Money - Income, Expenses, and Value
November 22, 2011
This is where we get into the meat and potatoes. This is where things get more fun. Since money is a tool, how and why should I use it?
To understand motivations, take a brief look at Maslow’s Hierarchy of Needs. It’s an old, well-used model, but it still has relevance to how we should organize and structure our lives.
Maslow’s pyramid tries to characterize what is important for a person to be a person. The bottom of the pyramid are all things we largely take for granted now: food, clean water, sanitation, sleep. The pyramid builds on every step, but each is required for our happiness. When Maslow described the last step, self-actualization, he said, “What a man can be, he must be.” Nothing is more important than that. At the very least, money shouldn’t get in the way. Maybe sometimes it can help too.
Minimize and Maximize
So the purpose of acquiring wealth is to use it for a range of needs from basic sustenance to Maslow’s self-actualization. On a practical, everyday level, there are two ways to do this: minimize your expenses and maximize your income.
People are generally oblivious of what they spend their money on. I know I was for the longest time. I had a set of credit cards and when I wanted something, I put it on a card. When the bills came, I did my best to pay some reasonable percentage of the bill, and told myself I’d do better next month. This is what most people do.
Most of my friends still think money flows out of me like water, because I never seemed to care that much. I just bought stuff. Those days are long gone now. I still spend money when it’s on something I feel is important, but I’m in a far better position now because I know exactly what I spend money on and I know why it’s important.
The number one thing you can do to manage your expenses is get better measurements of your expenses. You have to be able to measure something to effect a change. Fortunately, the tools available for this have gotten vastly better in a small amount of time. Gone is the day of the paper ledger, and even the spreadsheet (although if you use and are comfortable with a budgeting system on a spreadsheet, go for it). Most banks have good internal tools. My favorite is Mint, a free service that has a read-only view into your online accounts and provides great tools to determine your financial health and habits. I’m keeping a sharp eye on Simple as well.
Once you know what you spend, you can start asking real questions about what you really need. Maslow’s hierarchy is perfect for this. My goal for the basic needs now - food, clothing and housing - is to minimize it monthly based on a reasonable quality of life that allows me to continue my goals of self-actualization. In other words, the basics can be had for pretty cheap. But instead of seeking the cheapest possible solution, I want to find the cheapest solution that still lets me drive towards being who I am.
The artist I mentioned in the last article is the master of this. They meet their basic requirements in such a fashion as to focus on what’s important to them: working on their abilities as an artist.
Note how different this is from driving to keep up with the Joneses. In comparing to others, you and your family aren’t even a factor in the equation. The only factor is putting up a sufficiently pretty facade to meet the vision of some quasi-real group of people. People continually get sucked into having a more expensive car or house when what they have now suits their needs perfectly. Instead of putting their time and money towards a drawing class maybe they’ve always wanted to take, they drive towards a larger monthly mortgage payment and more hours at the office because they think they need a McMansion to live right.
When you focus on your own needs and with money as a tool in your toolbelt, the drive towards happiness becomes possible.
Of course, the entire world is arrayed against you. Here’s an open secret: the consumer companies of the world are intent on keeping you relatively unwealthy by getting you to give them money for things they make you think you need.
Brand is the method by which they do this. Long ago, brand was a sign of quality based on a reputation. Today, a lot of it is nonsense. This is because of another, less open secret: the manufacturing and technological capabilities of the world today are so good that the relative differences between brands are based on style and exclusivity, not on quality.
I talked about this before with regard to cars. Cars are a very poignant example for me because I’ve done such a bad job with buying cars in the past. It’s not that I’ve ever taken a very huge loss on a deal or defaulted on a loan, I’ve just been fickle about purchases. I’ve had 20 cars and I’m only 31. I’ve always assumed a car payment.
