Yes, You Can Have It Both Ways (And You Already Do)

You couldn’t set foot inside a b-school or econ classroom anywhere in the world and get a better discussion than happens regularly on FI blog comment boards.

There’s more intellectual firepower flowing from brains through fingers into blogospace from fellow FIends than there is actual firepower in a nuclear silo. Smart chicks and dudes out there!

Which brings us to a few days ago when FL published a little ditty about cash. How much is optimal for someone to keep on-hand, like in a checking account? We got kinda two answers.

Which way is up?
Which way is up?

First: For homo economicus, precisely zero cash (on average) is optimal because cash kills wealth-building efforts. This is correct. And mathematically provable. And also maybe a bad policy for lizard-brained investors (which we all are).

Second: For fearful lizard-brained investors, around three months’ worth of cash seems right. That amount helps keep sneaky de-risking from happening, and, according to pscyho-economics (aka, behavioral economics), a chunk of on-hand change seems to promote happiness and life satisfaction.

So that was that.

Say It Like You Mean It

And then the discussion board lit up like the jumbotron at the new Dallas Cowboys stadium. Three broad types of comments appeared.

1) The “I do this anyway/already” comment.

Which makes perfect sense because of the aforementioned intellectual firepower of FL’s readers.

And which makes perfect sense given the mechanism by which the behavioral economics research implying a link between cash and happiness was conducted. Basically, the researchers asked.

And so if it’s the case that lots of those surveyed with more cash happened to be happier (and maybe even discerned the link between their cash and happiness), then it’s not much of a stretch to assume other people outside the survey pretty much figured the effect out on their own and acted accordingly.

2) The “I subordinate my humanness to Spockian calculation” comment.

This sort of comment basically boils down to finding greater happiness in maxing out long-run investment returns than in feeling security from on-hand cash. Which is something we should all strive for. But which is something that, for some people, may not be entirely realistic.

After all, virtually all people value their health, and we all know that exercising is good for our health, but that doesn’t mean virtually all people regularly exercise. So there’s a chasm between theory and action for lots of humans on lots of fronts, both moneyed and not. And sometimes we do sneaky things (like join a gym but never go, or go and just sort of camp out on a stationary bike for 15 minutes while checking email, or subtly de-risk our investment portfolio) to try to cover up that chasm.

Danny Kahneman (who’s a psycho-economist of the first order and Nobel winner) might label those of us who understand the math and know how we ought to behave but maybe find sneaky loopholes as suffering a form of “theory-induced blindness” or “being blind to blindness” or some other form of ocular disorder. We may know the theory of keeping zero cash is right, even if behaving that way isn’t real-world durable for all of us.

3) The Mr. & Mrs. PIE comment.

It’s perfect in every way. If you haven’t read it, you should. Slowly. Deeply. Repeatedly.

So.

At least comment types 1 and 2 above provide insight to the essential struggle we humans face in most matters. We have the Spockian intellectual optimization side. And we have the bumbling human side.

And it’s not always obvious that one side dominates the other in a given scenario, or in a given person, or even in a given scenario for a given person at a given point in time.

In fact, sometimes a single, simple mathematical problem can be presented to a single person, and that person can find two different and mutually exclusive answers. And not be bothered by the contradiction at all. All at once.

To consistently get contradictory answers, all that has to be done is some slight tweaking to the form of the question that’s being asked. Same question. Two ways of phrasing. Two consistently different answers.

Ask Around

Here’s an example I love.

You have a selection to make. You can have either one.

Behind Door 1) A 97% chance of winning $10.

Behind Door 2) A 37% chance of winning $30.

What do you do, hotshot? What do you do?

All right. You think you know your answer. But you’re wary because this is FL you’re talking to, and you know I’m up to something.

So you probably “cheat” a little and maybe whip out the old smartphone calculator just to be positive. And, sure enough, you find the expected value of option 2 to exceed the expected value of option 1 by about $1.40.

So you should choose option 2, right? But then you get to thinking: Maybe not. Maybe I should really think about how binary this whole thing is. It’s all or nothing. I can’t really get the expected value. There’s a two-thirds chance of getting nothing with option 2. I should go with the safe bet. After all, what’s a buck-forty? I wanna buy some new calculator apps for my smartphone, and $9.70 will cover most of that cost by itself!

And you go with option 1. Just like most people do.

Which isn’t strictly wrong or right. But it is an unambiguous preference for option 1. Which means you value option 1 more than you value option 2. So option 2 must be worse. And worth less. And less precious.

But now I flip the question around.

Assume you “own” both 1) A 97% chance of $10, and 2) A 37% chance of $30.

They’re yours. And you have the ability to sell them.

What is the minimum price you’d accept for each?

So now you’ve got the smartphone calculator out again, and you’re plugging and chugging. And you’re a pricing deity. And you’re saying: The expected value of 1 is $9.70, so I won’t take less than that for 1. And the expected value of 2 is $11.10, so I won’t take less than that for 2.

And so you confidently write down your minimum acceptable price for 1 to be $9.70, and for 2 to be $11.10.

And you smugly hand me your answer sheet and drop your mic and spike a football and twerk your way out the door. “Stupid math games!” you exclaim.

All of which means, in sum, you value 1 more highly than 2, and you value 2 more highly than 1. You also think 2 is worse than 1 and better than 1. And you prefer 1 to 2 and 2 to 1. And you do it all at once. With a calculator app. And plenty of time to do the calculating. And real money at stake. Which is impossible. Right?

Tell It Like It Is

Actually, it’s more than possible. It’s pretty common. As in overwhelmingly more likely to occur than not. As in the vast majority of people do this. Smart people. Economics students and b-school students. And people whose name really is Spock. (Note: There might be as many as ~1,500 people in the U.S. with the first name of Spock; they’re in the same ship, er, boat as the rest of us.)

Which is a way of saying that we simple humans can be both Spockian and bumbling at once. We can know the “right” answer and still get the problem wrong. And we can maybe have no clue what the “right” answer is and still not do any worse than anybody else.

So, no matter which side of the comments board you come down on in the Great Cash Debate, you’re really probably on both sides of lots of finance and economics debates like it. All at once. And you should be super relieved about that since it means you’re undeniably, unequivocally and unaccountably human. Even if you’re named Spock.

Luchadores, would you go with option 1 or option 2? What would be your minimum acceptable prices for each? Holla!

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