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:
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.
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.
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.
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.
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
What a quarter-million dollars gets you in the western capital.
Alexandre de Betak and his wife are focusing on their most personal project yet.
Multinationals like Starbucks and Marriott are taking a hard look at their Chinese operations—and tempering their outlooks.
4 min
For years, global companies showcased their Chinese operations as a source of robust growth. A burgeoning middle class, a stream of people moving to cities, and the creation of new services to cater to them—along with the promise of the further opening of the world’s second-largest economy—drew companies eager to tap into the action.
Then Covid hit, isolating China from much of the world. Chinese leader Xi Jinping tightened control of the economy, and U.S.-China relations hit a nadir. After decades of rapid growth, China’s economy is stuck in a rut, with increasing concerns about what will drive the next phase of its growth.
Though Chinese officials have acknowledged the sputtering economy, they have been reluctant to take more than incremental steps to reverse the trend. Making matters worse, government crackdowns on internet companies and measures to burst the country’s property bubble left households and businesses scarred.
Now, multinational companies are taking a hard look at their Chinese operations and tempering their outlooks. Marriott International narrowed its global revenue per available room growth rate to 3% to 4%, citing continued weakness in China and expectations that demand could weaken further in the third quarter. Paris-based Kering , home to brands Gucci and Saint Laurent, posted a 22% decline in sales in the Asia-Pacific region, excluding Japan, in the first half amid weaker demand in Greater China, which includes Hong Kong and Macau.
Pricing pressure and deflation were common themes in quarterly results. Starbucks , which helped build a coffee culture in China over the past 25 years, described it as one of its most notable international challenges as it posted a 14% decline in sales from that business. As Chinese consumers reconsidered whether to spend money on Starbucks lattes, competitors such as Luckin Coffee increased pressure on the Seattle company. Starbucks executives said in their quarterly earnings call that “unprecedented store expansion” by rivals and a price war hurt profits and caused “significant disruptions” to the operating environment.
Executive anxiety extends beyond consumer companies. Elevator maker Otis Worldwide saw new-equipment orders in China fall by double digits in the second quarter, forcing it to cut its outlook for growth out of Asia. CEO Judy Marks told analysts on a quarterly earnings call that prices in China were down roughly 10% year over year, and she doesn’t see the pricing pressure abating. The company is turning to productivity improvements and cost cutting to blunt the hit.
Add in the uncertainty created by deteriorating U.S.-China relations, and many investors are steering clear. The iShares MSCI China exchange-traded fund has lost half its value since March 2021. Recovery attempts have been short-lived. undefined undefined And now some of those concerns are creeping into the U.S. market. “A decade ago China exposure [for a global company] was a way to add revenue growth to our portfolio,” says Margaret Vitrano, co-manager of large-cap growth strategies at ClearBridge Investments in New York. Today, she notes, “we now want to manage the risk of the China exposure.”
Vitrano expects improvement in 2025, but cautions it will be slow. Uncertainty over who will win the U.S. presidential election and the prospect of higher tariffs pose additional risks for global companies.
For now, China is inching along at roughly 5% economic growth—down from a peak of 14% in 2007 and an average of about 8% in the 10 years before the pandemic. Chinese consumers hit by job losses and continued declines in property values are rethinking spending habits. Businesses worried about policy uncertainty are reluctant to invest and hire.
The trouble goes beyond frugal consumers. Xi is changing the economy’s growth model, relying less on the infrastructure and real estate market that fueled earlier growth. That means investing aggressively in manufacturing and exports as China looks to become more self-reliant and guard against geopolitical tensions.
The shift is hurting western multinationals, with deflationary forces amid burgeoning production capacity. “We have seen the investment community mark down expectations for these companies because they will have to change tack with lower-cost products and services,” says Joseph Quinlan, head of market strategy for the chief investment office at Merrill and Bank of America Private Bank.
Another challenge for multinationals outside of China is stiffened competition as Chinese companies innovate and expand—often with the backing of the government. Local rivals are upping the ante across sectors by building on their knowledge of local consumer preferences and the ability to produce higher-quality products.
Some global multinationals are having a hard time keeping up with homegrown innovation. Auto makers including General Motors have seen sales tumble and struggled to turn profitable as Chinese car shoppers increasingly opt for electric vehicles from BYD or NIO that are similar in price to internal-combustion-engine cars from foreign auto makers.
“China’s electric-vehicle makers have by leaps and bounds surpassed the capabilities of foreign brands who have a tie to the profit pool of internal combustible engines that they don’t want to disrupt,” says Christine Phillpotts, a fund manager for Ariel Investments’ emerging markets strategies.
Chinese companies are often faster than global rivals to market with new products or tweaks. “The cycle can be half of what it is for a global multinational with subsidiaries that need to check with headquarters, do an analysis, and then refresh,” Phillpotts says.
For many companies and investors, next year remains a question mark. Ashland CEO Guillermo Novo said in an August call with analysts that the chemical company was seeing a “big change” in China, with activity slowing and competition on pricing becoming more aggressive. The company, he said, was still trying to grasp the repercussions as it has created uncertainty in its 2025 outlook.
Few companies are giving up. Executives at big global consumer and retail companies show no signs of reducing investment, with most still describing China as a long-term growth market, says Dana Telsey, CEO of Telsey Advisory Group.
Starbucks executives described the long-term opportunity as “significant,” with higher growth and margin opportunities in the future as China’s population continues to move from rural to suburban areas. But they also noted that their approach is evolving and they are in the early stages of exploring strategic partnerships.
Walmart sold its stake in August in Chinese e-commerce giant JD.com for $3.6 billion after an eight-year noncompete agreement expired. Analysts expect it to pump the money into its own Sam’s Club and Walmart China operation, which have benefited from the trend toward trading down in China.
“The story isn’t over for the global companies,” Phillpotts says. “It just means the effort and investment will be greater to compete.”
Corrections & Amplifications
Joseph Quinlan is head of market strategy for the chief investment office at Merrill and Bank of America Private Bank. An earlier version of this article incorrectly used his old title.
