How Smart Investors Avoid the Contrast Principle Trap

As part of my work at Kennon Green Enterprises overseeing our various investments, I read a lot of research reports and talk to the staff about how we can implement them to the benefit of our shareholders.

It may not be obvious at first, so to give you an example of how this reading can pay dividends for our investments, consider the “contrast principle” in psychology. Dave Thomas perfected this at Wendy’s. Mr. Thomas placed a triple cheeseburger on the menu, knowing full well that it was far too much food for most people to consume and the price was higher than people would be willing to pay. The intended result of this move, however, was successfully realized when sales of double cheese burgers skyrocketed because people would “compromise”, as he put it, between the two extremes, ordering more actual food and spending more money than they would have had the triple not been on the menu to provide a reference point. Wendy’s shareholders experienced great growth under his leadership because of shrewd moves such as this.

Unfortunately, the contrast principle has a downside for investors. According to one research paper I read recently by a highly respected university, happiness results not from being rich, but from being richer than your neighbors, friends, and family. In other words, on a subconscious level, most people don’t care if they have $1 million or $100 million, so long as their bank balance, cars, houses, clothes, and education are better than those in their social and professional network. The same steel mill executive who was thrilled to make $120,000 per year and live in Pittsburg would suddenly find himself miserable were he to move to Greenwich and be surrounded by hedge fund managers making $50,000,000 per year, despite the fact that his absolute situation has not changed one penny. That means that earning your place in the capitalist class alone won't make you content.

This finding has powerful implications for your investments and financial life. It helps explain why someone can go from earning $30,000 a year at the beginning of their career to $150,000 as they get promoted and still be living paycheck-to-paycheck. As their social status rises, they attempt to acquire the same badges of success that their older, and wealthier, colleagues enjoy, such as a new Mercedes or Brioni suits. Those who avoid this psychological temptation, in part by living in areas of the country where conspicuous displays of wealth are frowned upon, end up being wealthier and far happier. This is precisely what Dr. Thomas Stanley found in his Millionaire Next Door studies. It is easier for an engineer driving a Toyota to build wealth despite a lower salary than a rapidly rising associate in a gilt-edged law firm who finds it necessary to keep up appearances with high earning clients and partners.

The contrast principle is also responsible for large financial waste when purchasing big ticket items. Take a car. A few days ago, a friend of mine had a quote prepared for a beautiful new black Mercedes-Benz. One of the options was “keyless start”, which would allow him to keep the key to the car in his pocket and simply press a button to get going without having to fumble in the dark or struggle with the door when his hands were full. The price for this rather convenient option was $1,200. Compared to the overall cost of the car, it was small. However, ask yourself if you would take your existing car into a dealership and write a check for $1,200 to have that feature added. That allows you to see the price in absolute dollars, not relative to the large price of the car.

The moral: Whether you are buying a house, car, or expanding a small business you own, the contrast principle can cause you great harm. It is absolutely vital to measure dollars in absolute, not relative terms if you want to be a successful investor.

By Joshua Kennon

Categories: Investing