“How much? You have got to be joking!”
The reaction is instant. Instinctive. Visceral. Inducing major pucker factor, and a troubling feeling of being mugged, scammed, or otherwise taken advantage of.
It occurs with virtually every purchase for the first week or so during my sporadic visits back home.
The cause of the reaction is not rampant inflation, in the mould of Venezuela, Lebanon, or Turkey.
Nor is it (entirely) induced by greedy merchants charging exorbitant prices in a misguided attempt to recapture lost pandemic-era profits, while pleading staff shortages and high energy costs.
It can’t be explained away by the tiny domestic markets, each controlled by small oligopolies who long ago chose a path of collusion over competition. Incumbents content to retain their comfortable market shares, while collaborating to keep new entrants out.
No, the failing was mine alone: faulty mental accounting.
My sense of local value was pegged to the prices of old, based upon childhood memories.
Subsequent visits provide fleeting snapshots spaced years apart. Each a jarring reminder that purchasing power fails to remain constant, rather it erodes as relentlessly as the waves wash away coastlines.
My absence between those visits meant I lacked the gradual conditioning to rising prices.
The locals, having lived the rises, were akin to the fabled frog who was contentedly boiled alive in a gradually warming pot of water. By contrast, my experience was that of the unfortunate frog being suddenly plunged into already boiling water. A rude shock, followed by a desperate yearning to escape, and some painful scars to provide a lifelong reminder of the experience.
My faulty mental accounting set values based upon my fallible memory. I was living in the past.
Then, a can of coke was $1 and a Big Mac cost less than $2. Movie tickets were under $10, or half that amount on “tight arse” Tuesdays. $20 bought the petrol required for a weekend getaway to the coast. A brand new 4 bedroom McMansion in an outlying suburb cost less than $200,000, which the average worker struggled to afford on their $35,000 average wages.
Today, things are a bit different. That can of coke costs $3 and the Big Mac is $6. A cinema seat is $29, but thankfully tight arse Tuesdays remain a firm favourite for cheap date nights! $70 is required to fuel the coastal escape. While that now 20-year-old McMansion would sell for $815,000, even further out of reach of the average earner’s $92,000 income.
Intellectually, I recognise that time has passed. Inflation has compounded. Prices have risen.
Instinctively however, everything feels like it costs 3x more than it should. The same reaction elicited when buying £8 pints in a City pub, food at a major sporting event, or overpriced London property.
Recently I helped my younger son with a project for school. He had chosen money as his topic, and his research turned up some fascinating facts that dramatically illustrated this same phenomenon played out over a much longer time frame.
When the pound sterling was introduced as the currency of England some 1000+ years ago, £1 could buy 15 cows.
Today, 15 cows would cost around £18,000. A single pound is insufficient to purchase a loaf of bread at my local supermarket.
300+ years ago, the Bank of England started printing paper money. £50 was the smallest denomination of banknotes initially produced. At the time, the average family earned less than £20 per year, which meant the bulk of the population went their whole lives without ever seeing a banknote.
Today, £50 notes remain rarely seen in the wild. While they are no longer the exclusive preserve of the wealthy, they are now a medium of exchange favoured only by drug dealers and the airport money changers who delight in ripping off foreign tourists.
When confronted by diminished purchasing power, we face three possible outcomes.
Sometimes, we simply can no longer afford the item in question at its new price. A point of fact, there is no decision to make. Acceptance, learning to live with disappointment, and moving on is the only productive course of action.
Other times, we are unwilling to afford the item at its new price. A subjective decision applied to discretionary spending, based upon some combination of pride and prioritisation. A worked example of the old cliché: “we can afford anything, but not everything”.
Then there is the third option. Swallowing our pride. Paying what it costs. Buying it anyway. A must for the necessities. A conscious decision for optional expenditure. Charitable giving. Entertainment. Gifts. Holidays. Investing. Saving. Voluntary pension contributions.
No amount of complaining, hand wringing, or living in the past will change those available options.
This can provide a useful lens through which to view changes to our financial circumstances.
Just over a decade ago, cryptocurrencies weren’t a thing. Then, suddenly, they were.
This time last year, the cryptocurrency Bitcoin had a market capitalisation of over USD$1.25tn. Yes, trillion as in 1,000,000,000,000. A number larger than the Gross Domestic Products of any but the 15 largest economies in the world.
Think about that for a second. The perceived value of Bitcoin was worth more than the entire annual economic output of the Netherlands or Indonesia. Economies housing and productively employing millions of people were perceived to be worth less than dubious digital assets that had been made up out of thin air.
A valuation fuelled by nothing more than the collective fervour of millions of recently converted true believers, and a much larger number of greater fools suffering from a fear of missing out. As with any religion, those believers had bought into a product purportedly solving an intangible problem that nobody proveably has. An investment philosophy based solely on hope.
