Let’s say Adam is earning $10/hour, net. This means money in the pocket, at the end of the day. So if he works eight hours, he gets $80. Now Adam decides to have a night out. The bill is $120. Adam feels it is a bit high but since he has several thousand dollars into his account, he doesn’t really care. In practice, Adam has to work twelve hard hours for just two hours of fun.
This is just a basic example that shows us how disconnected we are from the idea of money. When we spend money, we don’t really think in terms of the effort we trade for the product or service we receive but rather, we use biases and heuristics to guide our efforts.
Because of this, most people are broke.
You see, money in a very real sense, is a zero sum game.
Money doesn’t appear out of nothing.
In order to get money, you must exchange something. Even if you are an investor, you must exchange the risk of losing money or the effort to manage it. Money, in the terms of USD and EUR is something we build through some productive or less productive effort.
For most of us, this means a job. You go there, you work, you create results or at least, effort for another human being or organization and you are paid in return. At the most basic level, you are exchanging hours of your life in exchange of tokens of value that you can exchange for other’s people effort. In this manner, when you want to buy an ice-cream, you don’t go work into the kitchen for 15 minutes. You just pay $5 and be on your way.
Yet the irony here is that while we’re very aware of this, on a conscious and even unconscious level, it is almost impossible for us to link money to our effort. If we did, we would not get credit card debt nor would we make large purchases. If you knew that you had to work 50 hours in order to pay for that weekend vacation, then chances are you would not take it. If you knew that buying with a credit card (using credit) will make you work an extra two hours per week, just to pay the interest, apart from paying it back, you would not use credit.
Imagine how a world like this would look like.
You go to the restaurant and you don’t see dollar values. You see durations. This meal costs me 3.4 hours to pay for. This mean costs me 1.41 hours. This bottle of wine costs me 41.9 hours to drink. You and I would automatically become a lot more conscious about our decisions on how we spend our money.
And in the past, this was true. If you were in Japan, for example, you would work for three months for a bag of rice. It was effort traded directly for the commodity. There was no middle ground. You could translate in your mind directly what you do and what you get. In some societies, this is still a valid approach – trading services for services or services for goods. It is nowadays very rare but you can see examples in rural areas of “I’ll help you fix your car if you help me with collecting the crop”.
In modern societies this would lead to chaos, therefore, money. It is a standard unit of exchange. Yet, we’ve stopped thinking in the terms of effort we’re putting in behind it. Therefore, you see people earning $5 per hour buying a $700 phone. It takes 140 hours of effort to pay that phone. That’s 17.5 full days and that’s assuming that you don’t have any other expense whatsoever, no rent, no food, no needs whatsoever.
Now let me ask you – if I go to a student and I tell him – first work for 140 hours and then you can get the phone, would he agree?
Of course not.
I don’t care about how cool is the iPhone 8. Almost no person would agree to 140 hours of productive effort in exchange of it. If it was a life saving device, yes, but for something that’s just nice to have, the answer would be “no thanks, I’ll stick to my old phone”.
The irony is though that he is trading 140 hours for that phone. He’s just not realizing.
The money for the phone came from somewhere and that required an actual investment of his resource (time and effort) in exchange for money (the $700 to buy the phone). So the joke is on him. The principles of free market economics work no matter if we’re aware of them or not.
So what is the solution?
Well, short of explaining accounting to you, the solution is to translate monetary value in tangible effort in order to get that value. If you have a fixed income, like a salary, this is simple. You take your net revenue (what’s left to you) and you divide it by the number of average hours you work in a month. So if you earn $2000 month and you work the standard 160 hours (40 hours per week), you are earning an average of $12.5 per hour.
The number is never fixed but a general approximation will do for most people.
Then you make a list of purchases you desire and you calculate based on your hourly rate. Let’s say that you want to spend money on three things this month. The first one is the new iPad that’s $800. The second one is a watch that is $150. The third one is a gym membership that’s $200.
Most people at this point would enter the fuzzy area of irrationality. They would take decisions based on how much money they have into the account, like if you have $20.000 instead of $2000, the expense is lower. No, $100 spent is the same $100, no matter how much you have. But if you calculate based on effort, you can determine if you want to spend it or not. If there was any difference, it’s based on your PC (production capability), the output generated in one hour not so much about your reserves.
