The marginal utility of money
I know I’m taking a risk by starting an article by defining a term from economics. But please, stick with me. It’s not a hard concept to understand, and it directly relates to your financial success.
Utility is a term used in economics to describe how much value or happiness one derives from a good or service. Marginal utility refers to how much additional value/happiness is derived from one additional unit of the good or service. Most goods and services are said to have “decreasing marginal utility.”
“Decreasing marginal utility” sounds like gibberish, but it’s actually pretty easy to understand:
- First slice of apple pie: “Yes, please!”
- Second slice of apple pie: “Well…OK…one more piece.”
- Third slice: “Oh, I couldn’t. I’m stuffed.”
Each slice of pie provides less happiness (“utility”) than the previous slice. The same thing holds true with nearly every good or service.
In fact (or perhaps, as a result), this idea holds true for money as well. For many of us, an extra $500,000 in cash could accurately be described as life changing. But what if you already had a liquid net worth of several million dollars? An extra $500k would still be nice, but I doubt it would change your life meaningfully.
Get Rich Slowly has practically been a real-time case study in this concept. J.D. used to be deeply in debt, at which point he had a high marginal utility of wealth. That is, every extra dollar he earned and saved made a big difference to his well-being.
However, as he climbed out of debt, built his income, and built his wealth, his marginal utility of wealth has slowly declined. J.D. recently put it this way:
“Debt used to be my biggest source of money stress. Then it became an obsession with frugality, which led me to cross the line to cheap bastard. Now my biggest problem seems to be an obsession with income: I want more money all the time. I’m beginning to see, however, that if I relax on my drive for a higher income, I can have more of other stuff, like time with friends — and travel.”
Marginal Utility and Risk Aversion
Because most us have a decreasing marginal utility of wealth, a loss of a given amount has a greater impact than a gain of the same amount. For example, would you be willing to accept a wager of $10,000 on a coin flip? If you win, you get $10,000 — but if you lose, you owe me $10,000?
I sure as heck wouldn’t take that bet.
The idea of winning $10,000 is exciting, but the idea of losing $10,000 in an instant is downright sickening. Fifty-fifty odds just aren’t good enough to get most people to put a meaningful amount of money at risk.
In economic jargon, we say that we’re “risk averse”. That is, we’re unwilling to take a risk unless the probability is good that we’ll come out ahead as a result of taking that risk.
Eliminating Risk Where Possible
If you’re like most people, you’re more afraid of running out of money than you are excited about being filthy rich. And if that’s the case, why not eliminate as much risk in your investment portfolio as you possibly can?
For example, have you checked to see if you’re saving enough each year to meet your goals by investing entirely in TIPS? (TIPS — Treasury Inflation-Protected Securities — are bonds that provide protection against inflation.) If so, why take on stock market risk? With TIPS, you know exactly what inflation-adjusted return you’ll be getting. It’s hard to have less risk than that!
Or, if the modest return from TIPS isn’t going to be enough to meet your goals — and you therefore need the higher expected return that comes with stocks — why not try to make the stock portion of your portfolio as safe as possible? For example, if you’re saving enough each year to get the job done with index funds, why take on the additional risk that comes with picking individual stocks?
Alternatively, if you’re in (or near) retirement and you’re worried that you’re going to outlast your portfolio, why not minimize that risk by purchasing an annuity that can provide predictable income for the rest of your life?
When it comes to investing, rather than asking how much risk you can stomach, try asking how little risk you can get away with. After all, is it worth jeopardizing your goals for a shot at that third slice of pie?
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There are 36 comments to "The marginal utility of money".
This is a very nice dove-tail to the previous column!
(I know I’m harping on it, but the word “utilization” should really be replaced with “utility maximization” in that column– This column does a great job explaining what marginal utility is.)
Also, I read on Salon or some similar place that Suze Orman invests most of her money in TIPS. That’s because she does have enough capital to live off the interest and she’s very risk averse and doesn’t need to take more risks. (Don’t try this at home, she cautions, I have more money than you.)
Btw, as a note if people can’t see why diminishing marginal utility and risk aversion are in the same article… They’re flip sides to the same curve. I wish there were a drawing here with pie on the X axis and happiness on the Y axis. Then you would be able to see that as you gain pie, you get happier but the more pie you get the less extra happy you get. If people threaten to take pie away, the curve is much steeper going the other direction so you’re much less happy than getting the same amount of additional pie would make you more happy.
They’re two sides of the same chart. It’s really difficult to explain in words. Marginal utility is going right on the chart, risk aversion is going left. It’s steeper the further left you go and flatter the further right.
