Chapter 2

PRESENT VALUE IN THE DAY-TO-DAY WORLD

The idea of Present Value lurks just below the surface of an overwhelming number of decisions we make on a day-to-day basis, and being aware of its presence and how to incorporate it will lead to making better choices. In this chapter, we will look at a few of the common types of mundane decisions that arise in everyday life and see how taking a few extra minutes to think in terms of Present Value can often shed an entirely new light on those questions.

Do We Need a New Refrigerator?

Shortly after I began writing this book, my wife came to me and said that she was pretty sure we needed a new refrigerator. Needless to say, this was not exactly welcome news, and my fiscal defenses were immediately mobilized. My first response—perhaps familiar to many of you—was, “Why? The one we have is still working fine. And besides, it’s only seven years old, and the guy at Sears told us it should last ten or fifteen years at least.” I had a sinking feeling that this was the first volley in a campaign designed to achieve a comprehensive kitchen remodeling. But my wife knows me better than to lead with esthetics, and so she quite reasonably pointed out that while it was true that the fridge was still keeping everything cool, the outside of it seemed to be running hotter than normal and as our electric bill had recently been outrageously high she was sure we would actually save money if we bought a new one. If true, this was a powerful argument and one that I could not effectively parry. Essentially, she was saying that putting all the nonquantifiable reasons aside (and believe me she was loaded for bear if I ever engaged in that discussion) the Present Value of our future refrigeration expenses would be less if we purchased a new one now than if we waited for the old one to live out its life using up more and more electricity to do so. Clearly, the question called for just the kind of systematic thinking described earlier, so let’s see how I applied our 5-step process.

Step 1—clarify the choice. While the decision to be made was clear (to buy or not), the cost of each option was not. So first I had to figure out how much more in electricity we were now spending than we would if we bought a new refrigerator. The cost of the electricity on the new models was easy to determine, as such figures were prominently displayed (in some cases more prominently than the price tag) on the front door of each model in the showroom. The tricky part was figuring out how much the current one was costing us. One way to approach this was to assume that before it “broke,” our refrigerator electric costs were the same as those on the new model and that what we would save would be the amount by which our electric bill had gone up since the current one started running hot. But even with this simpler calculation, there were two problems. The first was purely psychological—I just didn’t want to believe that we had a problem, that things had changed, and that the original projections given to us by the salesman at the store where we purchased the refrigerator were simply not valid any more. The second one was all the “noise” in the calculation—such as all of the month-to-month variations in weather, vacations, light use, and so forth (not to mention price changes)—that affect the bill. Both of these issues come up again and again whenever one tries to apply Present Value to real-world decisions.

I will spare you the details of how I dealt with both my psychological demons and the messiness of the calculation. At the end of the day, it seemed that we were paying about $15 per month more in electricity as a result of our faulty refrigerator, and with that information I was ready for the next steps.

Steps 2–4. In thinking about the future possibilities, I thought about—and projected—the purchase price of a new refrigerator (either now or when the old one died) as well as the electrical costs of each in the coming years. In terms of actual numbers, new refrigerators comparable to our current model were running about $1700 at the time. Assuming that the current one had eight more years to live and that the price of refrigerators goes up at 2–3% per year, a new one could be expected to cost about $2000 when the old one died. The Present Value of $2000 payable eight years from now is, as we know, much less. But to actually compare Present Values, we need to perform step 4 and choose a discount rate assumption (taking into account all the factors we previously talked about). As I have mentioned previously, finding your personal rate of discount (i.e., how to weigh the future vs. the present) is an important step in using Present Value. In this case, because it was only money (and not a lot of it) that would otherwise stay in my savings account (vs. being spent on something else that I valued), I only cared about how much I could earn on the money if I didn’t spend it. As a result, I chose a discount rate of 5% (what you could earn on bank CDs at the time).

Step 5—do the numbers. In chapter 4, we will describe the technique for doing this calculation (this was one of those cases where an actual calculation was required), but the important part of the result was that while the value today of waiting to buy a new refrigerator after the old one died was less than the $1700 it would cost to buy a new one immediately, the Present Value of the extra electricity costs associated with waiting more than offset that difference.

For those that are interested, the following is how the actual calculation went. Using our 5% discount rate, the Present Value of buying a new refrigerator eight years from now was $1353, while the Present Value of the extra electric bills that I would have to pay if we waited until the old refrigerator died was another $1163. Adding the two together ($1353 + $1163), we get a total Present Value cost of holding on to the old refrigerator of $2516. Given that $2516 is much greater than the $1700 a new refrigerator would cost, the conclusion was inescapable. As usual, my wife was right and we did need to go appliance shopping.⁶

This was a simple example (albeit one that required a little bit of arithmetic) because the alternatives were clear, the money impact was (mostly) measurable, and there was very little uncertainty about the future. Most of the situations we will discuss require less calculation, but are not quite as clear when it comes to some of the other steps in the process. Let’s now look at a couple of others.