Finally now, I’m on the way to changing that. I’ve got a sturdy, comfortable, reliable Nissan SUV I bought used that satisfies all of my needs. We’re working towards having no car payments. Racing - the reason I’ve had so many cars - used to be a point of contention between my wife and I. That has basically ceased ever since we did a very simple thing: we set a budget for it.
So despite what brand and marketing tells me, the differences between a Honda or Nissan and a BMW or Mercedes are far less discernible, especially compared to my needs for a car. My Nissan has heated seats, a heated steering wheel, A/C, sunroof, a great stereo, iPod hookup, DVD player, great brakes, and great towing capacity. What does a Mercedes have that I need? Seat massagers? Distronic? I don’t think so. A Nissan will have all of that in ten years anyway.
But I’ll Still Buy Luxury Brands
Brand for cars is equivalent to a sign of the future. It serves a different purpose for other consumer products. The CEO of McDonald’s once said that they are in the real estate business rather than the food service business. Similarly, Louis Vuitton has LV draped over all their products. Why? Because when you see LV on a brown purse, you know it cost the idiot carrying it $1600. Louis Vuitton isn’t about fine linens and purses, it’s about a name; they’re in the celebrity business. Brand in fashion is signaling on income. Old Navy signals stylish mainstream. Levi’s Jeans signal tough and durable. Louis Vuitton signals money. Fuck that. For a very small, very wealthy segment of the population, buying a $1600 purse is like you or I buying a pack of gum. Let them keep their purses.
That said, luxury brands still have a place in our world and it’s important to understand what that place is. Most people have an expectation that when they buy a $100 bottle of wine, it will be 10x better than their normal $10 bottle. A $1000 bottle would be 100x better. Unfortunately, quality doesn’t scale so linearly. It’s been shown in studies that price itself is one of the number one signals that a consumer uses to rate wine. On price alone, the average consumer will think a $30 bottle better than a $10 bottle.
It might be better, but only a connoisseur might notice. More importantly, luxury products like this move towards some undefinable point of perfection on a log scale. A $100 bottle is 99.9% of perfect rather than 99%. If the approach of that perfection is important to you, maybe the price tag is worth it. If you understand it.
Computers and jeans are my own examples. I’ve spent quite a bit more than I need to on computers. But I’m on them so much, everyday, that the value of a $1500 Macbook Pro over a $250 Acer is paid for a thousand times over. Extra software and data backups are a no-brainer too. As technology gets better and better, these things become closer to commodities. The hardware of my iPhone is just a commodity tool for data and communication now.
It’s a similar story with jeans. I’ve tried a ton of brands and I’ve hated every pair. They’re uncomfortable, scratchy, fall apart and look silly to me. Then I stumbled on Ermenegildo Zegna, an Italian luxury clothing manufacturer. They’re the only jeans I wear now. I have 3 pairs at $200/pop, but I wear them constantly, they’re incredibly comfortable, they have more longevity, and they actually look good. The value proposition they offer me are worth their price.
Value is the underlying principle of importance when looking at acquiring material goods. Will the value of this “thing” reflect it’s price for me? Price is specified by the seller. Value is discerned by the buyer. The value might be reflected by time saved, peace of mind, or the happiness of your children. Being able to discern this on your own, without the influence of the Joneses around, is a profoundly freeing process.
Notice I said “discern” rather than “decide”. There’s a subtle difference. Discerning is the act of recognizing something. Deciding is a choice you make. The reason that finding value is a discernment rather than a decision is that it’s based on your own Hierarchy of Needs. Deciding on something can be fleeting and fickle. Discernment is a search for the truth of something. Deciding is looking at some “thing” and saying “I want this.” Discerning is looking at some “thing” and saying “How will this help me and my family towards our goals?”
Income is the flipside of expenses. There are three basic ways to make income:
- Trade your time for money directly by means of some skill
- Trade the time of a set of people for money by means of some skill
- Provide a product with a value proposition people are willing to pay for
Trading time for money directly is what most people do. They have some set of skills that their employer pays them for based on a set amount of time per year. In the US today that’s roughly 1900-2000 hours. In France it’s less hours. In Japan it’s more.