Wikipedia isn’t helping me find a picture, but this blog has a chart in the middle that has the same shape (the one going up and flattening out):
http://www.providentplan.com/330/the-diminishing-marginal-utility-of-hoarding-why-being-a-stingy-miser-doesnt-pay/
The YMMoYL guy’s chart actually turns down after a while… he notes that after you get too much pie you start feeling sick. Economists don’t generally think there’s such a thing as too much pie because they assume you can costlessly throw out any pie you don’t want.
Hi Nicole.
I had been pondering mentioning in the previous post’s comments that this afternoon’s post would be about the topic you brought up, but I didn’t want to steal Paul’s thunder. 🙂
And I agree: It probably would have been a good idea to include a chart showing “declining marginal utility” visually.
This is a great article and you just explained Marginal Utility 500 times better than my Economics textbook ever did. If only all of my courses related the topics to food, I’d be a fully accredited Accountant by next week!
@3 Procrastamom You should read the textbooks by Bob Frank– I swear all his examples are Pizza vs. beer
Hey, Mike! I agree with the others that you did a great job of explaining marginal utility. I actually had a decent econ professor in college and this is how he explained it as well. I like how you applied the concept to risk and investing as well. You made a very good point about seeking as little risk as you absolutely need to achieve your goals.
This is a great way of looking at decision making. what it tells me is that a simple priority structure isn’t enough. Like your kids may be the most important thing to you, but they won’t likely reap the benefits of designer clothing. What this also tells me is that if you have met your obligations and find more money, maybe the best utility for that is to increase slightly the categories you feel deprived in. A fancier restaurant, a maid service. But on the flip side you could run around your life and pick out anything that feels incomplete/broken and fix it.
Marginal utility is why I stay at my job making $35K when I could be making $50k elsewhere…the extra $15k just doesn’t make up for the extra stress. Great job at defining it and thanks for the reminder that more isn’t always best.
Here’s a stark example:
Imagine you’re on the edge of spending less than you earn.
If you’re spending even $10 more than you make each month, you’re actively going into debt, effectively imprisoning your future self.
On the other hand, if you can cut corners or sell something to scrape up an additional twenty bucks during the course of the month, you’re now well on your way to savings and freedom.
We usually don’t think of a $20 bill as so powerful, but in that case, it is. That’s marginal utility.
Great concept!
Unfortunately, for some people, they aren’t risking “jeopardizing their goals for a shot at that third slice of pie” but rather need to take on more risk to stretch limited savings to last them through retirement. This accounts for quite a few people who started saving late.
What about the rest of us?
I have been saving since I started working (in my 20’s), and without a minimum 6% return on my retirement investments, I have little chance of meeting my goal of retiring early and living on my savings for the rest of my life. Even if I extend my working life, I think that just investing in bonds won’t cut it.
I like the article, and I get the point, but think that it might not be practical advice for a large portion of the population.
@ Budgeting in the Fun Stuff:
I agree; I’m in the same situation.
@Alexandra (#9)
It sounds like what you’re doing is actually very much in line with what I was suggesting. You’re looking at how much risk you need to take and investing accordingly — as opposed to the common approach of just taking on as much risk as you think you can take.
I’m in complete agreement that most investors can’t get away with a zero-risk portfolio.
Nicole:
It’s just an exponential graph. There are a number of ways to do it but one is: y = 1-1/e^x for y > 0.
Or in Excel ‘=1-1/exp(Ax)’. Where column A is some arbitrary steps such as 0.01, 0.02,… .
Great analogy! – “Decreasing Marginal Utility of apple pie” 🙂 I’m gonna go check out Oblivious Investor!
I agree with #9 Alexandra. I don’t want to be taking on any risks, but the way our generation’s retirement looks, we’re going to have to.
Well, our generation may have to give up the idea of retiring early. It wasn’t a very practical idea anyway … I don’t know a single person who has retired, done nothing, and enjoyed it.
I really think it helps the contentment quotient if we remember that the notion of early retirement, and our picture of it as necessarily including travel, a vacation home, or expensive leisure activities like golf, is extremely recent.
Before Social Security, most working Americans never owned a home, worked until they physically could not work any more, and then moved in with a relative. After Social Security and into the 1970s, most people did not live 20+ years after retiring.
The percentage of workers who have EVER been able to “retire” early and never work again must be vanishingly small. Our generation is not facing a unique challenge.
