Chapter 2 - Money and Happiness

Good financial management is not about making or keeping money. In fact, fixating too much on money can cause people to make major mistakes that create lots of heartache and misery for people. Money is just one of many resources that we use to better our lives.

The ultimate goal of the financial planning process is to maximize how happy you can be over your lifetime with the resources that you have.

In financial planning, a resource is defined as anything that we use to improve our lives. We all have limited resources. Even the richest or most talented person on the planet has a limit to how many resources they can access and use. This is the principle of scarcity. Because of scarcity, we can’t have everything that we might want from life. We have to pick and choose how we will use our limited resources. Good financial management is the process of using our resources to get as much from life as we can. This means making decisions about which resources to acquire and how and when to use those resources.

The question of how money relates to happiness is one of the oldest questions humans have ever asked themselves. For literally thousands of years, the greatest minds of philosophy and religion have debated this relationship. Some feel that money has no relationship to happiness. The “best things in life are free” they say. Others say that money buys so many pleasures and experiences, that it’s essential to human happiness.

Economists have entered this discussion in recent decades and started using surveys and scientific tools to try to assess how money affects how happy people report feeling. They’ve found some very interesting results.

There are many different words we could use to define happy or positive feelings. For example, we could use words such as “happy”, “satisfied”, “comfortable”, “optimistic”, or “un-stressed” to describe the positive feelings we have. In order to be clear in their research, economists created their own term to capture all of these ideas in one. That word is utility. Utility simply refers to improvements to our lives. An increase in utility means that your life has become better in some way.

Goods often provide utility in a variety of ways. For example, a car provides utility because it is useful to provide transportation, but it may also provide utility for some people because it is beautiful and admiring it makes them feel good. A bed can provide utility because it lets people sleep well and maybe even helps relieve pain. Other times, a purchase may provide no utility at all, no matter how much you spend on it. For example, suppose you buy an expensive piece of clothing that you really love, but you are so scared to ruin it that you never wear it.

As you can see, utility is a flexible concept. It includes happiness but isn’t happiness. It includes comfort but isn’t comfort. It includes all of these positive feelings but isn’t limited to any one of them.

When thinking about a purchase, think carefully about how this purchase will affect your life. Will it make it lots better? A little better? Not better at all? The more utility a purchase will provide, the more you should be willing to pay for it. One of the most common mistakes people make with their money is buying things that they don’t actually ever use or that don’t really make their lives any better. Be sure to stop and think carefully and be very honest with yourself about how a given purchase may or may not produce utility for you before you buy. To buy something that doesn't really make your life better is to have wasted some of your scarce resources!

So, what do we know about the relationship between money and human utility?

Fact #1: Those with high incomes report greater utility than those with low income.

Research shows quite conclusively that people with high income are happier and less stressed than those with low income. This would suggest that more money does indeed result in more stability, more products and services, more fun activities, and more opportunities.

However, this relationship is not quite as simple as it first appears. Intuitively, we tend to feel that if “more is better”, then “most is best!” This, however, turns out to not be true, because…

Fact #2: Our utility from income starts to decrease once we are comfortable

Consider the chart below. It shows how positive emotions (happiness, lack of sadness and worry, and lack of stress) do increase with income… but really only to a certain point. That point happens in this chart around $70,000. This happened to be almost exactly the average household income in the United States at the time. What we are really seeing here is that once you have enough money to not have to worry about paying for the essentials like rent and groceries, more money and more stuff doesn’t seem to significantly affect how happy we feel.

(Source: Deaton and Kahneman, 2010)

The information in Figure 1 tells us that pursuing happiness through pursuing wealth is not likely to be effective for most people. Instead of trying to make endlessly more money to buy endlessly more stuff, we should concentrate on getting enough money to cover our essential needs, and then spend the rest of our energy on other activities that have been found to bring true joy – such as spending time with friends, family, and loved ones and helping the less fortunate.

There are three types of resources we will discuss. Your primary resource is your collection of knowledge, skills and abilities. We call this resource your human capital. Human capital can be traded over time for money, otherwise known as financial capital. Financial capital can be used to purchase durable goods, which are items which provide lasting value. The most expensive durable goods most people buy are automobiles and homes.

Each type of resource provides utility in different ways. Human capital can provide utility directly through the exercise of talents and skills. For example, someone who is a skilled surfer can get happiness directly through the exercise of their surfing skills. Durable goods also provide utility directly through their use. For example, living in a nice home or driving a nice car provides utility directly.

Financial capital provides utility only indirectly because it is used to purchase the things that provide happiness. Money itself does not make us happy. We sometimes get tricked into thinking that money makes us happy because we use it to buy the things that DO provide happiness. This is a vital distinction because it means that the goal of maximizing utility is not the same as maximizing our total wealth. Keep this important point in mind throughout the class.

So how do we maximize the utility we can get from our money? The figure below shows the financial planning lifecycle, which illustrates the process of maximizing utility from money. The vertical axis is dollars, and the horizontal axis is your age. The tall curve shows your actual income over time. As you can see, income starts low when you are young, rises in middle age, and then falls again in retirement.

The way to maximize utility in life is to balance out the differences in income between these time periods and consuming about the same amount of goods each year of your life, as illustrated by the straight line.

The Financial Planning Life-Cycle

The reason for this is best described by example: suppose someone gave you $1,000, how excited would you be by that gift? How much difference would it make in your standard of living? Probably a lot, especially if you do not have a lot of money.

Now think about if someone gave Elon Musk a gift of $1,000. Do you think he would be as excited as you would be? Probably not. Why not? Is it because he can buy less things than you can with $1,000? Of course not, he can buy exactly the same amount of stuff as you can. So why is he so much less excited about the money?

The answer is because he already has lots of money. The $1,000 that made such a big difference in your life will probably not make any noticeable difference in the way Elon lives. This illustrates an important principal. The more money you spend in a given period of time, the less utility you get for each additional dollar that you spend in that same period. For example, which do you think would produce more satisfaction – 50 vacations in one year with zero vacations for the next 49 years, or 1 vacation per year for 50 years? Probably one vacation per year, right?

The implication from this principle is that you will be able to produce more happiness from your money if you spend a little less when you have relatively high income so that you can spend a little more when your income is low, such as in youth and old age.

You can achieve this steady standard of living by borrowing and saving. Borrowing is simply the process by which we transfer future income into the present so that we can spend it. Saving is the reverse; it is the process by which we transfer money from the present into the future so that we can spend it later. We will discuss these two processes extensively at a later time.

Let’s look at an example of how this works. Suppose you are currently a 19-year-old college student earning $12,000 per year waiting tables while you are in school. Tuition, books, fees, and rent take up about $7,200 per year. This leaves you with only $4,800 per year (or $400 per month) to spend on groceries, clothing, entertainment, insurance, etc. Seeing this, and looking ahead to your future, you expect that your income will increase later in your life. You decide to borrow $5,000 this year using a student loan.

This loan will effectively double your standard of living: you can go on twice as many dates, eat at twice as many restaurants, buy twice as many clothes, buy twice as nice of a car, and so on. In other words, you have improved your standard of living a great deal as a result of this loan. You don’t have to decide between fixing your car and buying groceries. You don’t have to stress about replacing a worn-out pair of shoes. You aren’t living rich, certainly, but you are much more comfortable than you would be without the loan money.

Now fast forward. It’s five years later. You have graduated college and are earning $55,000 per year, but you also have to repay your student loan. The payment for that $5,000 student loan is about $600 per year. How much worse off are you as a result of having to pay off this loan? Is $600 per year making a particularly large difference in your standard of living? The answer is probably no. You may not even notice when your student loan payment is withdrawn from your account each month.

The difference between your life being much better when you increase your income as a student and only a little worse when you repay the loan as a working professional is what economists call “utility maximization.” That’s just a fancy way of saying that you are overall happier over your life. A lot happier now, a little less happy later.

What makes the income curve have that strange shape? It all has to do with your human capital. When you are young, you have lots of physical energy, vitality, and time. However, you have very little knowledge, skill, and experience that you can use to earn income. To correct this problem, you go to school to get training that will increase your human capital. Then, once you graduate, you get a job and begin trading your human capital for financial capital, picking up new experience and skills on the job.

As you grow older, you gradually begin to lose your human capital. Your mind slows and your body begins to experience the adverse effects of age. This gradually reduces your ability to generate financial capital. Eventually, you stop working altogether and your income falls dramatically. The pattern by which your human capital increases and decreases over time determines your ability to generate income.

Everybody has a slightly different pattern of income in their lives. For example, a professional athlete will have very little income while young and in college, but once they graduate their income becomes very high. Unfortunately, athletic careers have a tendency to be quite short. This means that a typical income profile for an athlete will have a few years of very high income and a lot of years of very low income. Child actors also often face this type of income pattern. On the other side of the spectrum, university professors often have very low income for an extended period of time early in their lives while they complete their extensive education, but their income rises and stays consistent for a very long time after that because they can work at much older ages than many other professions.

Regardless of the pattern, the human happiness that is produced by consuming goods and services is maximized by spreading out this consumption evenly across our lifetime.

Spend some time considering your future career.

What do you think your income will look like across your entire life?

It is the restrictions imposed by your human capital that makes it necessary to develop a financial plan. If you could produce all of the income you needed at all phases of your life, then you would not need much financial planning. However, this is not the case for most people. Most of us when we are young do not have the ability to produce the income we desire. Almost nobody has the ability to generate the needed income at an advanced age. Because of this, you need to have a plan developed so that you can always have the income you need to live the lifestyle that you want at all phases of your life.

Lecture:

This is an excellent time to watch Lecture 1 if you are taking the complete course!

Definitions:

Resource: anything that we use either directly or indirectly to make ourselves happy.

Borrowing: the process by which we transfer future income into the present so that we can spend it now.

Saving: the process by which we transfer money from the present into the future so that we can spend it later.

Consumption: Money that is spent on goods and services in the present.

Human capital: The time, talents, and energies which we can use to either provide ourselves with happiness directly, or trade for financial capital.

Durable goods: Objects which we have purchased we can use repeatedly over time to produce happiness.

Financial Capital: Money that can be traded for goods and services