Percentages are the Way You Think

Time for another episode in my continuing series People Are Idiots. Previous installments have included how to sell your students wine and how to get rich on the internet.

Car_accident_poland_2008 Today we visit another phenomenon of cognitive misbehavior, what I like to call the Small Percentage Effect.  (It has some other fancy name among behavioral economists. I like mine better.)

Imagine that you have decided to buy the latest, totally cool and sexy, iPod. It retails for $200. You are about to pick it up at a shop near your home when you hear that all the way across town a store is running a one-day special promotion, selling this iPod for only $100. It is a 90 minute round-trip drive, but you gleefully head off to score your bargain iPod.

Unfortunately, after a while you realize that the iPod is not attracting nearly the number of members of the opposite sex that you expected. So you hatch Plan B, an even more totally cool and sexy convertible. The dealership near your house will let you drive it off the lot for $50,000. But then you find out that another dealership, coincidentally next to the place where you got the bargain on the iPod, will sell it to you for only $49,900.

Do you make the same trek across town to save $100 on the car? Most people would not, even though they would to save the same $100 on the iPod. Because people are idiots.

There are two things going on here. One is the natural tendency to think of things like discounts as proportions or percents, rather than as absolute amounts. The discount on the car is a joke, only 1/500 or 0.2% of the total. Most people think of it as being essentially zero. But the discount on the iPod, 50%, is worth getting excited about. Our brains are wired to think in terms of proportions like this. They just are.

(When people predict future downward pressure on mutual fund fees I tell this story about iPods and convertibles. The simple truth is that no matter how many dollars it translates into, hardly anybody will pick a fund because the annual fee is 0.25% lower.)

The other important pseudo-logical failing at work here is that people have trouble believing, or acting as if they believe, that all dollars are worth the same. The $100 saved on the iPod just seems more exciting and useful than the $100 saved on the car. You could use it to buy music to put on the iPod or you could buy a second iPod in another color. The money saved on the car, well, you could use it to start saving for the next car, or apply it to the purchase of some other large-ticket item. Not so exciting.

To a certain extent everybody mentally sorts expenditures like this. The only way to get our heads around the spending of our money on all the things we buy is to separate out the expenditures into buckets, for example housing, clothing, eating out, etc. Every person may have a different set of buckets, but dividing things up and then concentrating our efforts on allocating inside the buckets is the natural and practical approach.

The side-effect is that we have trouble relating savings in one bucket to things we might buy in another. An example from the behavioral economists illustrates this nicely.

Researchers found that people who move from cities with less expensive housing markets to more expensive ones, Toledo to New York perhaps, or vice versa, tend to spend the same on a house that they did in the old city. So a person going from Toledo to New York will squeeze the family into a tiny apartment and the one going the other way will buy a palatial mansion. It seems very likely that the new New Yorkers would be happier if they spent a little more on housing and less on everything else, just as the new Toledoans would be happier spending less on housing and more on the other stuff.

People are idiots.

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