I’d rather think of it as an opportunity, anyway – to be able to leave a certain line of work and do something completely different and still have time to get good at the new profession.
But I guess that’s kind of off topic. Sorry! Liked the marginal utility explanation!
I’m glad you liked the analogy, Chris. 🙂
chacha1: I agree. I’m not a big fan of the typical stop-working-completely idea of retirement. It doesn’t sound like much fun to me!
At the same time, if that’s what a person is shooting for, I try my best to help them achieve it. 🙂
I agree with chacha1 – my personal goals are to save enough while I’m young to be able to start a second, more relaxed and fun career in my late 40’s that will carry me through to my 60’s. I don’t expect to stop working until I am well into my 60’s – who wants to sit around doing nothing? And I hate golf and most traveling.
@ chacha1
I totally agree! I get so sick of people complaining about not being able to retire at 60 like every other person in history has been able to. Some people can, but it’s due to good planning, not because it’s a universal human right. But that is how many people think of it, and like the rest of us should support everyone over 60 until they die if they haven’t saved enough on their own.
Good analogy, and it’s the same with income.
I’ll tell you guys this datapoint, once you make over around $250,000…. it doesn’t matter too much how much more you make again, your lifestyle doesn’t really change.
20) “’ll tell you guys this datapoint, once you make over around $250,000…. it doesn’t matter too much how much more you make again, your lifestyle doesn’t really change.”
Not true!!
Try paying for a full-time nanny or private school on $250k and you will see what a huge difference ANOTHER $100k of income make.
Same if you make $500k. Making another $100k on top of that allows you to bail out more financially inept relatives (being sarcastic)
Or if you make $1M. Still short of fractional jet ownership … another $1M would help (being really sarcastic)
Its only diminishing returns if your expectation of what to do with money stays the same.
Bill Gates would probably like to make more money so that he could push his foundation further and cure Malaria faster. He wasn’t thinking that when he made his 1st million. But his horizon (and spending expectation / desire) increased as his income did.
@Alexandra – a required return of 6% is awfully low which means that you probably have a great deal of savings thanks to starting early. I would wager that if you require a 6% return, your investable assets are likely in the top 20% of your peer group.
Also, to achieve a 6% average annual rate of return, you could invest in a ‘minimal risk portfolio’ which would have far outpaced the market over the last decade plus.
@Mike – Nice post! Marginal utility is a GREAT topic even if it’s something most of us do unwittingly everyday (I’m always amazed at how well we all do with making choices without knowing anything about the economic theory behind it). I have a post scheduled for Friday that will take a slightly different angle in explaining the subject.
I’m completely off-topic here, sorry. Anyway, I don’t know how early retirement became a part of this, I always figured I’d work to the normal age. And this: “I don’t expect to stop working until I am well into my 60’s” doesn’t seem to be anything shocking; my parents will be working into their 60s with SS.
Maybe it’s just because I read these PF blogs or just because I’m still young, but it seems like everything needs money, and money comes in so slowly, that I can’t imagine ever saving up enough that I can live any portion of my life without working.
Thanks for the commenter(s) who pointed out that risk and marginal utility are on the same curve. It seemed to come a little out of left field in the article. From pie straight into recommending TIPS.
@ Financial Samurai
I agree with Jake (21). The extra money might not be necessary, but the examples Jake provides are true, and what JD’s always reminding us to beware of: lifestyle increase.
Technically in his last example, your relatives are having a lifestyle increase at your expense…
Regarding the discussion on retirement: in France, there is an on going discussion to increase the legal retirement age from 60 to 62… And the general public is horrified by this proposal! Without this change (which I find insufficient)our retirement system will collapse. Time will tell if the french government will do the right thing, or fold under public pressure.
I agree that this gives a good defination of marginal utility. However, it is obviously different for every person depending on one’s goals and objectives.
Two great books that touch on this…
“Stumbling On Happiness” by Daniel Gilbert and “The Paradox of Choice” by Barry Schwartz. Both have changed the way I think and behave when it comes to money, shopping, and consumerism in general.
Both include fascinating studies that reveal how poorly we all estimate what will make us happy and by how much, with implications for how to be happier with what you have, or to change behaviors to be more in line with what will truly satisfy. Great for thinking about economics, and life in general.
Great post. I think ‘I should’ invest in stocks, but Im really not that much into it. Third slice of apple pie explains so much of my mental blocks. And why take risks when we dont want to just to get a little more ? Great explanations of our thinking.