Roll forward to today, and those Bitcoins are perceived to be worth just a quarter of their former value. Nearly one trillion dollars worth of hopes and dreams vanishing almost as quickly as their owner’s faith in the inevitability that blockchain changes everything. Still dubiously perceived to be worth more than the economic output of Finland or Columbia, but now perceived to be worth a lot less than a year ago.
But here is the thing. That perception of lost purchasing power, and being the poorer for it, feels the same whether caused by inflating prices or declining asset values. Either way, our money simply doesn’t go as far as it once did.
The mantra that long-term investors relentlessly beat is that you only lose money if you sell, so short-term price fluctuations are as irrelevant as they are noisy.
Unfortunately, for most of us, our mental accounting just doesn’t work that way.
We sing when we’re winning. When markets surge, we subconsciously adapt our plans and enlarge our dreams of what might be. Nicer holidays. Shinier cars. Better housing. An earlier retirement date.
Our tastes and outlook adjust almost instantly to those rising investment values, just as they do when we receive a pay rise at work. Our inflating expectations happen gradually, slowly enough that we seldom realise it is happening. Hedonic adaptation in all its glory.
Those long-term investors also know that Isaac Newton was onto something when he said, “what goes up must come down”. Many would ruefully add that those downward movements inevitably occur at the most inopportune of times, such as just before they wished to convert financial assets into material goods.
When the market turns downward, those dips tend to be sharp and unexpected. About as fun as a gut punch, the investing equivalent of the frog diving into boiling water. The impact measured emotively not in pounds and pennies, but in the things we can no longer afford to buy. A new car or kitchen renovation we can no longer afford, or a retirement date deferred.
These dips hurt because investing is not an outcome, it is a lifestyle enabler. The value of those investments is tangible, representing real-world purchasing power that has diminished.
The last time I checked, my portfolio had experienced a six-figure decline in value since the market last peaked. In the grand scheme of things this represented more of an inconvenient pothole than a yawning chasm of financial doom, yet it was enough to dispel the familiar warm fuzzy feelings that a rising market provides.
A rising market inflates the ego. Bestowing misplaced confidence in our investing prowess. Leading to mistaking good fortune for competence and control. We must be smart, because we are getting richer!
Over a similar time frame, I rebalanced a similar amount from productive investment assets to lifestyle-enabling expenditure.
This coincidental timing has provided an interesting parallel experiment.
One stream of activity saw my wealth reduce, through circumstances almost entirely beyond my control.
The second stream saw me reducing my wealth, through circumstances almost entirely within my control.
The interesting part was that they both felt the same. In terms of purchasing power, that single factor which governs how wealthy we feel, the cause of the decline made absolutely no difference.
Capricious market gods could have wreaked their vengeance upon my portfolio.
The mother of all spending splurges could have taken place. Perhaps buying an island. Riding in a spaceship. Paying for experimental medical treatments. Or thoroughly indulging a midlife crisis.
Or I could simply have built a bonfire of £50 notes and toasted marshmallows on Guy Fawkes night.
The loss of purchasing power would have felt exactly the same. The value of the funds lost, spent, or squandered was simply gone.
I may feel better about some causes than others, for example those traded for more.
Possibly more smiles.
But regardless of the cause, the difference between what I have and the lifestyle costs I wish to afford remains unchanged.
We are bombarded by news coverage about a cost of living “crisis”, where inflating needs and wants outpace any growth in wages experienced by large portions of the population. Those who are impacted find themselves needing to reduce spending, reign in expectations, and recalibrate what is possible. An uncomfortable adjustment.
Many will judge the crypto kiddies, who have seen their purchasing power reduce at an eye-watering rate. Fewer will similarly judge those holding stocks and bonds, for whom the drop was been less of a rollercoaster ride, but nonetheless a material change in their financial fortunes. Yet a decline in wealth is a decline in wealth, regardless of cause.
The main difference is that for the investors, the purchasing power lost is money they should be able to afford to lose. If not, it shouldn’t have been placed at risk in the first place. Those facing rising mortgage rates or wondering if they can afford to switch on their heating are confronted by more acute and immediate challenges however.
Feeling poorer, as their feeling of wealth diminishes.
Hopefully many will swiftly shift their perspective from focussing on the immediate symptom, diminished purchasing power, to addressing the underlying cause.
Inadequate wages in the current job. Leading to negotiating a pay rise, or finding a new employer. Possibly after retraining into a more lucrative role.
Housing that is expensive to finance, heat, and maintain. Leading to downsizing, geographic arbitrage, or improving the energy efficiency of the property.
Lifestyles that are better suited to the influencers people strive to emulate, rather than those that are commensurate with their incomes.
Which boils down the the secret of personal finance success: earn more, spend less, and invest the difference.
Get that right, and the feeling of wealth should soon follow.