A “Once in a Lifetime” Opportunity?

If you are like me, your mailbox, telephone, and e-mail are constantly inundated with marketing offers that seem too good to be true. From offers to switch cable companies to “free” home inspections, blowout sales at your local “big box” store, and Groupon deals, it seems that we go through life spending far too much money on the things we need and if we just took the time to read and act on all these “once in a lifetime” opportunities, we could improve our financial situation considerably.

Many of us are either so suspicious or have become so numb to sales pitches that we just refuse on principle to even investigate the offers. Others respond when the offer hits a chord within them or happens to come at a time when they are looking for exactly the service that is being presented. More often than not, when we do respond, we are disappointed in the results, but there are exceptions, and using Present Value can help you separate the winners from the losers.

To see what I mean, consider an offer that arrived in my mailbox a while ago. It came in the form of a bright yellow flyer from a local heating and plumbing company telling me that for $89.95, a licensed expert would come to our house and clean all the heating vents/air ducts and inspect our furnace. They would come at my convenience and there would be no further obligation. Since the last time we had our vents cleaned it cost about $300, this was an offer that caught my attention. However, before I made the appointment and began to use Present Value in earnest, there was one other important factor I needed to consider.

Specifically, I needed to determine whether this was a legitimate offer and, if so, why was the company providing such a deep discount. This is an important question in almost any special offer that arrives unsolicited, but in this case I had not only heard of the company (they were a company we had called previously to repair our furnace), but given that the offer came during a period when the economy was in recession and contractors of all sorts were struggling to find work, it seemed very likely that this promotion was driven by the company’s need to generate new business and utilize its otherwise idle employees.

So with that threshold question addressed, I started to think about the question from a Present Value perspective.

Starting with step 1, I had to decide whether or not the vents needed cleaning at all. Just because I was getting a $300 cleaning for less than a third of the normal price didn’t mean I should buy the service if the vents were not dirty. So I looked back and it turned out that our air ducts had been cleaned about three years previously. A quick Internet search indicated that cleaning is recommended every four to six years, so while a cleaning might improve things, we weren’t quite due. So now I knew my choice—get the vents cleaned now or wait two years to get them cleaned when they were “due.”

Step 2 was also fairly straightforward. When I considered that within the next couple of years (as long as I didn’t sell the house) I would need to have the vents cleaned, the future possibilities were only two—pay $90 now or pay $300 two years from now (assuming that there wouldn’t be a similar deal offered at that time).

Jumping ahead to step 4, I realized that even though my personal rate of discount is high, it’s not that high and so clearly getting the cleaning done now was the right move.

But you may ask, weren’t there other possibilities to consider in step 2, and what about step 3? Well, in step 2 above I did consider the possibility that I wouldn’t need the vents cleaned (if I didn’t own the house) or that it might not cost $300 in the future, but I essentially assigned these possibilities a “zero” and that is sometimes what happens. You imagine those different possibilities but then consciously decide not to include them in your Present Value calculation. This is one of the reasons that using Present Value can be a lot simpler than it might appear—once you imagine the possibilities, you will find yourself eliminating some of them from consideration either because they won’t affect the calculation too much (they have similar values) or they are too unlikely and therefore should be completely discounted.

The mathematically astute among you may point out that I have oversimplified things a bit in that if I were to get the vents cleaned now I would have to get them cleaned again two years sooner than otherwise (i.e., five years from now vs. seven if I stuck to the original vent cleaning schedule). While true, it turns out that that has only a minor impact on the calculation and is even less important given all the other uncertainties (e.g., I actually might sell the house in the next five to ten years) about our future vent cleaning needs.

I was now almost done, but there was another factor to consider and that was the value of my time. By having the vents cleaned, I would need to find a day I could work from home and then spend an hour or two watching and supervising the contractors as they turned the house into a chaotic noisy mess while they did their job. This was a non-trivial factor, as I value my time considerably. But even if I priced the time as worth $100 (i.e., more valuable than the $90 out-of-pocket cost), then the question still became how much more is the value of the time today ($100) than the Present Value of the time two years from now when the vents would normally be cleaned. Even at a very high discount rate (e.g., let’s say we discount by one half and consider the future time worth $50 today), this factor was not enough to offset the monetary savings.

