Percentages are the Way You Think

[This Thursday re-run first appeared July 24, 2009.]

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.

5 Comments

  • By Ron, July 22, 2010 @ 12:19 pm

    “Two things are infinite: the universe and human stupidity, but I’m not 100 percent sure about the the universe.” ~~Albert Einstein

  • By Steve, July 22, 2010 @ 12:22 pm

    Even having noticed this effect it’s hard to avoid. For instance, tooth paste can be had for a dollar on sale, or two dollars not on sale. I won’t buy it not on sale, even if I have to check the tooth paste aisle every week when I go shopping. We use, what, 6 tubes of toothpaste a year? maybe 12? About enough to buy a decent lunch.

    But in the almost exact scenario above (buying a car across town would have been $125 cheaper) I did the expected thing. That’s 10 to 20 years of toothpaste discount, down the drain.

  • By Investor Junkie, July 22, 2010 @ 2:01 pm

    Lets not forget even the time it takes to go across town to save the $100 (which is what I thought the article would be about). What stupid people do to be frugal and save a few dollars. It’s been said the average person’s hourly rate is approx $15-20/hr (meaning no matter what you do if you are working or not). I find it amazing the amount of effort people do to save that amount when say changing your oil (which in most cases will take an hour to perform if you do yourself) when you can get an oil change for $19.95 and be done in 15 min.

  • By Lola, July 23, 2010 @ 10:59 am

    I don’t think it’s “People are idiots” as much as it is “People are emotional.” Or as Dan Ariely calls it, “irrational.”

    With your iPod vs. car example, I would venture to say that since so many people now have an iPod, they could relate and, (I would hope) be happy for a friend who found such a good deal. It would be a better story than getting a little bit off the total of a new car, which most people don’t buy very often at all.

    For many people, this is the huge appeal of shopping on the day after Thanksgiving – it’s like a quest.

    Of course, some financial behavior is very stupid for long term sustainability and based completely on wishful thinking rather than the most basic arithmetic. Again, I don’t know that I would attribute that to most people being idiots, but rather to most people being weak and a lot of them being poorly educated.

    Maybe the current reality of the downscaled economy and accompanying media focus on how people are looking to save more and live within their means will help the financial education process along for a lot of people.

  • By Adam, July 23, 2010 @ 3:31 pm

    You make a ton of small purchases. If you make an effort to save ~50% regularly on all the small purchases it will add up. You make very few huge purchases like a convertible. If you make a big effort to save .2% on all purchases made, its not going to have the same effect.

    What bothers me in common PF literature is advice that requires an enormous amount of effort to save the .2% on lots of small purchases (latte factor) when its such a pain in the ass. Much better to spend 50% less on the big purchases (house and cars for example).

    Sorry just pulling your .2% and 50% numbers from above.

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