just double.

The lesson:  Don’t make the mistake of thinking that something as complicated as finance can be adequately explained with quips that would be at home on a bumper sticker.  Because while there may be some truth to such notions in some cases, it is not likely that they will ever be adequate to fully describe all that’s important.

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