Why Do People Borrow Using Constant P2P Lending?

I like to dabble in different types of investments, and as a consequence of this I have small amounts of “play money” (that is, money I can afford to completely lose) in almost all the different categories of investment available to someone who isn’t an accredited investor. One of the first investments I tried (and still use, through LendingClub) was peer-to-peer (P2P) lending, largely because it’s so simple to understand. The idea behind it is that people who need a loan (e.g., to pay off credit card debt) borrow money directly from other individuals. The borrowers get loans for situations they normally couldn’t (or they get better rates), and the lenders get better returns than they would for the debt investing normally available to them.

The biggest problem with P2P lending as an investor is that when a borrower defaults, you lose the money you had lent them. This risk is partially addressed by the interest rates being higher for riskier borrowers. You can also spread your lending over as many borrowers as possible so that you don’t take a big loss when a single one defaults. To give an idea of typical default rates at LendingClub, the interest rates on most of my loans are around 12%, but my effective rate of return has bounced between 6–8% (suggesting a ~5% default rate). These are solid returns, but I’m getting a bit less than 6% right now, and my returns could go much lower (maybe even becoming negative) as the pandemic-induced recession affects more people.

Cryptocurrency-Backed P2P Lending

A different type of P2P lending has been advertised to me for a while now that removes this risk — P2P lending where the loans are backed by cryptocurrencies. In this case, borrowers must put up some cryptocurrency as collateral in order to procure their loan. The advantage for the lender is that they don’t completely lose out when a borrower defaults. Instead, the borrower’s collateral is liquidated and used to pay back the lender. The collateral is also liquidated if its value falls too close to the loan value, to ensure that lender will be repaid. The advantage for the borrower is that they can secure much lower interest rates by putting up the collateral.

Asset-backed loans aren’t new (two of the biggest categories of debt for individuals are asset-backed: mortgages and car loans), but the novelty behind crypto-backed loans are that they can be handled by “smart contracts” (programs that run automatically based on preset rules). With smart contracts, the lender doesn’t need to have any trust in the borrower. Once the collateral is locked up in the smart contract, the only way the borrower can recover their crypto is to pay off the loan.

Constant, the crypto-backed P2P lending service I learned of, offers lenders 7% returns. This is a great rate (higher than I’m getting from my traditional P2P lending at present), but it’s even more impressive because it’s essentially risk-free. I can only think of 3 reasons why you might lose money with a crypto-backed loan, and they’re all much more dramatic (so hopefully less likely) than borrower defaults.

  1. The business isn’t legit. If Constant’s owners decide to take the money and run (like the cryptocurrency exchanges of yore), then you would lose any money you put into it. I don’t think this is likely because the owners would be risking jail time and a lot of general unpleasantness.
  2. Crypto value crashes too fast to be liquidated. The collateral is liquidated when its value drops to 110% of the loan value. If crypto markets crash so fast that the collateral value drops from 110% to less than 100% before it can be sold, then the liquidation wouldn’t actually cover your loan. I don’t think this is likely because as volatile as crypto is, flash crashes are still few and far between.
  3. Your account gets hacked. Since money can be taken out of a Constant account in the form of crypto, you don’t have the same fraud protection as with most financial institutions. But as long as you use 2 factor authentication, it is very difficult for someone else to get into your account.

For a long time, I didn’t bother with Constant because I assumed there was no market for it. Who would want to pay 7% interest when they already had enough money for whatever they wanted to buy (they would just need to sell their crypto)? However, the promise of 7% returns risk-free was enough to finally get me to try it, and to my surprise they originate $100k+ in loans daily, and all my loans have been filled the same day.

Note: since I wrote this, Constant switched to a lending pool model. Basically, rather than individual lenders matching directly with individual borrowers, lenders pay into a pool that borrowers draw from. It doesn't really change the mechanics of being a lender except that now loans are filled instantly and if you can get slightly better rates for longer loan terms (7% on 1 month up to 7.5% on 6 months).

My initial concern was unfounded, and borrowers are really using this service. But that still leaves the question: why take a loan rather than just selling your crypto?

Potential Uses for Crypto-Backed Loans

The classic loan use cases (home improvement, large purchase, etc.) make even less sense when you look at the details of how Constant’s loans work. First, they are paid back in a lump sum at the end of the term, rather than in monthly installments like most personal loans. This means repayment won’t feel very manageable/affordable for someone who needs to take out a loan for a big chunk of cash in the first place. Second, the terms are short: the most common loan term is 30 days, and as far as I can tell no loans are for longer than a year. If you can save up enough money to pay back a loan in a couple months, it really begs the question: why not just wait for a couple months instead of taking out a loan?

While Constant makes basically no sense for classic loan uses, I have come up with some potential reasons borrowers might have.

1. Leverage to buy more Crypto

I suspect the main reason people borrow through Constant is to get leverage on their crypto (similar to margin trading, if you’re familiar with that). Basically, they’re making a bet that crypto prices will go up, and they’re confident enough about this that they’re willing to stake the crypto they already have on this bet.

