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Terhorst and coin flipping

 
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ataloss
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PostPosted: Wed Oct 29, 2003 11:34 am    Post subject: Terhorst and coin flipping Reply with quote

Nice post from FMO

From Terhorst's "Cashing in on the American Dream"

"LESS IS MORE

Perhaps more than anything else, retiring on $50 a day requires a new state of mind. Simplify your life by having only the things you need or want. Consume less to enjoy life more. Living with this new state of mind works because of what economists call the Law of Diminishing Marginal Utility. I call it the Coin Toss Law.

I offer to toss a fair coin. If it comes up tails, I pay you a dollar. If it comes up heads, you pay me a dollar. Sure, you say. Why not? We play a couple of times. Then I ask if you want to play for $10. Of course. We continue to play. Then I offer to play for, say, $500,000, your entire net worth. You laugh. It's ridiculous. Yet, the game hasn't changed at all. The coin is still fair and the odds are the same. What's happened?

What's happened is that you've moved down your "utility" curve. Lose the $500,000 coin toss and you're wiped out. You're without a house, car, furniture, savings, everything. If you're retired, you'll have to go back to work. If you have one. job, you'll have to work at two. You're in worse shape than a chow-mein joint without a reliable noodle supply. You'll probably have a nervous breakdown. It's a disaster.

Winning half a million dollars, on the other hand, wouldn't do that much for you. You could buy a shiny car and a house a couple of blocks farther up the bill. You could stick the kids into a more expensive private school. You'd like to have an extra half-million dollars. But your day-to-day life would change hardly at all. To the extent that you become a victim of upscale marketing, your life could even deteriorate. Status cars upset us when something scratches them. Home computers that do our banking and lock our house can make us feel helpless and frustrated when something goes wrong. Fine furniture and paintings demand that our fire insurance become. a part of our life rather than an annual bill. Modern insurance ads show smiling, wealthy couples surrounded by their possessions. In the next sequence we see the possessions destroyed by fire, flood, or theft. At best the couple recuperates, but only after hours of paperwork, phone calls, and tense talks.

Result: winning the toss offers little or nothing. Losing is a mess. You don't want to play the game.

The Coin Toss Law means that the upside, past a certain point, isn't all that great. If you already have forty pairs of shoes, adding ten more isn't a big deal. If you already have a Mercedes with a small engine, getting one with a bigger engine is a cheap thrill that costs a fortune. Buying a new car makes you feel good, but it doesn't excite like that first clunker when you were sixteen. A bigger house can be pleasant, but it brings bigger problems as well. Compact discs are cute but you have to strain to hear the improved sound.

Millions of Americans in their 30s and 40s already have much of the American dream along with some fun little extras. You're a candidate for retirement at this point if you feel you want more out of life than a new car. You're a candidate for retirement if you suspect that time isn't money. - it's better than money. If you live in a four-thousand-square-foot house with two extra rooms, would adding on make you that much happier? How many fur coats are enough? If you already have $40,000 dollars' worth of jewelry you never wear, would a new necklace make a big difference?

It's ironic, but the only way to change this state of affairs is to have less, not more. If it's been four years since you bought a new tie, choosing a tie might be fun. If you've lived ten years in a small apartment, having a place with a yard might be very pleasant. In every case the marginal whoopee is greater, the less you have to begin with.



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therealchips
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PostPosted: Wed Oct 29, 2003 12:05 pm    Post subject: Reply with quote

Thanks, ataloss. I have posted here repeatedly on the subject of utility theory. (Just search on the word utility with me as the author.) Here at NFB, I have demonstrated, to my own satisfaction at least, that personal utility theory influences financial planning and (do I dare say it?) SWR analysis. That influence will still be there even if the utility function is not explicit in the analysis. It's easy to show, as Terhorst did, that major errors can result from thinking that each subsequent dollar has the same value to you regardless of how many you have already.



