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.
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.
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.
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.
The bequests benefit charities, distant relatives and even pets
Charities, distant relatives and even pets are benefiting from surprise inheritances. They can thank people without children.
Not having children is becoming more common, both among millennials and older people. A July Pew Research Center analysis found that 20% of U.S. adults age 50 and older hadn’t had children.
And many of these people don’t have wills. An AARP survey found half of childless people age 50-plus who live alone have a will, compared with 57% of others that age. Those without wills have less control over what happens to their money, which often ends up in the hands of people who don’t expect it.
This phenomenon of a surprise inheritance is common enough that it has a name: the laughing heir .
“All they do is get the money and go, ‘Ah ha ha, look at that,’ ” said Michael Ettinger , an estate lawyer in New York.
Kelley Gilpin McKeig, a 64-year-old healthcare-industry consultant in Ridgefield, Wash., received a phone call several years ago saying her cousin Nick Caldwell left behind money in a savings account. They hadn’t been in touch for 20 years.
“I thought it was a scam,” she said. “Nobody else in our family had heard that he had passed.”
She hunted down his death certificate and a news article and learned he had died about a year and a half before in a workplace accident.
Caldwell, who was in his 50s, had died without a will. His estate was split among cousins and an uncle. It took about two years for the money to be distributed because of the paperwork and court approval involved. Gilpin McKeig’s share was $2,300.
Afterward, she updated her will to make sure what she has doesn’t go to “just anybody down the line, or cousins I don’t care about.”
There are trillions of dollars at stake as baby boomers age.
Most people leave their money to spouses and children when they die. A 2021 analysis of Federal Reserve survey data found that 82% of heirs’ inheritances came from parents.
People with no children say they want to leave a greater share of their estates to charity, friends and extended family , according to research by two Yale law professors that surveyed 9,000 U.S. adults.
Rebecca Fornwalt, a 33-year-old writer, created a trust after landing a book deal. While her heirs are her parents, her backup heirs include her sister and about a half-dozen close friends. She set aside $15,000 for the care of each of her two dogs.
Susan Lassiter-Lyons , a financial coach in Florence, Ariz., said one childless client is leaving equal interests in her home to her two nephews. Another is leaving her home to a man she has been friends with for a long time.
“She broke his heart years ago and she feels guilted into leaving him property,” Lassiter-Lyons said.
A client who is a former escort estranged from her family is leaving her estate to two friends and to charity.
Lassiter-Lyons, who doesn’t have children, set up a trust for her two dogs should she and her wife die. The pet guardian, her wife’s sister, would live in their house while taking care of the dogs. When the dogs die, she inherits the house.
In the Yale study, people without descendants—children or grandchildren—intended to give 10% of their estates to charity, on average, more than triple the intended amount of those with descendants.
The Jewish Community Foundation of Los Angeles, which manages $1.3 billion of assets, a few years ago added an “heirless donors” section to its website that profiles donors and talks about building a legacy.
“Fifteen years ago, we never talked about child-free donors at all,” said Lew Groner , the foundation’s vice president for marketing.
In the absence of a will, heirs are determined by state law . Assets can wind up in the state’s hands. In New York, for example, $240 million in unclaimed funds over the past 10 years has arrived from estates of the deceased, not including real estate, according to the state comptroller’s office. In California, it is $54.3 million.
Financial advisers say a far bigger concern than who gets what is making sure there is enough money and support for a comfortable old age, because clients without children can’t call on them for help.
“I hope there is something left to leave,” said Stephanie Maxfield, a 43-year-old therapist in southern Colorado. “But if there isn’t, I think that’s OK, too.”
She said she would like to leave something to her partner’s nieces and nephews, as well as animal shelters and domestic-violence shelters. Her best friend is a beneficiary.
Choosing an estate executor and who would handle money and health decisions on your behalf can be difficult when you don’t have children, financial advisers say. Using a promised inheritance as a reward for taking care of you when you are older isn’t a good solution, said Jay Zigmont , an investment adviser focused on childless people.
“Unfortunately, it is relatively common to see family members who are in the will decide to opt for cheaper medical care (or similar decisions) in order to protect what they will be inheriting,” he said in an email.
Kirsten Tompkins, who is from Birmingham, U.K., and works in consulting, along with her husband divided their estate among their dozen nieces and nephews.
Choosing heirs was the easy part. What is hard is figuring out whom to ask for help as she and her husband get older, she said.
“A lot of us are at an age where we are playing that role for our parents,” the 50-year-old said, referring to tasks such as providing tech support and taking parents to medical appointments. “Who is going to do that for us?”