If there is anything this country enjoys, it’s measuring things by numbers and then comparing numbers. We divide people into percentile according to net worth, credit score, GPA, GDP, IQ, etc. with the implicit assumption that it is possible to understand the entire scale simply by multiplying by a number. For instance, someone spending twice as much must live twice as well or someone with twice the IQ must be twice as smart.
However, all of these numbers are a function of something that is very complex and nonlinear. Therefore it makes no sense to compare two numbers which are very different. While it is possible to compare the expense level of persons A and B, say $40,000 and $39,000, respectively, and conclude that person B is slightly better with money than person A, it is impossible to compare A and B to person C who only spends $20,000. Here person C would live qualitatively different and make qualitatively different choices. For instance, A and B might have two cars each and here B would be driving a slightly more fuel efficient model, whereas C would not be driving a crappy car. More likely, he won’t be driving a car at all relying on other means of transportation. Hence it is impossible to make any conclusions merely based on comparing numbers.
So how do we compare?
When two things are scaled different, one usually builds ratios. Nobody but an absolute rookie would consider a stock priced at $30 to be twice as expensive as a stock priced at $15, say. No, the ticker price must be scaled by some value. Earnings per share is a very popular scaling factor. Suppose that the higher price stock has an EPS of $4, while the lower priced stock has an EPS of $1. Then the P/E ratios are 30/4=7.5 and 15/1=15 respectively. All other things being equal, the former is the least expensive. Stocks with high P/E values are called growth stocks and stocks with low P/E values are called value stocks.
If we go back to the car example, there are various ways to build a ratio (making up ratios seems to be a primary occupation of stock analysts by the way). We could divide by the number of cars. This would mean that person C would have a ratio of infinity. We could divide by the distance travelled giving some indications of mileage costs or we could divide by the time spent on transport. One or more of those ratios would show a substantial difference.
This is interesting, when one is comparing budgets like frugal vs frugal or when comparing food expenses. It is very likely possible to establish several classes of lifestyles. Comparisons should then be done within a class. For example, it does not require a genius to establish that all value stocks by definition are 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 frugal tips and suggestions from most personal finance blogs, because they are out of my league. I simply can’t afford to follow their advice 😛
In a future post I will hopefully have been able to develop some ways of classifying the different personal finance setups. Until then any suggestion is welcome.
Originally posted 2008-09-05 07:33:12.