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karma
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PostPosted: Wed Oct 29, 2003 1:15 pm    Post subject: Reply with quote

From Chips:
Quote:
I have demonstrated, to my own satisfaction at least, that personal utility theory influences financial planning and (do I dare say it?) SWR analysis. That influence will still be there even if the utility function is not explicit in the analysis. It's easy to show, as Terhorst did, that major errors can result from thinking that each subsequent dollar has the same value to you regardless of how many you have already.


I have read your stuff, then I went on vacation and it evaporated from my meager brain.

My question is: How does this fit in with the old saying in economics that you cannot compare personal utility functions? Wouldn't that mean you can't truly compare personal, uh, sensible withdrawal rates across a population? Am I even warm?

karma


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NeuroFool
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PostPosted: Wed Oct 29, 2003 1:32 pm    Post subject: Reply with quote

And I have a question/comment/observation about this utility thingy...

As our portfolios grow, doesn't it make it harder to keep contributing money as the contributions become a small percentage of the total?

For example, the first 5 years I funded an IRA with $2000 or $3000, each contribution was a nice jump. But now that my portfolio is growing, each year's IRA contribution just doesn't fell "as much".

I'm imagining someone who has $400,000 invested on the way to $1M giving up any more contributions because what's another $15,000...but of course with 15 years, let's say, to compound, it could be significant. But that $15,000 might feel REALLY NICE put towards a new car or kitchen remodel, for example.

Does this make sense? Does this feeling, loosely tied to 'utility', keep some of us from staying the course?

Maybe that emphasizes the importance of estimating the amount one needs to retire, and if one is short of that amount they'll make every effort to save more and spend less to reach it.

Anyway, just a random thought as I watch my portfolio grow faster than my income...


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Cut-Throat
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PostPosted: Wed Oct 29, 2003 2:34 pm    Post subject: Reply with quote

Interesting Post ! - I have always subscribed to the Less is More theory - But in a slightly different way.

Life is a Balance and to fully enjoy it you have to have some possesions to be comfortable, but not too many to be uncomfortable. I do believe in quality and would rather have 1 Car such as my Lexus than 3 or 4 other vehicles. The Lexus takes little or no Maintenance. I also got rid of the Boat!

Same with Dining. Better to eat only 1 Lobster than chow down 5 Big Macs. Your waist line will appreciate it as well!

Live in 1 house that you really enjoy rather than trying to maintain 2 homes- like A vacation Home. Always rent the vacation home - then when you're on vacation you don't have to work!

I live in a townhome association and retired from Lawn Maintence and outside Painting. This was actually more freedom than Retiring Early from my Job! I also got rid of the Boat!

Also the nice thing about Travel is that it can be cut from the Budget without disruption and it does not require any maintenance dollars. I believe that you have to have needless luxuries in the budget, so that when times get tough, you have something easy to cut!




Last edited by Cut-Throat on Wed Oct 29, 2003 8:36 pm; edited 2 times in total
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ataloss
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PostPosted: Wed Oct 29, 2003 3:26 pm    Post subject: Reply with quote

IIRC, Joe Dominguez had a curve in his book that rose then fell. His idea was that once you got past "enough" you actually had a decline in quality of life with more stuff (since you have to maintain it, guard it, insure it worry about it etc.) This made a lot of sense to me.

Cut-throat. I assume you have heard the old joke about the two happiest days in a boat-owner's life.

Neuro fool, I remember the days when my account balance too a big jump with each monthly investment. It seemed like it would take forever for the portfolio to get "large." Now, years later, I find it a little discouraging that day to day market fluctuation moves the portfolio more than the monthly contribution. I just keep sending the checks in and try not to think about it too much.



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WiseNLucky
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PostPosted: Wed Oct 29, 2003 4:04 pm    Post subject: Reply with quote

Quote:
As our portfolios grow, doesn't it make it harder to keep contributing money as the contributions become a small percentage of the total?


I thought this would be a problem but found that I didn't even suffer emotionally (too much) when my market losses outstripped my contributions. If I can get throught that experience I can survive when my contributions have minimal day-to-day impact on my portfolio. I know that little things add up to a lot.