- The first one would cost you 64 hours of effort.
- The second one twelve hours.
- The third one 16 hours.
I’m again assuming you pay your rent and everything else from the remaining and that this is discretionary income, so no “upkeep” tax is applied.
Now the question is not if it is expensive or not. Are you willing to trade 64 hours for an iPad? If you know that it is going to offer you more value than this, sure. I’d definitely got a lot more value out of my iPad than I’ve paid for. If you know you’ll hardly use it, then it doesn’t make sense. So it is with the others. If you know that you’ll use that watch for the next three years or even one year, why not, it makes sense.
The idea here is not to tell you where to spend your money. It’s your choice if your next shirt comes from the thrift store or from Burberry. I am not a frugal person and I buy items that are rather expensive. The logic here is to translate monetary costs into your effort, so you know if it is worth it.
Many times, when we do this, we realize that saving half an hour would cost us more in actual effort involved. The priority lane at the airport is an example. You pay an extra $50 for a flight in some cases to save what, 10 minutes? For this to make sense, you would have to be earning around $300/hour, otherwise it is a net loss.
If we were aware how we’re trading our life for money, we would limit our discretionary spending dramatically. That coffee from Starbucks may be one hour of your productive effort. That dinner with friends may be five hours. That holiday you’re taking may be 100 hours. That dream party you’re giving may be the cost of your productive effort for the next two months.
This idea can get more complex with cost of ownership and other factors. COO means how much you’re paying for an item during the lifetime use of that said item. I have a MacBook Air. I’ve bought it about 18 months ago. I’ve paid around $1000 for it. I’ve paid an average of $1.8 per day to use it, not taking into account the electricity and such. I’ve once bought a blazer that I really liked. I’ve worn it for about 2.5 years. It had cost me around $100. This means I’ve paid an average of about ten cents to wear it. I’ve once bought an XBOX 360. I’ve paid $300. I’ve used it for about 20 hours before deciding to give it away. My cost of ownership was then $15/hour.
Then you have ROI.
This is assuming that your asset generates a return. If you spend $500 on a dinner with a client but this nets you a $50.000 contract, then theoretically, your ROI is 9900% (many things are involved too but it’s just an example). If you are a graphic designer and buying the new iPad Pro earns you another $5000 year, then your $1000 investment will net a 400% ROI. Theoretically everything was an ROI because everything helps in some way. The ROI though can be lower than the cost of ownership, leading to a negative return.
I’m not trying to teach you value based accounting here. You can simply stick to translating prices into actual effort. Of course, if you are an entrepreneur or if you make big purchase, do calculate ROI and cost of ownership. It’s just that most people don’t need to learn how to invest in assets first, but rather start with the basics – stop the insanity of spending without realizing the value of their income. If you are an entrepreneur or you make big asset investments though, chances are you don’t need to hear from me about COO and ROI.
This is how I do it. I translate value.
I have a list of investments that I want to make, from a new laptop as soon as this reaches two years to buying a new blazer to the rent and utilities cost. I know how many hours and subsequent days my rent costs and to some degree, I’m starting to know even for small purchases. It’s my heuristic model that allows me to take good decisions with money. And you know what happens? I invest more and more in what matters, I’m building financial cushions and I’m progressing in life.
The best part is that since I’ve started translating money into effort, I gave up on many things that were hurting me. I don’t eat sugar, I don’t smoke, I don’t drink and not only that I’m saving money, even if the savings are not that big, but I’m improving my health at the same time. Maybe the most important thing is that I’m done with impulse buys. It was not unusual to buy anything from expensive headsets to gaming consoles to $500 in some appliance I never use just because I had a lot of money in my account. That’s how I’ve bought a very expensive coffee machine when … I don’t drink coffee that much.
When I know that I would have to work 20 hours to pay for it, I realize that I want to translate my time into something useful. Something that builds for my future and that has an ROI higher than the cost of ownership. For me, the next step is to learn value based accounting or the method used by Eric Ries in lean methodology. Financial discipline is a must if you want to progress in life.