I read a great comment on the blog Frugal Professor that I’d like to share. The business school professor there needed a new mattress. One model that came into consideration costs $3,500. Someone commented that considering that you spend around 1/3 of your life on the mattress, it’s worth spending $3,500 on a good mattress. The professor replied:
These thoughts have gone through my mind as well. But I also spend around 95% of my life wearing socks and can’t justify paying $3500 on them. The tradeoff I’m making with this purchase, as with all purchases, is to maximize value by maximizing marginal benefit divided by the marginal cost. In the case of the mattress, I’m trying to figure out what the marginal benefit is of a $3500 mattress relative to a $500 mattress (does the marginal benefit exceed the marginal cost of $3k). But, overall, I’m sympathetic to the idea of not cheaping out on a mattress given that it will affect the quality of my life in a non-trivial way for at least 10 years.
This highlighted the difference between what I call the absolute value and the relative value.
The absolute value is the value of having something over having nothing. If I must sleep on concrete for 10 years, I would spend $3,500 on a mattress. If I must walk 10 miles to work every day, I would pay $35,000 for a car.
The relative value is the value of something over its next acceptable alternative. When a $1,000 mattress does the job, a $3,500 mattress offers poor relative value. When a $5,000 car gets me to work just fine, a $35,000 car offers poor relative value.
Sellers like to use the absolute value to make the sale and justify to themselves they are providing value. Here are some examples:
“Before I sold you this whole life policy, you had no life insurance. You would’ve blown your money on unnecessary spending. You should be happy your family is protected now and the policy is worth something.”
“When you walked into the bank, your money was all in CDs. These mutual funds with 2% expense ratios still made more money for you than those CDs.”
“I talked you out of selling at the bottom when the market crashed. That’s worth a lot more than the 1% I’m charging you.”
“If I didn’t treat you after that bus accident, you would’ve bled to death. So pay me $27,000 for giving you stitches.”
In each case the sellers provided absolute value. However, buyers still received poor relative value. A whole life policy isn’t the only option to protect one’s family. You don’t have to blow away your money if you don’t buy a whole life policy. When you can buy a target date fund with expense ratios under 0.2%, paying 2% is crazy. Even if you need someone to talk you out of self-inflicted harm, 1% of assets under management is still 5-10 times too high.
A fair price is determined by the next acceptable alternative. When you must have something and nothing else will do, you will pay a very high price. You will get better relative value when you are open to more alternatives. If you hear a seller making the argument based on the absolute value, alarm bells should go off right away, because doing nothing is almost never the true alternative. They make the argument based on the absolute value when the relative value is poor.