If there is something that this country likes, it is to measure things with numbers and then compare numbers. We divide people into percentiles based on their net worth, credit score, GPA, GDP, IQ, etc. with the implicit assumption that it is possible to understand the full scale simply by multiplying by a number. For example, someone who spends twice as much must live twice as well, or someone with twice the IQ must be twice as smart.

However, all these numbers are a function of something that is very complex and non-linear. Therefore, there is no point in comparing two numbers that are very different. While it is possible to compare the level of spending of people 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 with the person C who only spends $20,000. Here person C would live qualitatively differently and would make qualitatively different decisions. For example, A and B could each have two cars and here B would drive a slightly more fuel efficient model while C would not drive a poor quality car. You most likely do not drive a car and are dependent on other means of transportation. Therefore, it is impossible to draw conclusions based simply on the comparison of numbers.

So how do we compare?

When two things are scaled differently, proportions are usually built. No one except an absolute novice would consider a stock priced at $30 to be twice as expensive as a stock priced at, say, $15. No, the ticker price must be scaled by some value. Earnings per share is a very popular scaling factor. Suppose the highest-priced stock has an EPS of $4, while the lowest-priced stock has an EPS of $1. So the P/E ratios are 30/4=7.5 and 15/1=15 respectively. Other things being equal, the former is the least expensive. Stocks with high P/E values â€‹â€‹are called growth stocks and stocks with low P/E values â€‹â€‹are called value stocks.

Going back to the car example, there are several ways to build an index (by the way, inventing indices seems to be a main occupation of stock analysts). 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 traveled, giving some indication of mileage costs, or we could divide by the time spent on transportation. One or more of those proportions 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 probable that various kinds of lifestyles can be established. Comparisons must then be made within a class. For example, it doesn’t take a genius to establish that all value stocks are, by definition, 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 find it difficult to use frugal tips and advice from most personal finance blogs, because they are out of my league. I just can’t afford to follow his advice.

In a future post, I hope I’ve been able to develop some ways to classify the different personal finance setups. Until then any suggestion is welcome.

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Originally posted on 2008-09-05 07:33:12.