Michael #22
I’ve been working and investing for the past 12 years since college. In that time I have had very little return on my investments, almost nil, thanks to the repeated market drops, and I know most people in my age group are the same way. Sure when I first started 11 years ago I was racking up some nice gains, and once again feeling good three years ago, but now, I sure would love to say I’ve achieved 6% a year in returns over the past 12. And I’ve invested in a wide mix of mutual funds, primarily index, domestic and international, plus some aggressive growth and conservative funds, nothing exotic or risky, primarily through USAA and Fidelity. Maybe the next 12 years will be less chaotic in the markets, but for my saving career the risks have predominated. Maybe that will switch over the next 12 years, and I’m definitely going to keep a risk component in there, but from my experience the risks in assuming the next decades will replicate the average 10% annual return of the US stock market over the 20th century seems to outweigh the rewards. I’m going to have to research these TIPS and maybe start adding them over time.
@Wilson – TIPS are an important fixed income instrument, and can be a nice complement to any portfolio.
I just wanted to point out that while the market is going through a tough period, it isn’t unusual at all and long-term returns remain intact. We saw similar markets during the Great Depression, from 1968 to 1982 (the Dow gained zero during that period), and others. However, over a 25 year period, the returns are in a very narrow range that are all well in excess of inflation.
My point is that while the last decade hasn’t been fun, it has certainly been normal. Something that is a good exercise is to go to Yahoo! Finance and pull up an interactive chart of the Dow for the maximum time available. If you take that chart and draw horizontal lines from each major peak, you’ll see that times like these are both normal and recurring.
As we continue to go through this deleveraging cycle, the market won’t make large, sustained gains. However, the market remains the best place to be for the long haul. If you want to sprinkle in some bonds to create rebalancing opportunities or to dial down risk, nothing wrong there, but take care not to develop a distaste for the stock market.
This is one of the lessons from the Great Depression as folks shunned the market and ended up with very poor real returns for decades afterwards.
I can’t buy your recommendation of TIPS as very low risk places for your money. The idea looks great on paper, but the problem comes with the government’s questionable index of inflation. Historically the government has consistently understated the real increases in our cost of living–often by as much as 50%. In otherwords, if the rate of inflation published by private sources e.g. shadowstatistics.com (not sure this is correct url) is 8%, our government may report it at 4%. There are many reasons the government does this, all politically related. Tips are hardly risk free if this practice continues and there’s no reason to believe it won’t. For those considering TIPS, check out the fairly new investment vehicle, Build America Bonds. Fair disclosure: I own some TIPS myself, but they are a very small portion of my portfolio. For whatever it is worth, a very large portion I have invested in gold and silver–stocks, funds and coins.
This is a great post. I definitely believe in empowerment when it comes to finances (or anything else in life), so I love it when difficult concepts are examined in lay terms. It’s just as important to understand money and economics as it is to create a budget. We should not be afraid of words like “marginal utility.”
Marginal utility is one thing I have always wondered about when it comes to the ultra-rich. We see people like Bill Gates and Warren Buffet giving away a vast majority of their fortunes, but why not others? Why don’t we see every ultra-rich person doing the same – because, really, what is the utility of money past a certain level (say, $500 million)?
@Fred Daily – I think you would agree that there is no such thing as a risk free asset. Regardless, TIPS have substantially less risk than most other types of assets.
While the argument about CPI can be made 300,000,000 different ways as it is different for each person, it is generally OVERSTATED for the basket of goods it measures. For me, it’s been much higher than CPI thanks to increasing health insurance premiums and out of pocket costs as well as consistent price hikes at the golf courses I play. Either way, in lieu of an asset that can track my specific inflation rate, TIPS certainly cannot be dismissed simply because CPI doesn’t track each person’s inflation experience.
Since economics is in part, a behavioral science, you can apply the concept of marginal utility to other parts of your life.
When you start to apply this concept to relationships it can really mess with your head. In a way this concept makes you realize that being married to a model or super model may not give you the level of satisfaction you may have expected!
-Mike
Mike Harr–you are exactly on target with your comment that everyone’s rate of inflation experience is different. However, I have never seen any individual’s number as low as the figures from Uncle Sam. Like I mentioned, I own some TIPS, bought long ago. Not sure I would buy them today though.
i look at investing from a glass half full perspective. its like going to Vegas, most people say, “well i can take $300 to gamble with and once that’s gone i’ll quit”
you focuses on losing? not me..
i look at it like this, i have going to invest X amount and turn it into Y. at this point i will cash out and move on to the next investment.
stop focusing on lose and start to focus on winning and see how it plays out for you!!!