A Dollar Is A Dollar Is A Dollar. Except in Our Minds.
The form of money—salary vs. bonus, income vs. capital—affects the way we treat that money. Sometimes that helps us financially. And sometimes it hurts us.
7 min
Do you care if an assistant at the chemist gives you change in one $10 note or two $5 notes?
Are you more reluctant to spend hard-earned dollars than windfall dollars?
Do you distinguish the “income” dollars paid as dividends on your stock from the “capital” dollars of the value of the stock itself?
Rational investors answer “no” to each of the three questions. After all, money is money, and rational investors can easily distinguish between the substance of money and its form. Hard-earned dollars and capital dollars are no greener than windfall dollars and income dollars.
Normal investors, however, are likely to answer “no” to the first question, but many are sure to answer “yes” to the second and third questions.
All of us are normal investors. For us, the form of money does make a difference. A dollar may be a dollar may be a dollar. But not in our minds.
Sometimes, such normal thinking helps us in our financial lives. But sometimes it hurts us. And understanding the difference between the two—that is, knowing when we’re being smart, even if not rational, and when we’re being neither smart nor rational—can make us better savers, spenders and investors.
Here are some examples of our normal thinking, and when it hurts and helps us:
Framing money into pots
We regularly divide our paychecks into pots. Sometimes they are tangible pots, such as checking accounts or glass jars. Sometimes they are virtual pots, such as Excel sheets or mental pots in our minds. We mark each pot with a label such as rent, food, entertainment, Christmas gifts or emergency funds, and refrain from dipping into pots other than designated ones.
Of course, none of this is rational. Rent dollars aren’t any greener than entertainment dollars. Rationally, they should all be in one pot labelled “money.”
Yet this practice is smart when it makes budgeting easier and prevents bounced checks and disappointed children on Christmas morning. For example, one couple I read about maintained a joint account and two sets of checking and savings accounts—one for daily expenses, such as groceries, and the other for larger expenses, such as taxes. The wife was responsible for paying daily expenses from one account and the husband was responsible for paying larger expenses from the other. The idea was to make sure they always had enough for both groceries and taxes.
Rational? No. Smart? Yes.
Of course, refraining from dipping into pots other than designated ones requires self-control. Yet this is difficult when we face temptation, such as using money in the emergency pot for entertainment. One smart way to bolster self-control is to place obstacles in the way of pots other than designated ones.
For example, one woman who contacted me put her money in a bank that is an hour’s drive away, and cut the bank’s ATM card.
Similarly, the government places obstacles to dipping into retirement pots by generally imposing a 10% penalty on withdrawals from defined-contribution retirement saving accounts on those younger than 59½.
Again, none of this is rational. A dollar is a dollar is a dollar. But thinking about the form of those dollars can make us financially healthier.
Except not always. Sometimes self-control is too strong rather than too weak, preventing reasonable dips into ample capital pots. That’s especially true for retirees who have plenty of money, but have spent a lifetime cultivating a saving mantra: Never dip into the capital pot. Now at the very time when they should be doing just that to enjoy life, they can’t bring themselves to do it. They continue to spend only the income they derive from their savings, and their lives are more constrained as a result.
Rational? No. Smart? No.
Distinguishing hard-earned money from windfall money
Easy come, easy go.
We regularly distinguish money earned with much effort, such as salary, from windfall money obtained with little or no effort, such as gifts. We tend to place hard-earned money in one mental pot and windfall money in another, and we spend windfall money more easily than we spend hard-earned money.
That distinction also affects our willingness to take risk. In one set of experiments, people were divided into two groups, hard-work earners and windfall receivers. People in the hard-work group received an amount of money for completing work requiring physical effort—peeling 25 potatoes or making nine envelopes within 30 minutes. People in the windfall-receiver group received the same amount of money as a gift, with no work requirement. Subsequently, people in the hard-work group made less-risky and less-impulsive choices than people in the windfall group.
Rationally, of course, it makes no difference whether somebody receives money from a windfall or hard work. It may also not be smart if it leads recipients of windfalls—whether bonuses, bequests or lottery winning—to fritter away these windfalls on meaningless purchases or risky investments. Then again, it could be smart if you’re a person who is not spending as much as you should because of an unwillingness to tap money from a large account. If thinking differently about “extra” money makes you more likely to spend what you can afford, go for it.
Tripped up by the ‘money illusion’
Money illusion refers to the failure to distinguish dollars framed as “nominal” from dollars framed as “real”—that is, after inflation. For example, a 2% increase in a nominal annual salary, say from $100,000 to $102,000 is a 1% decrease in the real annual salary when the annual inflation rate is 3%.
Rational investors are immune to the money illusion, but many normal investors are not. And that is not to the benefit of the normal investor.
We see the distortions caused by money illusion in the current concern about the low yields of bonds. For example, the average nominal yield on 3-month Treasury bills during the first nine months of 2020 was a meager 0.42%. The real yield is even lower, a negative 0.98%, because the rate of inflation during the period was 1.40%. Indeed, inflation has exceeded Treasury-bill yields in most years since 2002.
