Hauke Hillebrandt

Mar 2022 · Productivity

Big life decisions

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The efficient market hypothesis applied to big life decisions

In terms of the biggest life decisions, most people are trying to solve the same problems:[1]

  1. Where should I put down roots? (Buying vs. renting, city, country, country-side, suburbia vs. living in a city)
  2. How should I earn a living?
  3. What kind of education should I get?
  4. What kind of family should I build?

1. Buying a house vs. renting

Some argue that renting is 'pouring money down the drain' and that you should buy a house and 'get on the property ladder', which implies steadily rising house prices. Others say: don't buy a house—actually, for many people it's better to invest in ETFs. Even if you disagree, at the very least one must concede that the financial benefits of buying a house are often exaggerated. The strongest and simplest argument for that is that markets are efficient.

What does the Efficient Market Hypothesis state? Asset prices reflect all available information and so it is impossible to 'beat the market' consistently on a risk-adjusted basis, since market prices should only react to new information (For a quick intuition on this read the 'Efficient Restaurant Hypothesis', or book review of 'Inadequate Equilibria', or this intro on efficient markets and investing). In brief, if buying houses is such a slam dunk win, why don't rich people buy up all the houses and hold none of their assets in stock? Why don't more people start businesses to buy up property leveraging loans? Why don't you just buy stocks of real estate stocks of where you live? Etc. Because it's not a slam-dunk win in terms of investment. Is buying a house a very bad financial decision? Probably not either. If you're very worried about the lack of diversification, then you can just buy home equity insurance or short the residential real-estate market.

Rather, it's much better to view this major life decision not from a financial side but from a personal preferences point of view.

Overall, buying a house might be a good deal for certain people who work 40-hours at their main job and then want to a 'house-ownership' part-time job, with duties like:

  1. Scouting and evaluating which houses might be undervalued by the market. People who tell you they buy houses will tell you about the 100s of hours they spent on this. If you earn $100/h and you spent a mere 100h on buying a house, that's $10k of income lost. Dealing with mortgage applications.
  2. Fixing up a house (interior design, etc.)
  3. Then, after buying it: Dealing with repairs and maintenance, handymen, insurance payments, etc.

Some really like renovating. If you're renting, you outsource all these services to a landlord. It's also important to renegotiate your rent, make credible threats to move, and be willing to move sometimes. So you need to stay a bit more nimble. Also, of course, all else equal, if you have both a normal job and the 'house-ownership' part-time job, you will earn more than someone who only has a normal job and rents. However, the person who rents and puts in additional hours at work will be able to earn more if they have a job with career progression (think: lawyer looking extra hard working and becoming faster at processing their caseload vs. barber who's marginal wage is similar to their average wage).

2. Self-employment vs. employment

There's a similar rhetoric around entrepreneurship and being self-employed: having a job is being exploited and wasting money- everybody should go into the 'millionaire fast lane' and earn more money while being self-employed.

But if markets are efficient this should not be true, and being self-employed is not a slam-dunk investment either.

According to a literature review on earnings of entrepreneurs:

~70% of the variance in income is explained by socioeconomic status and the country you're born in. 

[2]So just like buying a house, being self-employed is not a slam-dunk investment either.

Being self-employed is a good deal for certain people who want to work ˜30-hour on the craft of their job (e.g. hairdressing, research consulting) and then want to have a 'business-related' part-time job, with duties like:

  1. Evaluating business opportunities
  2. Ongoing running of the business (e.g. accounting, etc)

Some really like doing this. If you're employed, you outsource all these services to your employer. It's also important to renegotiate your salary, make credible threats to leave, and be willing to quit sometimes. This requires you to remain a bit more nimble. You can then make more money by focusing on your core skills.

There are many reasons for why startups aren't good for learning.

'Founders tend to be generalists — running a startup requires juggling more duties than one can really learn how to do 'the right way.' It crucially relies on the ability and willingness to handle many things 'just well enough' (usually with very little training or guidance), and focus one's energy on the few things that are worth doing 'reasonably well.'' Founder of new projects tackling top problems - Career review

In sum, you won't be able to specialize as much if you're running a startup.

Meanwhile, when employed you might want to do less 'work' 

3. Education (unfinished)

4. Children (unfinished)

Notes

[1] What Are Life's Biggest Decisions?  

[2] Global inequality of opportunity