This direct trade has a natural limit, and doctors and lawyers hit it (and engineers are driving towards it too). These types of jobs are full of esteem and establishment because their required skills demand a very high pay for a given amount of time. Deservedly.
Unfortunately, trading money for time directly is about the most inefficient way of acquiring income. To get any more than a doctor or a lawyer requires something new, something different than trading time for money.
The next option is to trade the time of a bunch of people for money. It’s easy to see how the owner of a plumbing company with 250 plumbers working for him can make far more than a doctor. The employees are paid for their time directly and the owner gets a cut of each for the overhead and drive to manage the business itself.
The last choice is to provide some sort of product that people are willing to pay for. Car manufacturing, Panera Bread, writers, Walmart, real estate investments, and Google are all examples of this. They are successful or not based on the value they provide, the resources necessary to meet demand, and the ability of the value proposition they offer to scale to a large audience. Google, for instance, provides extremely valuable services (information search), has very low overhead, and can scale out to literally the entire world. That’s why they’re so successful and profitable.
Russ Roberts of Econtalk described this with an analogy on Gilligan’s Island. If the Professor spends a bunch of time inventing some time-saving device that he can sell for $1, he’ll have a problem. There’s only 7 people on the island, so his potential income is only $7 and he won’t even bother to build such a device. If, on the other hand, he can get off the island his potential customer base is 7 billion people, and his potential profit is thus $7 billion. When you can scale a product to a large audience, you can drive a lot of value to a lot of people.
This is why it always seems ridiculous when you break out Lebron James’ salary on a per game basis. If you did that he’d make way over $100,000 per game. It doesn’t make any sense for a very good reason. He’s not paid per game. He’s paid for his value to the corporation that hires him. That value is based not only on his basketball skills, but also his celebrity and branding opportunity. How many people wanted a Cavaliers jersey before he showed up in Cleveland? How many people in Miami wear a Mario Chalmers jersey now?
I ordered these three options for a purpose. The further abstracted your income is from your time, the more secure it is. Disability insurance is needed for salaried employees because without trading their time for money directly, they have no income. A real estate owner or investor doesn’t need that. Neither does someone with passive income off stocks. Similarly, your time is more free to do what you want with it. You don’t have to keep working all the time to keep income. Rarely does a salaried worker take a 4 month vacation, but investors, business owners, or anyone with a passive income source has more of those opportunities.
When push comes to shove, which is more important, minimizing expenses or maximizing income? In the short term, it’s certainly easier to draw down expenses. Unfortunately this can only go so far. You can’t get to zero, and the more you cut out the harder it is to shave even more.
There’s also always the question of wealth in the form of quality of life, time, health, work, family and happiness. For instance, there can be a huge time commitment involved in cutting bills. The Extreme Couponers on TLC are the edge case. Some of those people spend hours and hours a week to shave their grocery bills down close to zero. It’s almost another full time job. What would happen if they focused that energy on building income instead?
Income is, in a strict sense, limitless. Bill Gates certainly doesn’t worry if his food budget is $1000 or $5000 per month. In the longer term, life gets easier when you can expand your income so that your bills just don’t matter that much.
The worst thing to do is float along with a net zero budget regardless of income. I call this Subsistence Budgeting. Just as subsistence farming is farming only barely enough food to survive, so subsistence budgeting is budgeting with the simple goal of ensuring that your income and expenses net to zero each month. You can make $25,000 or $500,000 a year and still be simply subsisting. It’s a setup for failure, usually but not always driven by the Joneses. Subsistence budgeting means that as soon as your income is turned off, you’re screwed. Your expenses are so high that you have no buffer. Especially when you work for a salary at a company, the on/off income switch is completely outside of your control, whether you feel comfortable or not.