Plus, as my income increases, I up my contribution to keep spending levels in line. No use learning to live on more money. Wink



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therealchips
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PostPosted: Wed Oct 29, 2003 7:30 pm    Post subject: Reply with quote

Karma asked:
Quote:
My question is: How does this fit in with the old saying in economics that you cannot compare personal utility functions? Wouldn't that mean you can't truly compare personal, uh, sensible withdrawal rates across a population? Am I even warm?

I think the minimum requirement for a personal utility function to make sense is that it increases at a decreasing rate. That is, every dollar added to your wealth has positive value, but not so much as the previous dollar has. (For any such function, if it is differentiable, the first derivative is positive and the second derivative is negative.) Other than that, choice of a utility function is up to anyone's personal taste, so far as I know.

As I see it, calculating personal withdrawal rates would, ideally, consider life expectancy, income tax liabilities, attitudes about continuing withdrawals in the face of declining markets, as well as a utility function and the usual features of market return and inflation and their variability. Also, ideally, the analysis computes the withdrawal amounts for a thirty year period, say, as a thirty-dimensional optimization problem, without necessarily assuming a constant real standard of living throughout the plan. I haven't yet figured out a way to include all those factors at once. Some of us have worked on plans for the accumulation period while others have worked on plans for the distribution period. Again, ideally, the analysis would include both phases.



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ataloss
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PostPosted: Thu Oct 30, 2003 2:21 am    Post subject: Reply with quote

wnl
Quote:
Plus, as my income increases, I up my contribution to keep spending levels in line. No use learning to live on more money.


Andrew Tobias (formerly a financial writer) said in one of his books something to the effect that luxuries that you sample can become necessities. I have tried to avoid automatically spending more.



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therealchips
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PostPosted: Thu Oct 30, 2003 8:02 am    Post subject: Reply with quote

Quote:
As our portfolios grow, doesn't it make it harder to keep contributing money as the contributions become a small percentage of the total?

Yes, that makes sense both psychologically and mathematically. Utility functions are supposed to increase at a decreasing rate. That means that the dollar you add to your wealth today is not quite so useful to you as the one you added yesterday. On the other hand, (Oh, for a one-handed economist! -- President Truman) the fall-off in utility is very gradual, so the dollar you add today is almost as useful as the one you added yesterday. Also, as you get closer to the amount of wealth that will give you FIRE, today's contribution makes a larger percentage reduction in your shortfall, until the last few dollars or thousands of dollars you add to your stash reduce your short fall by 100% of its previous value. That might or might not fit your personal psychology. I would like to see you achieve FIRE, if that is your goal. Between now and then, I would also like to see you derive satisfaction from your work that is based on more than just getting a pay-check and, of course, buy some fun things along the way too.



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karma
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PostPosted: Thu Oct 30, 2003 8:17 am    Post subject: Reply with quote

Chips:
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I would like to see you achieve FIRE, if that is your goal. Between now and then, I would also like to see you derive satisfaction from your work that is based on more than just getting a pay-check and, of course, buy some fun things along the way too.


Gaaack! Are we talking about a utility function with intertemporal aspects? That sounds pretty hard to model because people's vision of the future changes over time, so the utility function is always changing, so anything it is an integral part of is also changing... I bet you're going to tell me I can approximate it with Solver.

I think it's back to Gummy's world tours vs canasta, and just leaving it at that. I'm a pretty simple person, so canasta doesn't sound all that bad. Laughing

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TRyan
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PostPosted: Thu Oct 30, 2003 8:50 am    Post subject: Reply with quote

Chips said:
Quote:

That means that the dollar you add to your wealth today is not quite so useful to you as the one you added yesterday


... or the dollar you add today is MORE useful than the dollar you add tomorrow.

That should keep us adding today.



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PostPosted: Thu Oct 30, 2003 2:22 pm    Post subject: Reply with quote

Andrew Tobias (formerly a financial writer) said in one of his books something to the effect that luxuries that you sample can become necessities. I have tried to avoid automatically spending more.

This was part of why I rarely gambled and generally would prefer to avoid individual equities - I was afraid of winning ('sampling luxuries' in Tobias' vernacular).

Unfortunately, ERs being what they are and the underrepresentation of the value segment being what it is, I am being forced into this arena.



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