In the end, I did have the vents cleaned, but there was a final question to consider. Remember, the contractor was not making this offer just to clean vents. In fact, at $90, the company may have even been losing money on the deal. What they were really interested in was selling me more services. They were hoping (planning?) to find other problems when they saw my heating system that would allow them to obtain other more profitable business, which would offset any money they lost on the vent cleaning. Like most of us, I completely discounted this factor. First, if they did find something that truly needed doing, I would want to know (and could get a competitive bid on), and if they tried to sell me something I didn’t need, I could always say no. This last point may seem too obvious to mention, but as we will see in the next example, assuming you will always act rationally can be dangerous indeed.

A Dream Vacation

My wife has always wanted to go to Hawaii. Maybe it was growing up in the Israeli desert, or maybe it was watching Hawaii Five-0 on television as a child, but whenever the idea of planning a trip comes up, websites depicting volcanoes, luaus, and lush Hawaiian landscapes will mysteriously appear in the browsing history of our computer, and whenever our future vacation destination wish lists are discussed, Hawaii floats to the top of hers.

One night we had just finished dinner and were having just such a discussion when the phone rang. We have a policy in our house of not responding to telephone marketers, but when the caller mentioned Kauai, it just seemed like too much of a coincidence, and I suffered a moment of weakness. The proposition was one that we have all heard many times before.

“Come and enjoy our beautiful resort for an incredibly low price. All we ask is that you listen to a brief 90-minute presentation about the benefits of vacationing with us more often.” Sound familiar?

I had always assumed that Time Share deals were one of the worst scams out there—a bait and switch on what you get up front, a painful, inconvenient high-pressure sales pitch to endure, and since no one except a true “sucker” would actually buy the Time Share and the marketing people had to be making some money somewhere, it just couldn’t be worth it. But this time I decided, perhaps as much out of curiosity as anything, to try and really understand what was going on in this business.

It turns out that the up-front bait was pretty attractive and dovetailed perfectly with our vacation goals—five nights at a one-bedroom suite at a high-end Kauai resort including lots of extras (a free car, one dinner, a bunch of continental breakfasts, as well as $200 worth of credit at various shops at the resort) all for $899. There were no restrictions on when to schedule the trip and some flexibility on when to schedule your ninety-minute “tour” of the facilities.

To take advantage of the offer, we paid our deposit ($300) and then tried to schedule our trip. Our first choice of dates was not available (according to the reservations operator we had not acted “quickly enough”), but we were able to get our second choice about nine months later—so far, so good. Even discounting heavily, the up-front deposit only added a little bit to the cost of the vacation, but things got a little more complicated when it came time to make our plane reservations (not included in the deal). Here, because we now had no flexibility in our dates (we needed to book and confirm the hotel before buying plane tickets), we ended up spending more (about $2000 vs. $1500) on getting to Hawaii than we otherwise would have.

So, let’s see where we are from a Present Value perspective. The original price was $899, and the cost of the plane tickets was $2000, so to this point the cost of the vacation was a little less than $3000. Of course this was not the total cost of the vacation, as when we arrived there would be incidentals, meals, and the inevitable shopping we would do. I estimated this to be about another $2000, for a total vacation cost of about $5000. Not bad for a week in Kauai for a family of three, but now I had to determine, from a Present Value perspective, how good a deal it really was.

In other words, it was time to begin our five-step process. Starting with step 1, I first had to “clarify the choice.” Specifically, it was important to note that had we been going to a place that we wouldn’t have ordinarily gone to, this step would have been very complicated indeed as I would have had to consider the $5000 versus all the other possible vacations we could take with both their financial and non-financial aspects. But in this case, the choice simply came down to whether to go to Kauai now and listen to the Time Share pitch or should we defer our trip to Kauai to sometime in the future.

The importance of the above should not be underestimated, and it alone could have tilted the Present Value calculation against the trip. Too many times, when we look at “deals,” we only compare the price/value of the product or service offered to how much that same product/service normally costs. Any deal needs to be compared to all of the alternatives, which might include either a different product/service or not buying at all. In our case, it was much simpler in that I knew that eventually we were going to go on a Hawaiian vacation. That I didn’t know when that vacation would happen is important, and I did need to factor that into the calculation, but at least I didn’t need to compare the price of our trip to a dozen others we might make. As noted, while we almost certainly would eventually go to Kauai, it would most likely have been a year or two later than when we went, and so after figuring out what the trip would cost in the absence of the Time Share deal, I needed to determine its Present Value and compare it to the $5000 I was about to spend. This is where step 2 began.

