Have you ever noticed what goes on in your mind before buying something? I am going to talk about how to exactly think while making any purchase decision. You might already know about these; just giving it a structure so that it becomes easier to remember and apply.
These models could be applied to any kind of purchase you do — a car, a home, a phone or a piece of cloth. I am extensively using Issue Trees to break things down.
1. Motive of Purchase
Let’s answer the question — why are you purchasing something?
A clear definition of the motive of purchase becomes necessary to evaluate whether or not the purchase is worth it. It should also comes in handy when there’s a choice between purchasing X or Y; or to figure out the relative priority w.r.t. multiple purchases which could help us with deciding what to go for first.
There could be three motives to it:
Now breaking down each of these, one by one:
A. For Usage or Consumption
As you look at it, the clearer is our purchase reason and the ROI we get from it, the better our purchase decisions could get.
Some situations which don’t let us think through —
- Binge buying
- Buying eatables while hungry
- Buying because someone else is buying
- Getting manipulated by salesmen / ads
“Wants” v/s “Needs” Framework:
Here’s another framework which could be used to evaluate whether you truly ‘need’ something:
This is good framework to gauge the urgency of buying something based on its utility [a product of Frequency of use and value derived per use].
How much should I Purchase:
To answer this question, let’s look at the utility and ROI curves in reference to the amount you buy. Have taken example of cars, applicable to any other goods / service:
As evident, we derive the highest ROI from the first quantity, which keeps on decreasing as we add quantity.
B. For Investment
If we want to buy something as an investment for future, here are the parameters you should look at to decide whether to go ahead. Note that this is relative and should be compared across alternatives to find the best one.
To calculate returns, the ‘+’ and ‘ — ’ symbols are representative and doesn’t mean they could be directly added. Bringing them to a common denominator is required to get a clear picture.
Some people make investments to maintain / create their perception on others. This section only deals with an investment for a proper purpose of generating return. Perception related purchases could be treated as ‘usage / consumption’ and should be dealt as per point A.
Now obviously risk goes in correlation with return but the idea is to choose amongst options in such a way and do things differently so as to tilt the risk-reward equation in our favor. Taking an example, if you are investing in stocks, you could —
- choose your broker wisely to save on running costs
- skip initial experimentation and tuition fee [the market indirectly requires whether you like it or not] by learning it first before taking the plunge
- setup a realtime outcome measurement mechanism to track your prime KPIs [XIRR, in this case] to gather more focus behind it, rather than working blind.
C. For Insurance
Many people confuse insurance with investment, thanks to our sales guys. Insurance is to be evaluated on completely different parameters, as listed below:
Trigger event refers to the incidence against which you are taking the insurance viz., death, in case of term plan.
Here is a clear way to visualize whether the insurance is worth it:
Note that the insurance decision needs to be based on the ‘Actual Upside’ as elucidated, and not on the promised upside [the money which is going to be credited to your account in case trigger event takes place] which doesn’t take into account the opportunity cost of premiums you are going to pay.
Also notice that if the trigger event doesn’t happen till p years, the ROI becomes negative for you. Anyhow though ROI is not a major criterion of going for insurance [but covering downsides of the trigger event is], it’s still relevant while comparing between two different insurance options.
2. Economics of Purchase
This model breaks down a purchase decision w.r.t. the economics of it. We answer the question — whether what we purchase increase or decreases in value w.r.t. time, alongwith how does that fare with how we are going to fund that purchase.
A. Kind of Asset
Kind of assets w.r.t. this line of thought could be three:
Examples taken in the above diagram are indicative. For example, Gold is not just an hedge against currency risk [which is only one of the reasons of rise in its value] but also rises due to changes in perception [more precisely, demand — supply mechanics].
A stock of a profitable enterprise which is growing its profit year after year is an example of an asset which grows its value due to rise in its intrinsic value. The same thing doesn’t happen with assets like Gold or Real Estate, if you notice. It’s not like stocks don’t grow in value due to perception changes [PE Expansion is what I’m referring to here] but they are probably the only asset class where intrinsic value actually rises — think of this as Gold producing more gold by itself every year.
Depreciating assets could devalue due to different reasons as listed above. Now idea is to think about your asset and see if it depreciates due to one of these factors or more than one of these factors. For example, a luxury car that runs on petrol might depreciate due to change in perception [a luxury car’s resale value sees a steep fall after the first purchase], technology redundancy [with the advent of electric cars, for example] as well as due to wear and tear. So the rate at which it must depreciate could definitely be higher than, let’s say, a refrigerator.
On the other hand, some assets might depreciate due to just one factor but that one factor works against them in a major way. Take a smartphone — technology changes here much faster than in case of an Oven or a Washing machine.
How to think about Capability Enhancement
Breaking down capability enhancements:
So these are one-time expenses which could set you up for a higher capability to earn and enhance your other-asset-creation ability.
Taking an example of an educational program, we have to basically evaluate your perceived career trajectory’s $ value if you take the course vis-a-vis if you don’t.
From the above graph, we could have the delta $ value for each of the future years which is the difference in salaries if you take the course v/s if you don’t — area between green and blue lines. Now we bring all these delta $s to their total present value [let’s call this PV]. So the cost of the educational program should definitely be less than PV [right?] or in fact, much less than PV to derive exceptional ROI.
Once you come up with this ROI, I’d also recommend pitting it against the ROI you would have gotten by investing this money elsewhere viz., stocks etc. How do the two match up?
Some such decisions are really hard to calculate ROI for. Higher education for our kids is one. But the above thought process could certainly leave us with a better clarity than if they are done in blind.
B. Funded By
How are we funding the purchase is an important parameter in terms of a good or bad financial decision.
Let’s imagine the situation on x and y axes — the mode of funding and type of asset respectively:
Once we have this, what do you think should be the best and the worst decision-quadrants here? Would you agree with me that —
While purchasing a depreciating asset with debt should make the least sense financially, the opposite quadrant of it looks to be the right thing to do.
An appreciating asset could be funded with debt when the cost of debt < returns generated by the asset [CAGR / XIRR]. This could even be tried and scaled [as done by firms which take debt to scale]+ this could also become a source of passive income for you. But remember if things go sideways, it becomes a sureshot way to burnout as debt is to be serviced even if the growth rate of your asset stagnates / sees a bump.