The Giffen Good Concept Applied To Investments

Editor’s Note: A version of this post appeared in the San Antonio Express News “So…Money” column.

The only “C” I got in college was in Intermediate Macroeconomics, but I remember one economics term that I really loved — the “Giffen Good.”

With ordinary, rational, economic behavior, we expect that when prices go up, people buy less, and when prices go down, people buy more. We buy more things, for example, at Wal-Mart and Costco because of their low prices. We buy fewer things at Nordstrom because of their higher prices. Makes sense, right?

sir_robert_giffen
Sir Robert Giffen

A Giffen Good — named for a 19th Century Scottish economist named Sir Robert Giffen — is an odd thing. It’s something that people buy more of as the price goes up. With a Giffen Good, people act in exactly the opposite way we would normally expect them to in response to the price of things.

When you look up Giffen Good in Wikipedia — as I just did to refresh my memory — you read that little evidence exists for Giffen Goods in the real world, and people do not generally purchase more of something when the price goes up.

When it comes to our investments, however, I totally disagree with Wikipedia.

Ever since learning about Giffen Goods, I see them everywhere, as well as what’s known by analogy as “Giffen Behavior.”
Outside of the investing world, I remember reading with much interest the story of a guy trying to get rid of his mattress. He posted a “Free Mattress, Used” notice on Craig’s List, and got no responses. When he posted “Mattress, used, just $10,” he had to turn away interested buyers who lined up with their trucks to try to take advantage of a great bargain. That’s a Giffen Good.
Here’s an example of a Giffen Good from the art world: Imagine if I landed on Earth knowing nothing about art and somebody offered me the Edvard Munch painting “The Scream” for $1,000 to hang in my living room.

The_Scream_giffen_good
I’d offer you $75 for this, because I love a bargain.

I don’t know about you, but I might just think, “Whoa, that’s kind of a lot of money, and although there’s something neat about the painting, it’s still a bit creepy.”
And then I might think, “How about I give you $75 for it?” Because I love a bargain.

Of course, knowing that somebody else paid $120 million for it last year changes its attractiveness to me. Would I sell every single one of my worldly possessions right now to own “The Scream?”

Duh. I’m a finance guy. Of course I would. That painting is the ultimate Giffen Good.

Shifting from the absurd to the irrelevant, a concept like Bitcoin suddenly became everybody’s most desired tulip bulb last year when the price starting shooting upward, making it the Giffen Good of 2013.

And now lets return to the core of ordinary investment behavior: Discretionarily-managed equity mutual funds typically charge 0.75 to 1.5 percent management fees, while equity index mutual funds typically charge one-third of that amount in management fees, despite offering the same long-term results, according to every academic study that’s ever been done. Like, ever.

Most investors figure — wrongly — that if the fees on the discretionarily managed equity funds are higher, they must be a better product. The lower-priced index mutual funds just seem less attractive. That’s a Giffen Good.

In fact, much of the time, the entire stock market is an example of a Giffen Good. We really don’t want to own stocks when they fall in price. On the other hand, we really, really, really get interested in stocks after they’ve jumped 10 to 15 percent a year for a couple years in a row. This is madness, of course, but it’s also exactly what drives much investing activity.

active_vs_index
Most of the time, indexing wins

Beware of your own Giffen Behavior.

Final note: Real, live economists reading this may object to my imprecise adaptation of an economic term for the popular illustration of a personal finance concept. In anticipation of their objection, I can only show them my previously mentioned “C” on my college transcript. Also, lighten up, dismal scientists.

 

Please see related post: Guest Post by Lars Kroijer – Agnosticism over Edge

A book review of Investing Demystified by Lars Kroijer

 

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Ask an Ex-Banker: Is This The Greatest Wealth-Making Opportunity Of All Time?

Souvenir Penny MachineAndrew, in Baltimore, writes in with a sure-fire way to earn 1%, risk-free, for 10 seconds of ‘work.’

I’m almost afraid to let out his secret, as mobs will soon descend on the City of Baltimore’ inner harbor Aquarium to attempt to reproduce this sure-fire money-making process.

But, I owe it to Bankers Anonymous readers to try to enrich them as well.

(Be sure to sign up for my daily newsletter for similar wealth-building tricks.  For just $999.99 per month, you can learn all the techniques.  Up next month: Bitcoins.)

 

Dear Bankers Anonymous,

I am a long-time reader, first-time letter writer. I’d like to get your advice regarding a great wealth-creation opportunity that I stumbled upon.

While at the National Aquarium in Baltimore, my son asked me for a penny to put into one of those souvenir penny press machines. Conveniently, next to the penny press machine, there is a change machine. However, this is a not a typical change machine. In this particular change machine, you receive 4 quarters and one shiny penny for each dollar bill you insert. The penny is free!

baltimore aquarium pennies
The original intended use for Andrew’s serendipitously discovered ‘perpetual money machine.’

This may not sound like much, but it amounts to a risk-free 1% return for 10 seconds of “work.” I immediately realized that there was a tremendous opportunity here. I returned the next day with $200 in crisp bills.

After just 30 minutes I was able to able to convert the 200 ones into 800 quarters and 200 pennies- $202.

I realized that I could repeat this process for the remaining 8 hours that the aquarium was open and walk out with more than $234! In order to do so, I just needed to convert my $202 in change ($201 after I bought a Fresca) back into one dollar bills. Unfortunately, changing the coins back into bills was not easy to do at the aquarium. The cashier at the gift shop seemed unhappy when I gave her my coins and asked for 201 one dollar bills. Her manager explained that “We’re not a bank.”

(Of course not! What bank would pay 1% every half hour!  Duh!)

Eventually, we agreed that I could use the change machine but that the gift shop or cafeteria would not change my coins for bills.  I am unable to lug 50 pounds of coins around, especially because just 30 minutes of the repetitive motion of inserting the one dollar bill into the machine exacerbated my carpal tunnel syndrome in my wrist.  Another alternative is that I could purchase one of these machines for my home.

Note: Not the actual Fresca bought by reader Andrew
Note: Not the actual Fresca bought by reader Andrew with his newly-made riches

I have a few questions for you:

1) In consideration of the above challenges, how could I scale this operation up?

2) Perhaps I should try this same strategy, but with bitcoins?

3) What are bitcoins?

Thanks, Andrew

Dear Andrew in Baltimore,

This is the most brilliant money-making strategy of all time.  As an initial investment to scale-up your strategy, I have ordered from China 50 of these special “extra-penny” change machines for my basement.  I’m going to set them up to work constantly in parallel, churning out 1% return on my dollars every few seconds, relentlessly.  Those bitcoin miners haven’t seen anything like this!

Regards,
The Banker

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