Yet there was less concern in 1979 when the nominal yield on 3-month T-bills was 10.07% and the rate of inflation was 12.26%, implying a negative 2.19% real yield. This is because many normal investors are misled by the money illusion, comparing the low 0.42% nominal yield of 2020 to the high 10.07% in 1979, while neglecting to note that the real yield in 2020, while negative, is higher than in 1979.
Moreover, 1979 investors paid higher taxes on a 10.07% yield than 2020 investors pay on 0.42%. Investors tend to overlook this 2020 tax balm.
Framing money in nominal terms is easier than in real terms because it does not require knowledge of inflation rates and how to use them to convert nominal dollars into real ones. Yet such framing is not smart when it misleads us to act as spendthrifts when high inflation pushes nominal interest rates up, and as misers when low inflation presses nominal interest rates down.
Spending company-paid dividends but not ‘homemade’ dividends
Investors holding shares of a company have two ways to derive money from these shares. Say you need $1000. You can receive a $1000 company-paid dividend. Or you can create a $1000 homemade dividend by selling $1000 of shares.
Rational investors would prefer homemade dividends to company-paid dividends because they can time homemade dividends when it is best for them, whereas timing of company-paid dividends is in the hands of the company. Also, taxes on homemade dividends are likely lower than on company-paid dividends. Homemade dividends do involve transaction fees as investors sell shares, but these fees are now pretty close to zero.
Many normal investors, however, prefer company-paid dividends to homemade dividends.
That can be both smart and not so smart.
Normal investors have two distinct mental pots: “income” and “capital.” Company-paid dividends, like wages, belong in the income pot. Shares, like other savings, belong in the capital pot. The self-control rule many people live by is to “spend income but don’t dip into capital.”
Thinking of the money as being in two distinct pots is smart when self-control is too weak to protect savings from excessive spending. A $1,000 company-paid dividend places a definite limit on the amount that can be spent, whereas a $1,000 homemade dividend opens the door to selling and spending, say, $2,000 of shares when a tempting vacation overpowers weak self-control.
Still, dividing money this way can backfire. To understand why, consider that an anticipated pain of regret is another reason for preferring company-paid dividends to homemade dividends. Imagine that you received $1,000 as a company-paid dividend and used it to buy a TV set. Compare it to creating a $1000 homemade dividend by selling shares to buy a TV, only to find that the price of shares zoomed soon after you sold them. The pain of regret is likely greater with homemade dividends because you bear responsibility for selling shares when you did, whereas you don’t bear responsibility for the company paying dividends when it did.
But the pain of selling stock—and then watching the price rise—should not be determining which form of money we “prefer” when we need $1,000. Stock prices do not zoom after we sell shares just because we sold shares. It’s just bad luck.
Avoiding selling stock and waiting for dividends because of the fear of regret may be what a normal investor would do. But it isn’t rational. And it probably isn’t smart.
Preferring ‘bond ladders’ to bond mutual funds
A bond ladder is composed of bonds of a range of maturities. For example, a $10,000 bond ladder can be built by allocating $1,000 to each of 10 Treasury bonds with maturities ranging from one to 10 years. The alternative is to place the $10,000 into a Treasury bond mutual fund.
In substance, a bond ladder is a “homemade” bond mutual fund with average maturity equal to that of a corresponding bond mutual fund. The value of a bond ladder declines when interest rates increase, as much as the value of a corresponding mutual fund. Therefore, rational investors are, at best, indifferent between the two if their costs are the same (more on that in a minute).
Many normal investors, however, prefer bond ladders because they can manage them in ways that reduce regret.
Imagine that you hold a bond ladder with 10 bonds with maturities ranging from one year to 10 years. You bought each of them at their $1,000 face value. Nine months pass, and you need $1000 to buy a TV set. Meanwhile, however, interest rates increased such that the prices of all 10 bonds are now lower than $1,000. If you sell the one-year bond you’ll receive, say, $995. Adding $5 to the $995 will not squeeze your budget too much, but realizing a $5 loss inflicts the pain of regret. A bond ladder gives you the option to wait three months until the one-year bond matures and receive $1,000, avoiding the pain of regret.
Bond mutual funds do not afford this waiting option. You cannot be assured that you’ll be able to avoid realizing a loss, no matter how long you wait.
None of it makes a difference to rational investors, because they know that a “paper loss” is no different from a “realized loss.” Sure, delaying realized losses may keep regret at bay, but it has no financial benefits. Indeed, rational investors prefer to realize losses, whether in a ladder or mutual fund, because realized losses become tax deductions, yielding them extra money. And waiting three months (or however long) to get the money you need means you won’t be enjoying whatever you need to use that money for.
What’s more, rational investors would ask themselves: Why build a Rube Goldberg bond ladder, when low-cost index bond mutual funds are simpler and likely cheaper, don’t require homemade construction, and don’t have the extra trouble of monitoring and replacing bonds that reach maturity with new bonds?
In other words, it is normal to try to avoid the pain of regret, but such avoidance can be costly.