How exactly does this work? Suppose you’re convinced the price of Bitcoin will rise substantially this month. You already own $15k in Bitcoin, but you want more and don’t have the cash for it. With Constant, you can take out a $10k loan by putting up your $15k in Bitcoin (they require 150% loan value as collateral), and buy more Bitcoin, so you now have $25k in Bitcoin. If the price increases by 20%, at the end of the month you’ll have $30k in Bitcoin, and after paying back the $10k loan you’ll have $20k in Bitcoin (it would actually be a bit lower because of interest and fees, but this is roughly the right amount). If you instead had just held on to your original $15k in Bitcoin, it would now be worth $18k. So through the leverage afforded by Constant, you gained an extra $2k.

Of course, this comes with a big risk. Suppose the value of Bitcoin dropped by 20% instead. If you had just held on to your original Bitcoin, it would now be worth $12k. But with leverage, the $25k of Bitcoin would drop to $20k, and you’re still on the hook for $10k, so after paying back the loan you would have $10k — an extra $2k in losses.

2. Avoiding Fees/Waits

Another thought I had is that borrowers might use Constant to avoid the fees and waits associated with exchanges. After doing a tiny bit of digging, I no longer think this is a valid use case, but the reasons why are relevant to the last potential use case so I’ll still discuss this one.

Here was my thought: it typically costs a ~3% fee to convert crypto to fiat on exchanges, and it might take a few days to get your fiat cash out. A 30 day loan on Constant has a smaller fee (1% origination + 7/12=0.58% interest) than that, and you can withdraw the fiat as soon as your collateral is posted. If you intended to default on the loan, this might still look like a better option than selling.

However, a few details rule this reason out. First, there is a 10% late repayment fee, so if you’re aiming to default then the fee goes from ~1.6% to ~11.6%, which is a steep price to pay to get your money a little faster. Second, from what I can tell, if you default Constant keeps all your collateral, they don’t return the excess value. This would turn a ~10% fee into potentially a 50% fee. Because of the fee structure behind defaults, this use case seems very unlikely.

3. Avoiding tax burden

The final reason I came up with seems possible, but I think it’s unlikely to make up a large portion of the loans. If someone wants to sell their crypto holdings, they’ll need to pay capital gains tax on it. Assuming they’ve held their crypto for a long time, they’d be on the hook to pay almost 20% of the crypto’s value in taxes.

I’m not familiar enough with the details to know if this is true, but it seems plausible to me that taking out a loan has no tax load, even if you don’t pay it back and it gets covered by your collateral. So in this case, a ~10% late repayment fee would be less than the ~20% tax rate associated with just selling, and the borrower would come out ahead.

However, this assumes that the collateral value has dropped down to 110% of the loan value, otherwise the borrower loses more from the excess collateral value than they would from taxes. So in a sense this would depend on them betting that their crypto’s value will drop ~30% over the course of the loan (from 150% loan value to 110% loan value), in which case they’d be better off selling while the crypto value is still high. Maybe this could be mitigated by purchasing a variety of options on crypto, but I haven’t thought of a straightforward way to guarantee that you come out ahead. Overall, it’s quite a convoluted way to try to pay 10% tax instead of 20%, but I wouldn’t completely rule it out because I’m sure people have done more to avoid less.

The bottom line

The only reasonable use case I can come up with for using Constant as a borrower is for leverage, and it doesn’t seem far-fetched that this is what borrowers are doing. After all, if they bought crypto in the first place, it’s clear that they have a big appetite for risk. But from the perspective of a lender, it doesn’t really matter what the borrowers are doing with the money. The loans are essentially risk-free, and there’s enough demand for them to fill all the loans I would make.

For now I will continue to dabble in Constant, but it’s possible that as I grow more confident in the company that I’ll move a significant chunk of my savings there. If it’s as risk-free as it seems, it’s a much more lucrative place to park my money than a savings account or treasury bonds.

Is Sustainable Investing Actually Helpful?

I graduated a couple years ago, but it’s only recently that I’ve had a cushy full-time job that pays me significantly more than I need to live comfortably. And that means that despite my interest in personal finance and retiring early, I am finally succumbing to some lifestyle creep. Fortunately for my wallet, I still have no desire to buy the latest flagship smartphone, move into a bigger house, or drive a luxury car (well, maybe a Tesla). Instead, my lifestyle creep has manifested in spending more for the “sustainable” choice: buying Allbirds instead of Pumas, buying organic rather than conventionally farmed food, and paying the small premium to get my electricity from wind and solar rather than fossil fuels.

While a lot of my choices surrounding consumption have changed, one area that’s been slow to change is where I’m investing. This might seem surprising, given the recent trend of “Sustainable Investing” — also sometimes called Socially Responsible Investing (SRI) or Environmental, Social, and Governance (ESG) investing. Part of the reason I haven’t changed much is that the “sustainable” funds most accessible to me don’t seem to actually be that different from normal index funds: compare the holdings of Vanguard’s ESG fund to their total stock market fund. But I was also hesitant because until recently I wasn’t convinced that buying stock of sustainable companies actually did any good.