When I did my research on the cost of going to Kauai on our own (including the lower-priced plane tickets, but higher-priced car, hotel, etc.), it seemed that it would cost us $7000–$8000 for a comparable experience (without having to hear the sales pitch). Step 3 was—as in the prior example—very simple. Here I assumed that it was a certainty that we would be going to Kauai and proceeded on to step 4.

In step 4, I decided to use a relatively low discount rate because I was not in that much of a hurry to get away and as a result came up with a figure of $6500 (the value today of the $7000–$8000 I was going to pay when I eventually did go to Kauai) to compare to the $5000 that we were going to pay. Thus, it seemed that we were essentially being offered $1500 ($6500 – $5000) to spend ninety minutes of our vacation listening to a sales pitch that we had no obligation or reason to accept. A few months later, we boarded our plane fully satisfied and proud of being savvy consumers who were about to take advantage of a large corporation that didn’t seem to be aware of the value they were “giving away.” But while the decision may have seemed like a “no brainer” from a Present Value perspective, things got a bit more complicated once we arrived in Kauai.

When it came time to actually listen to what the Time Share salesmen had to say, we quickly realized that we had seriously underestimated our ability to resist or even think clearly about what we were hearing. Softened up by three days basking in the Hawaiian sun and fragrant breezes wafting through the resort, our defenses were down, and the rationale for buying a Time Share seemed downright compelling. The idea of never having to pay another hotel bill and being able to go almost anywhere in the world (taking advantage of the reciprocity arrangements with other Time Share owners) and having equity to eventually sell (maybe even at a profit) and all the extra right now benefits (another discounted vacation between now and closing, extra discounts for the remainder of our stay, etc.) was just disorienting. They told us we had come at exactly the right time and that, as times were tough, the manager was allowing them to offer extra special incentives if we committed right then and there. In fact this was only a very temporary opportunity as they were only three sales short of their quota, and there were another ten conversations going on right then, and as soon as they met their quota, the deal would revert back to the already generous (though not quite as generous) terms that were originally put forth.

On and on and on it went. In some ways, my belief in Present Value was working against me. The numbers just made too much sense. I forgot one of the most important principles of Present Value thinking, and that is to take your time, to not let your desires cloud your evaluation of the future, and to stay unattached to any particular scenario of the future. In the end, it was my wife that saved us. She is a psychologist, and when the salesmen kept refusing her request to “sleep on it” and give an answer the next day, the alarm bells went off and she dug her heels in. We were not going to sign anything until/unless we had a few hours to consider it.

They finally agreed to give us the rest of the afternoon and when we were by ourselves, the fever broke, and we realized that we had narrowly averted a serious fiscal mistake. All kinds of obvious flaws in the rationale became apparent. Not only was the range of alternative future vacations we might want to take far broader both in terms of location and in experience than were available through the Time Share (i.e., all the reciprocal properties were at resorts in big cities or “attractive” destinations), but the timing of these future vacations was both farther in the future and much less certain than we had been convinced of. Beyond all the non-financial drawbacks that we now saw, the fact that the commitment required tens of thousands of dollars up front meant that the Present Value of the deal was not as good as it seemed. For example, just considering the equity that we would have been obtaining, we realized that to take advantage of all these future vacations (a key selling point) would require us to wait decades before selling, and it was not at all clear whether the Time Share would be worth anything at that point. And even if it was, the Present Value of that equity cash in would be only a fraction of the price we paid.

At the end of the day, taking a step back and using Present Value to say no ultimately allowed us to get a great deal on a trip we always wanted to take and kept us from making a very costly mistake.

Before we move on to some of the more serious decisions we make in life and how Present Value can guide us to the right path, I would be remiss if I didn’t mention probably the most prevalent kind of decision we face regularly, and that is whether to spend money on something we want now or to save that money for something (often far) in the future. Many of my colleagues in the actuarial and financial services industry make their living advising people on their savings and investing strategies, and in this book I have consciously avoided dealing extensively with those questions. There is no doubt that Present Value is integral to those decisions, but there are hundreds of books already written on the subject (e.g., on how to plan for retirement, get out of debt, save for the future, and get rich on real estate), and I wanted to focus on what I think is a relatively unknown aspect of these and many of the other decisions that we face.

Later on, I will talk about the one author (who happens also to be an actuary) that I would recommend reading to get better at your savings and investment strategy,⁷ but for now I would just leave you with the message that Present Value thinking can be applied to any financial decision where the alternatives are clear and the consequences of choosing one path over another are measurable and, if not predictable, can be imagined—both in terms of magnitude and in timing. My intent is not to tell you whether you should take that bonus that you just got and spend it on a new car, pay down your debt, or put it all in to your company’s 401(k) plan, but rather equip you with the tools to make that decision for yourself using the power of Present Value.