Step 2 - Spending

Low Cost ≠ High Value

One of the most common mistakes I see people make when it comes to trying to save money is that they confuse the concepts of cost and value. They assume things of the lowest cost are the highest value. Sometimes that is true, but often it is not. People spend far too much time looking for the lowest price, rather than focusing their energy on finding the highest value. So what’s the difference?

Can’t go wrong quoting the master

I think Warren Buffett’s quote is great because it captures a key piece of the difference between cost and value. Cost relates to what you are giving out and value relates to what you get back in return. While his quote is a good way to quickly understand the concept, it is missing an important piece. You see value isn’t simply what you get, but rather, it is what you back in relationship to what you spend. Or put in more mathematical terms:

The real value equation

As I said earlier, the name of the game is to maximize value to ensure that you get the most out of every purchase you make. For those of you that my not be mathematically inclined, there are two ways to increase value based on this equation. You can either increase benefit or decrease price. This is why people confuse low price with high value. Because as price goes down, value goes up. But that only holds true if the benefit is remaining the same. But the benefit side of the equation is where things start to get dicey. Although a math nerd might claim that the equation as written looks linear, in actuality I find that the relationship between price and value ends up being more of an ‘S’ curve due to the varying nature of benefit.

Relationship between price and value

I’ve highlighted some of the key points on the graph. For example, there is often an entry level price for a product or service. Even at the cheapest retailer, there is a price that they will not go below. As an example, if I want a pair of Bluetooth headphones, then the lowest I can go appears to be around $10. But reading reviews of the products at this price point you find things like “Left ear gave out after a couple of months.” So clearly not the best value. If I have to replace them in two months, then all I’ve done is thrown away $10. If I flip my Amazon sort from lowest price to best average review, then I start to see products in the $25-$35 dollar range, with reviews that start to say how well the product holds up. This is the bottom of that upgrade and save point. I’m spending a little more, but since they last longer, I am getting a lot more. Add to that the fact that those headphones appear better ergonomically designed than the $10 pair, and you’ve got a winner. What does it look like as I continue to climb the value curve? In the headphone example, at around $40 you begin to see things like an included battery-pack charging case that will recharge the headphones while you are on the go and don’t have access to a wall outlet.

At a certain point the additional benefits start to trail off. In the headphone case this is somewhere around the $50-$60 price point with the addition of active noise canceling. What happens above this price point? You start to see what we call “specsmanship”; that is companies vying for the best specs on their product. “Ours lasts 30 hours.” “Well ours lasts 40!” Sometimes it is real, sometimes it is inflated, sometimes it is outright misinformation. And at that point it is hard to tell the difference without trying it for yourself. The other thing that happens above this level is brand name products. I have nothing against brand name and will sometimes based on brand, if that brand has a proven track record of delivering quality or value that is meaningful to me. Just know that a brand name will always cost more for a “comparable” product. You just have to figure out if the brand name brings any benefit.

Quantifying benefit can be a very challenging task. It takes a fair bit of knowledge about the product or service you are buying. Often the sources that are driving that knowledge are marketing materials from the companies producing the products you are comparing. And those are meant to confuse you and just trust that their product is the best. Perhaps you could look at online ratings on a site like Amazon, but rarely do I trust those any more. In the best case scenario there is an online community of people who can provide honest feedback and input on the decision. Add to all that, the fact that benefit is subjective. What one person finds to be a wonderful feature, another will see as an annoyance. One person’s favorite chair, another finds uncomfortable. Taken as a whole, spending time figuring out benefit quite simply won’t be worth it for every decision. If you can afford it, shooting somewhere in the middle based on the prices you find is also not a bad strategy. As my income has increased that has been my version of lifestyle inflation. Moving from buying the cheapest viable product to buying something mid-range in the hope that it is a better value. If you are early in your FI journey, then erring on the side of lower price is often a way to make sure that you get at least a decent value.

“Great, so all that just to tell me that I should keep bargain hunting?”

No. For high dollar expenses, doing the research and figuring out the benefit ahead of time is absolutely an important and valuable investment of your time to ensure that you get the most for your spend. The high dollar spends are (hopefully) not ones you make very often. So when you make them, you want to ensure that you get something you will be happy with for a long time.

Secondly, even though I recommend starting at a low price for items that don’t warrant a huge time investment up front, it doesn’t mean that you should never spend more money on those things. As you use the product and learn more about it, you can figure out what it is you like and don’t like so that next time you can make a more informed decision. Let me give you an example, when I was an intern in college, the company I interned at had pick up soccer games every Thursday. One of my fellow interns invited me to play. Even though I had never played in my life, I figured I would give it a shot. But to do so I needed a pair of cleats. So I ran to a local sporting goods store and picked up a pair. There were lots of pairs for $50 or $100, but I had no idea if I would even like soccer. So I found a pair for $20 and gave them a shot. I discovered that I loved soccer. My first cleats lasted me two years and when I went to replace them I had to make the decision: do I spend more for something better or go cheap again? I got lucky and found a pair that was originally $60 on sale for $30 so I picked them up. They lasted me all of 6 months. WHAT!? My $20 investment lasted me two years and these things that cost three times as much only lasted me 6 months. It would have been fine if they magically made me a super awesome player or were crazy comfortable. But they were none of those things. So back to as cheap as I could buy for my cleats.

On the other hand I have personally found that cookware is somewhere that I started out super cheap but quickly saw the difference in performance and durability of more expensive products. I’m sure a large component of these differences was due to luck and personal perception, but that’s the true subjective nature of benefit.