Pete Wargent blogspot
Co-founder & CEO of AllenWargent property advisory & buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.
4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.
"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.
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Sunday, 27 January 2013
Tiger Woods and the law of marginal utility
In previous posts I’ve looked at supply and demand, and also at how some goods and commodities are price elastic and others price inelastic.
Today, I’m going to look at the triggers which actually cause a consumer to buy, through looking at the concept of marginal utility.
It’s not an easy concept to grasp at first, but I’ll explain in as plain English as a verbose twit such as me can manage, so here we go...
The marginal revolution!
Have you ever wondered why when we host major golf tournaments the promoters pay Tiger Woods such an enormous appearance fee as compared to the rest of the field?
Sure, he has been the world’s best player, but the multiples of the fee seem outrageous given how many other professional golfers there are. Part of the reason is that organisers know that more paying people will come to the course and the tournament will get greater TV coverage if Tiger is in the field.
Marginal utility is what economists call the gain or loss from an increase or decrease in the use of a particular good or service.
I’m sure the organisers don’t want to part with millions of dollars, but they fear that the tournament will be discredited without Tiger’s appearance. Thinking at the margin, they believe that he must be worth the fee.
It might sound obvious to us, but until the late 19th century people tended to think very literally about how much something was worth.
In his magnum opus of 1776 The Wealth of Nations, Adam Smith describes his “paradox of water and diamonds” - speaking of why a cut diamond is worth far more than a glass of water. It’s because of the cutting, refining and polishing – the hard graft - that is put into the diamond, he said.
That’s partly true, but even the rarity value of the diamond doesn’t explain why a diamond is worth many thousands of times more than the water.
What is obvious to us today, but was revolutionary when first considered by Austrian and British economists in the 1870s, is that goods and services also have a highly subjective value.
Marginal utility in action
Let’s go back to Adam Smith's hypothetical glass of water. Suppose I knocked on your front door tomorrow and tried to peddle you bottles of water – you would probably, and quite rightly, tell me to “do one”.
Why? Well, partly because it would be weird, but mainly because you could simply drink water from your tap to satisfy your needs if you were thirsty.
I’m living in East Timor at the moment, so when roadside vendors with their carts try to hawk me bottles of water for 25 cents, do I pay them? Absolutely!
Firstly, because I know that I can comfortably afford 25 cents and secondly because if I tried to drink water from the sewage-infested water system I would very quickly contract dysentery, or probably something much worse (and let's face it, my innards struggle enough with the vegetable rendang curry).
Now suppose I go up to the mountains next week, I become lost and fear dying of thirst. I would pay ten thousand dollars for a bottle of water then, in order to fulfil my satisfaction of needs! I might not pay so much for a second bottle assuming I had the strength to make it back to the city – that’s diminishing marginal utility at work there. The second bottle is worth less to me than the first.
We see the sort of price action and interplay all the time in the commodities markets, very often in oil prices, most recently in the wildly fluctuating iron ore spot. In China, when stockpiles run low or when seasonal bad weather is feared in the producing regions such as Western Australia, prices can often cyclically run far higher until stockpiles are fully replenished.
Marshall’s theory of marginal utility
It took Alfred Marshall in his 1890 work the Principles of Economics to put all of this into a neat theory which we as investors can use to our advantage. He said that buyers think at the margin, and that vendors need to consider the needs and desires of consumers, who only buy a product or service if:
1) it is attractive to them;
2) it is affordable to them;
3) it is reasonably priced as compared to other goods and services.
We can use this theory in our investing exploits.
When it comes to share investing, it is always about price versus intrinsic value for me.
Through using a quality brokerage site we already know what most other buyers and sellers are prepared to buy and sell for simply through looking at the market depth, and in one sense shares are almost always 'affordable'.
If you have $150,000 today you can buy millions of shares in a penny dreadful mining stock (if you wanted to do your stash, that is) or you can buy one solitary share in Berkshire Hathaway (BRK-A).
If you understand the concept of price versus intrinsic value you will know that that one single share in Berkshire probably offers you more than the millions of shares in the speculative venture. Too often share ‘investors’ think about (2) and (3) but forget (1) – what makes a stock attractive.
Marginal utility in property
When buying property as an investment you should consider Marshall’s three points on marginal utility.
1 Attractive to the buyer
This is why we say "look for properties with a twist”. Especially if you are buying apartments, what special feature is going to make yours stand out and be the one that buyers want? A great view? Larger bedrooms?
You might often hear property books say: “don’t even bother with whether you would like to live in a property – you are becoming emotionally involved - just crunch those numbers and if it generates a positive cashflow…buy the sucker!”
I was totally startled when I first read that, because every property I have ever bought I have always looked at as though I was buying for myself. I want a very clean, very spacious property, close to facilities, coffee shops and restaurants, and very close to transport which can have me in the city in no more than 15 minutes from clambering out of bed.
You can argue the toss over who’s approach is right – that’s been done before plenty of times - but I realised that the reason I do this is because, to some extent, my target market is me of five years ago. That is, young, well-paid professionals who want an attractive property which is close to ‘fun’ and close to the city for work.
2 – Affordable
Please don’t send me emails about property affordability as a result of this following comment. I already have enough trouble deleting all the “Dear Treasured Friend...” type spam.
I look to hit up properties in the $500,000 to $800,000 bracket in Sydney because the fact is that in the suburbs I buy in interest repayments of $30-$60k are very comfortably affordable to my target market.
Of course, if I was buying property in outer Adelaide or in the Queensland shires I would look at cheaper price brackets, but I don’t buy in those markets.
In Sydney, you could alternatively opt to look at houses in the $1 million plus bracket. The capital growth performance could be tremendous but two words of warning: firstly, yields are likely to be low which will smash you in the hip pocket, and secondly you may have to accept that capital growth rates will be more volatile.
3 – Reasonably priced
Apartments tend to be relatively easy to put a value on as there are often similar apartments nearby which have recently sold. This should give you a guideline as to how much you should pay as a maximum for an investment, although you should naturally try to buy “at the right price”.
The law of diminishing marginal utility states that where there is an increase in stock for a particular item or commodity its marginal value decreases. That’s why investors look for property with scarcity value and would be wise to steer clear of remote areas where there is land available for release.