If there’s one thing this country enjoys, it’s measuring things with numbers and then comparing them. We divide people into percentages according to net worth, credit score, GPA, GDP, IQ, and so on, with the implicit assumption that the whole measure can be understood simply by multiplying by a number. For example, someone who spends twice as much as others must live twice as long, or someone with twice the IQ must be twice as smart.
But all of these numbers are a function of something very complex and nonlinear. So it makes no sense to compare two very different numbers. While it is possible to compare the spending levels of people A and B, say $40,000 and $39,000 respectively, and conclude that person B is slightly better at handling money than person A, it is impossible to compare A and B to person C, who spends only $20,000. Here, person C may live qualitatively different lives and make qualitatively different choices. For example, A and B may both own cars, and B may drive a slightly more fuel-efficient model, while C will not drive a crappy car. He will likely not drive a car at all and will rely on other means of transportation. So it is impossible to draw any conclusions based on comparing numbers alone.
So how do we compare?
When two things are measured differently, one of them usually builds a ratio. No one but an absolute beginner would consider a stock that costs $30 to be twice as expensive as a stock that costs $15, for example. No, a stock price should be measured by value. Earnings per share is a very common measurement factor. Suppose the higher-priced stock has an earnings per share of $4, while the lower-priced stock has an earnings per share of $1. Then the price-to-earnings ratios are 30/4 = 7.5 and 15/1 = 15, respectively. All other things being equal, the former is the less expensive. Stocks with high price-to-earnings ratios are called growth stocks and stocks with low price-to-earnings ratios are called value stocks.
If we go back to the car example, there are different ways to construct a ratio (ratios are the main occupation of stock analysts, by the way). We can divide by the number of cars. That means that person C will have an infinite ratio. We can divide by the distance traveled to give some indication of the cost per mile or we can divide by the time taken to travel. One or more of these ratios will show a big difference.
This is interesting when we compare budgets like: Frugal vs frugal Or when Food Expense ComparisonIt is quite possible to identify several categories of lifestyles. And then comparisons must be made within each category. For example, it doesn’t take a genius to prove that all value stocks are by definition less expensive than growth stocks. But what about frugal lifestyles? Do some people exhibit a qualitatively different form of frugality? My answer is yes. I have a hard time using the frugal advice and suggestions from most personal finance blogs, because they are outside my scope. I simply can’t bear to follow their advice.
I hope in a future post I can develop some ways to categorize different personal finance settings. Until then, I welcome any suggestions.
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Originally published on 2008-09-05 07:33:12.
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