July 20, JDN 2457590

My posts recently have been fairly theoretical and mathematically intensive, so I thought I’d take a break from that today and offer you a much simpler, more practical post that you could use right away to improve your own finances.

Cognitive economists are so accustomed to using the word “heuristic” in contrast with words like “optimal” and “rational” that we tend to treat them as something bad. If only we didn’t have these darn heuristics, we could be those perfect rational agents the neoclassicists keep telling us about!

But in fact this is almost completely backwards: Heuristics are the reason human beings are capable of rational thought, unlike, well, anything else in the known universe. To be fair, many animals are capable of some limited rationality, often more than most people realize, but still far less than our own—and what rationality they have is born of the same evolutionary heuristics we use. Computers and robots are now approaching something that could be called rationality, but they still have a long way to go before they’ll really be acting rationally rather than perfectly following precise instructions—and of course we made them, modeled after our own thought processes. Current robots are logical, but not rational. The difference between logic and rationality is rather like that between intelligence and wisdom. Logic dictates that coffee is a berry; rationality says you may not enjoy it in your fruit salad. Robots are still at the point where they’d put coffee in our fruit salads if we told them to include a random mix of berries.

Heuristics are what allows us to make rational decisions 90% of the time. We might wish for something that would make us rational 100% of the time, but no known method exists; the best we can do is learn better heuristics to raise our percentage to perhaps 92% or 95%. With no heuristics at all, we would be 0% rational, not 100%.

So today I’m going to offer you a new heuristic, which I think might help you give your choices that little 2% boost. Expensive cheap things, cheap expensive things.

This is a little mantra to repeat to yourself whenever you have a purchasing decision to make—which, in a consumerist economy like ours, is surely several times a day. The precise definition of “cheap” and “expensive” will vary according to your income (to a billionaire, my lifetime income is a pittance; to someone at the UN poverty level, my annual income is an unimaginable bounty of riches). But for a typical middle-class American, “cheap” can be approximately defined by a Jackson heuristic—anything less than $20 is cheap—and “expensive” by a Benjamin heuristic—anything over $100 is expensive. It doesn’t need to be hard-edged either; you should apply this heuristic more thoroughly for purchases of $10,000 (i.e. cars) than you do for purchase of $1,000, and still more so for purchase of $100,000 (houses).

Expensive cheap things, cheap expensive things; what do I mean by that?

If you are going to buy something cheap, you can choose the expensive variety if you like. If you have the choice of a $1 toothbrush, a $5 toothbrush, and a $10 toothbrush, and you really do like the $10 toothbrush, don’t agonize over it—just buy the damn $10 toothbrush. Obviously there’s no reason to do that if the $1 toothbrush is really just as good for your needs; but if there’s any difference in quality you care about, it is almost certainly worth it to buy the better one.

If you are going to buy something expensive, you should choose the cheap variety if you can. If you have the choice of a $14,000 car, a $15,000 car, and a $16,000 car, you should buy the $14,000 car, unless the other cars are massively superior. You should basically be aiming for the cheapest bare-minimum choice that allows you to meet your needs. (I should be careful using cars as my example, because many old used cars that seem “cheap” are actually more expensive to fuel and maintain than it would cost to simply buy a newer model—but assume you’ve factored in a good estimate of the maintenance cost. You should almost never buy cars that aren’t at least a year old, however—first-year depreciation is huge. Let someone else lease it for a year before it you buy it.)

Why do I say this? Many people find the result counter-intuitive: I just told you to spend 900% more on toothbrushes, but insisted that you scrounge to save 12.5% on a car. Even if we adjust for the asymmetry using log points, I told you to indulge 230 log points of toothbrush for a tiny gain, while insisted you bear no-frills bare-minimum to save 13 log points of car.

I have also saved you $1,991. That’s why.

Intuitively we tend to think in terms of proportional prices—this car is 12.5% cheaper than that car, this toothbrush is 900% more expensive than that toothbrush. But you don’t spend money in proportions. You spend it in absolute amounts. So when you decide to make a purchase, you need to train yourself to think in terms of the absolute difference in price—paying $9 more versus paying $2000 more.

Businesses are counting on you not to think this way; that car dealer is surely going to point out that the $16,000 model has a sunroof and upgraded tire rims and whatever, and it’s only 14% more! But unless you would seriously be willing to pay $2,000 to get a sunroof and upgraded tire rims installed later, you should not upgrade to the $16,000 model. Don’t let them bamboozle you with “it’s a $5,000 value!”; it might well be a $5,000 price to do elsewhere, but that’s not the same thing. Only you can decide whether it’s of sufficient value to you.

There’s another reason this heuristic can be useful, which is that it will tend to pressure you into buying experiences instead of objects—and it is a well-established pattern in cognitive economics that experiences are a more cost-effective source of happiness than objects. “Expensive cheap things, cheap expensive things” doesn’t necessarily pressure toward buying experiences, as one could certainly load up on useless $20 gadgets or spend $5,000 on a luxurious vacation to Paris. But as a general pattern (and heuristics are all about general patterns!) you’re more likely to spend $20 on a dinner or $5,000 on a car. Some of the cheapest things people buy, like dining out with friends, are some of the greatest sources of happiness—you are, in a real sense, buying friendship. Some of the most expensive things people buy, like real estate, are precisely the sort of thing you should be willing to skimp on, because they really won’t bring you happiness. Larger houses are not statistically associated with higher happiness.

Indeed, part of the great crisis of real estate prices (which is a phenomenon across all First World cities, and surprisingly worse in Canada than the US, though worse still in California in particular) probably comes from people not applying this sort of heuristic. “This house is $240,000, but that one is only 10% more and look how much nicer it is!” That’s $24,000. You can buy that nicer house, or you can buy a second car. Or you can have an extra year of your child’s college fund. That is what that 10% actually means. I’m sure this isn’t the primary reason why housing in the US is so ludicrously expensive, but it may be a contributing factor. (Krugman argued similarly during the housing crash.)

Like any heuristic, “Expensive cheap things, cheap expensive things” will sometimes fail you, and if you think carefully you can probably outperform it. But I’ve found it’s a good habit to get into; it has helped me save money more than just about anything else I’ve tried.