Normal? Yes. Smart? No.
Copyright 2020, Dow Jones & Company, Inc. All Rights Reserved Worldwide. LEARN MORE
Chris Dixon, a partner who led the charge, says he has a ‘very long-term horizon’
Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual
Competitive pressure and creativity have made Chinese-designed and -built electric cars formidable competitors
4 min
China rocked the auto world twice this year. First, its electric vehicles stunned Western rivals at the Shanghai auto show with their quality, features and price. Then came reports that in the first quarter of 2023 it dethroned Japan as the world’s largest auto exporter.
How is China in contention to lead the world’s most lucrative and prestigious consumer goods market, one long dominated by American, European, Japanese and South Korean nameplates? The answer is a unique combination of industrial policy, protectionism and homegrown competitive dynamism. Western policy makers and business leaders are better prepared for the first two than the third.
Start with industrial policy—the use of government resources to help favoured sectors. China has practiced industrial policy for decades. While it’s finding increased favour even in the U.S., the concept remains controversial. Governments have a poor record of identifying winning technologies and often end up subsidising inferior and wasteful capacity, including in China.
But in the case of EVs, Chinese industrial policy had a couple of things going for it. First, governments around the world saw climate change as an enduring threat that would require decade-long interventions to transition away from fossil fuels. China bet correctly that in transportation, the transition would favour electric vehicles.
In 2009, China started handing out generous subsidies to buyers of EVs. Public procurement of taxis and buses was targeted to electric vehicles, rechargers were subsidised, and provincial governments stumped up capital for lithium mining and refining for EV batteries. In 2020 NIO, at the time an aspiring challenger to Tesla, avoided bankruptcy thanks to a government-led bailout.
While industrial policy guaranteed a demand for EVs, protectionism ensured those EVs would be made in China, by Chinese companies. To qualify for subsidies, cars had to be domestically made, although foreign brands did qualify. They also had to have batteries made by Chinese companies, giving Chinese national champions like Contemporary Amperex Technology and BYD an advantage over then-market leaders from Japan and South Korea.
To sell in China, foreign automakers had to abide by conditions intended to upgrade the local industry’s skills. State-owned Guangzhou Automobile Group developed the manufacturing know-how necessary to become a player in EVs thanks to joint ventures with Toyota and Honda, said Gregor Sebastian, an analyst at Germany’s Mercator Institute for China Studies.
Despite all that government support, sales of EVs remained weak until 2019, when China let Tesla open a wholly owned factory in Shanghai. “It took this catalyst…to boost interest and increase the level of competitiveness of the local Chinese makers,” said Tu Le, managing director of Sino Auto Insights, a research service specialising in the Chinese auto industry.
Back in 2011 Pony Ma, the founder of Tencent, explained what set Chinese capitalism apart from its American counterpart. “In America, when you bring an idea to market you usually have several months before competition pops up, allowing you to capture significant market share,” he said, according to Fast Company, a technology magazine. “In China, you can have hundreds of competitors within the first hours of going live. Ideas are not important in China—execution is.”
Thanks to that competition and focus on execution, the EV industry went from a niche industrial-policy project to a sprawling ecosystem of predominantly private companies. Much of this happened below the Western radar while China was cut off from the world because of Covid-19 restrictions.
When Western auto executives flew in for April’s Shanghai auto show, “they saw a sea of green plates, a sea of Chinese brands,” said Le, referring to the green license plates assigned to clean-energy vehicles in China. “They hear the sounds of the door closing, sit inside and look at the quality of the materials, the fabric or the plastic on the console, that’s the other holy s— moment—they’ve caught up to us.”
Manufacturers of gasoline cars are product-oriented, whereas EV manufacturers, like tech companies, are user-oriented, Le said. Chinese EVs feature at least two, often three, display screens, one suitable for watching movies from the back seat, multiple lidars (laser-based sensors) for driver assistance, and even a microphone for karaoke (quickly copied by Tesla). Meanwhile, Chinese suppliers such as CATL have gone from laggard to leader.
Chinese dominance of EVs isn’t preordained. The low barriers to entry exploited by Chinese brands also open the door to future non-Chinese competitors. Nor does China’s success in EVs necessarily translate to other sectors where industrial policy matters less and creativity, privacy and deeply woven technological capability—such as software, cloud computing and semiconductors—matter more.
Still, the threat to Western auto market share posed by Chinese EVs is one for which Western policy makers have no obvious answer. “You can shut off your own market and to a certain extent that will shield production for your domestic needs,” said Sebastian. “The question really is, what are you going to do for the global south, countries that are still very happily trading with China?”
Western companies themselves are likely to respond by deepening their presence in China—not to sell cars, but for proximity to the most sophisticated customers and suppliers. Jörg Wuttke, the past president of the European Union Chamber of Commerce in China, calls China a “fitness centre.” Even as conditions there become steadily more difficult, Western multinationals “have to be there. It keeps you fit.”
Chris Dixon, a partner who led the charge, says he has a ‘very long-term horizon’
Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual
