The Effect of the Small Percentage

Admin

March 29, 2014

Best Investments




Have you noticed that very often we approach any kind of discounts in such a way that we treat them as the proportion or percentage of the prices, and not the amount saved? It is best understood with an example. Suppose you want to buy brand Adidas shoes, in a store near you, which cost $ 200. However, someone told you that in another store (half an hour on foot from your home) exactly the same shoes cost $100. What do you do? Of course, you choose to walk. After all, you save 50% so it’s definitely worth a go. However, what if you intend to buy a car for $100,000? Imagine a situation, that you go to a dealer, when the phone rings from a friend informing you that he just saw the exact same car at another dealership (half an hour on foot) for 99,900 dollars. You can go there and keep $100 in your pocket. But what do you do? Of course, you choose not to go anywhere! You are not going to run around the city for a fraction of a percent discount. Two days earlier $100 was worth to go to the other end of the city, today the $100 is not worth it. Why?

Effect of a Small Percentage in Finance

This happens due to our human tendency to assess price reductions or discounts through the prism of percentages and proportions, rather than their real amount. Discount on shoes is exciting for us because “we earned” 50% reduction but on the car it’s not worth our attention, because we only save a fraction of a percent. And yet, in both cases, you keep $100 in your pocket! What is the moral of this story in according to our finances? First, in case of large purchases remember that it’s always worth to negotiate the price. Each percentage point when buying a home or car equals thousands of dollars. It’s similar in case of financial products. Fund (A) takes 3.5% per annum for management, where other Fund (B) takes 4% per year. Usually we even don’t think about this, saying that, it’s irrelevant because more important are good returns on investment. Half percent is no money! Could it be so? How much is 0,5% per year from 100,000 dollars? It’s $500! Giving five hundred dollars just like that, but going for promotion at the store, because $ 69,99 pants were overestimated at 39.99 dollars? The fact is that here we gain dozens of percent, and there we lose only 0.5%. This approach is called the effect of the small percentage!

This is an excellent example of how our human psyche can affect our wallets. We think we know this and do everything reasonably, but often get in this kind of traps. I always say that 99 % of personal finance is psychology. There is no any secret knowledge. You need to make money, spend a little less, and invest what’s left in some way. It’s simple as that, but why so many people have problems with this?

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