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A sense of values

Recession, continuing depression in the property market and deflation/inflation threats are all causing us to reconsider our attitude to money.

We are more focused on costs now. How much should I pay for this product or service? Do I really need it? How will it benefit me? In other words, we are concerned with value for money.

Your clients will be considering the service they may be getting (that is, losses) versus the associated costs.

The terms value and price are interchangeable – the value an estate agent puts on a house becomes the price but we are aware that value is in the eye of the prospective purchaser – the price the buyer is willing to offer. The accepted price becomes the value, but only at that moment.

Value is often defined in terms of gains and losses, or deviations from a reference point. For example, would you pay €25 if you had a craving for a burger? Could any burger be valued at €25? Two questions that carry a subtle distinction and that help us to understand the difference between price and value.

Imagine you are on holiday in Rome, Italy. Your partner decides you should head across the Tiber and into Vatican City. Having missed your usual hearty breakfast, you find yourself in St Peter’s Square at lunchtime. You are starving and with no sign of anywhere to eat, you are reminded that Vatican City is one of only five countries in Europe that does not have a McDonalds.

Then you catch the unmistakable, mouth-watering aroma of a Big Mac, wafting out of a bag held by a young chap next to you who has carried it on his Lambretta the mile from the Pantheon. With a polite “Diami venticinque euro, ciccione,” he hands you the bag with a grin while you hand over the cash, virtually sobbing with gratitude.

Price and value are variable and relative. What matters in any transaction is what the buyers can afford to pay and the satisfaction they expect to receive. All Big Macs will not thereafter be worth €25 – just that one, that day.

However, I will have a general expectation of Big Mac prices, based on my experience, that will help me assess relative value. In other words, to determine value, I might compare with the past.

We are all familiar with the price tag that says “was £999, now £499” often seen in department stores. We compare with the past, recognise the discount and find the result attractive.

It does not occur to us that the original price might have been inflated and used for a week in a shop in the middle of Bodmin Moor, solely to afford a discount everywhere else later.

However, another pricing tactic, the Keeping Up With the Joneses’ effect, is more powerful than you might imagine.

A number of years ago, up-market US retailer Williams-Sonoma added a bread-making machine in its popular kitchen retail stores. This new bread-maker was slightly bigger and almost 50 per cent more expensive than the original bread-maker it had been selling at the time. To the disappointment of Williams-Sonoma, this bigger and more expensive bread maker yielded extremely disappointing sales figures. Yet, after this new bread-maker had been introduced, sales of the original, cheaper bread-maker nearly doubled in its stores.

What explains this change in behaviour? When making a decision between a low-priced product and a moderately-priced product, people will often compromise with themselves by holding back on the more expensive product, choosing instead to opt for the less expensive version.

However, if an additional product were to be offered that was higher-priced than the other two choices, the compromise choice would shift from the lower-price product to the moderately priced one. In the case of the bread-makers, the introduction of the more expensive bread-maker made the original, and cheaper, bread-maker seem like a wiser and more economical choice in comparison.

Another problem associated with perception of value relates to the illusion of temporal perspective. Investors have great difficulty in recognising value over time.

Suppose I offer you £60 now versus £50 now. Obviously, more is better than less, so you take the £60. Alternatively, I might offer you £50 now, versus £50 in a month. You will take the £50 now because now is better than later – you expect your waiting time, the time you do not have use of the money, to be compensated for.

So the question is – what is the level of compensation required? I now offer you £50 now or £60 in one month. Despite the fact that the £60 in one month represents a 20 per cent return over £50 now, most people take the £50 in experiments. In fact, the interest has to be in the thousands of percent to compensate for the waiting for such a nominal sum.

Finally, then I offer you £50 in 12 months, versus £60 in 13 months. In this case, most people are prepared to wait that extra month and take the £60 option.

But as we have already identified in the previous example, 12 months from now, they will generally change their minds and take the £50.

As if these weren’t enough, the decisions we make regarding value can be manipulated by the way that choice is presented in terms of losses or gains.

Ask your clients about investing in UK equities with the following statement “by investing in UK equity funds over the last five years you had a 60 per cent chance of positive returns. Would you invest in UK equities?” Alternatively, “by investing in UK equity funds over the last five years you had a 40 per cent chance of losing money. Would you invest in UK equities?”

Both statements are correct but the second is more likely to persuade investors to avoid that asset class.

Given stockmarket returns over the last 10 years, the RDR and so on, the cult of the fund manager may be less fashionable, with advisers feeling under pressure to refocus their attention on price.

Relatively low-cost passive investments are attracting very positive press and dramatic increases in new business, arguably because fees are becoming a significant drag on lower expected returns in future. However, the means by which much of that business is transacted, that is, platforms, must also be included in that price refocus.

As we have seen, price and value are concepts that are not straightforward and opportunities to confuse and obfuscate abound. We should reconsider how customers think about price and what value actually means – to them and to adviser businesses.

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