Sunday, May 1, 2011

Of Marginal Utility and Pascal's Wager

To preface some of the material that will follow, it is important to think about how much happiness we receive from the money we are seeking. This is crucial in determining what to do in terms of personal financial decisions. For example, think about the principle of the marginal utility of wealth. This term from economics is simple to understand, yet has profound implications. It means that a dollar earned by a rich man will give him much less of a boost in happiness than a dollar earned by a poor man (notice the curved slope in this data). So, going forward, one has to consider the benefit of the positive increment of happiness, compared to the risk involved in achieving that expected return. Larry Swedroe explains:
While more money is always better than less, at some point most people achieve a lifestyle with which they are very comfortable. At that point, the taking on of incremental risk required to achieve a higher net worth is no longer acceptable to most people. The reason is that the potential damage of an unexpected negative outcome far exceeds the benefit that would be gained from incremental wealth. Thus each investor needs to decide at what level of wealth their unique utility of wealth curve starts flattening out.
In the United States, and particularly with many of our socio-economic backgrounds, it is important to consider the way by which we can preserve what we already have (even if our portfolios are currently small or nonexistent). This is largely done through insurance and it's often quite inexpensive. Yes, we could save a few hundred dollars a year buying inadequate insurance and (in 30 years or so) we could be talking about a significant amount of money. People often justify this by thinking, well, how likely is it that I'll cause a multi-car crash (involving litigious people with nice cars) or have my house destroyed in an earthquake. But, it is essential that the consequences of our decisions dominate the probabilities of the outcomes. This is akin to Pascal's wager, wherein he explained that even though the existence of God cannot be determined through reason, one should take the bet and believe, nevertheless. William Bernstein explains it thusly: "If a supreme being doesn't exist, then all the devout has lost is the opportunity to fornicate, imbibe, and skip a lot of dull church services. But if God does exist, then the atheist roasts eternally in hell."

Basically, don't treat unlikely events as impossible and carefully consider the implications of such events. The downside potential you're exposing yourself to by skimping and saving money on insurance may not always manifest itself, but it might. Considering the uncertain world we here have to negotiate, you'll likely be better off saving money elsewhere.

See here for things you probably didn't know about happiness.

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