My thinking went as follows: if I buy stock in a sustainable company, that money doesn’t go to the company — in the best case scenario all it does is raise the price of the stock (and therefore the valuation of the company) a tiny bit. So changing my shopping habits would do a lot more to give money to companies I think are doing good things than buying stock of those companies. I didn’t even think raising the stock price did any good, but after doing some digging, it seems there are some benefits. Some researchers have modeled the effect of sustainable investing, and found that a preference for sustainable companies does lead to societal benefits that arise from their stock prices going up:

  • It lowers sustainable companies’ cost of capital (basically, it makes it easier for those companies to raise/borrow money)
  • It encourages companies to become sustainable so that sustainable investors will buy their shares and drive their share price up

So at some point it may be worth revisiting the funds I’m invested in and perhaps choose some that hold companies explicitly connected to sustainable activities. But for now, since I’m not willing to pay a 2% expense ratio and the amount of money I have to invest is so small anyways, I’ll leave it to the professionals.

However, even though I’m not shifting all my stock holdings into sustainable companies/funds, I have found some other investing activities that seem like they make a more direct impact. One option would be to buy bonds from sustainable companies, because in that case your money is going directly to the company. (I haven’t pursued this because it’s not super convenient to buy bonds from specific companies.)

Another option that gets your money directly to the company is to buy equity during fundraising rather than buying stock on an exchange. When you buy stock of a well established company on a stock exchange, your money goes to some other person selling their stock, not the company. But if you buy the stock when the company is issuing it, your money goes directly to the company and can be used to do something (hopefully) useful and good. I didn’t think this type of investing was available to the general public, but it turns out there are some opportunities that don’t require you to be an institutional or accredited investor. Here’s one example I’ve been using.

From the finance perspective, is investing in these startups as smart as just putting more money into my brokerage account? Definitely not: it’s way higher risk. Consequently, I’ve just been putting small amounts of “play money” into these companies (i.e., money I can afford to completely lose), more to feel like I’m doing some good than to achieve financial goals. So while my investment choices haven’t shifted as rapidly as where I’m buying my clothes, I’m at least at the beginning of a path to sustainable investing that I actually buy into.

The Marginal Cost of Driving a Mile

For car owning Americans, vehicle expenses will almost always take up a significant portion of the monthly budget. Cars cost less than housing, and might cost less than food, healthcare, or childcare depending on specific circumstances, but they cost more than pretty much everything else. Since the great majority of American households (~90%) own cars, it is thus natural that cars are going to be a big topic when it comes to personal finance advice. Some examples of great personal finance advice that has to do with cars:

But most of the advice I’ve found deals with either which car you’re buying (e.g., luxury vs. standard, new vs. used) or whether you should own a car at all. Often the discussion surrounds the per-mile cost of driving and uses that to compare cars to other modes of transport. The IRS even provides an official value for how much you can deduct: $0.58 per mile driven. While this might be a decent estimate for the overall cost of car ownership, it’s not as useful for making day to day decisions of whether to drive someplace or bike/take public transportation.

For the day-to-day decisions, the marginal cost of driving a mile is a much more useful metric. That is: how much more expensive it is to own and operate the car for each additional mile driven. The idea here is that the costs of a car can be separated into a fixed portion (that you pay no matter how much you drive) and a variable portion (that increases proportionally to how much you drive the car). I’m in a one car household: I get by day to day without a car, but my wife has a car that she needs in order to commute. When we go into the city on the weekend, we have to decide whether to drive or take public transportation. For this case, it’s not really fair to include the fixed portion of the car cost in our decision, because we’re going to have pay that whether we drive on the weekends or not.

I think that a simple (but reasonable) treatment would be to say that the car’s principal cost (or depreciation, if you prefer to think about it that way) and insurance costs are fixed, and that the gas and maintenance costs are proportional to distance driven. Here are my justifications:

  • The year the car was made is more important to resale value than the number of miles on the car
  • Unless you use per-mile insurance (like MetroMile), how much you drive has relatively little influence on your bill
  • I don’t think anyone will argue with a model saying that gas burned is proportional to distance driven
  • While you are supposed to have maintenance check ups at regular time intervals even if you haven’t hit the next miles driven checkpoint, the costs of the actual repairs should scale more with distance driven

So regarding the costs that constitute the marginal cost of driving: gas expenses are simple enough to calculate. Your per mile cost is simply the cost of gas divided by the fuel efficiency of your car. E.g., if you drove a car that got 28 mpg, and gas costs $3.19/gallon where you live, then the gas cost per mile would be:

\frac{\$3.19\textrm{/gallon}}{28\textrm{ mile/gallon}} = \sim\$0.11\textrm{/gallon}

The exact gas cost to drive a mile will vary depending on how efficient your car is and how expensive gas is in your region, but for most places in the US, it should be in the ballpark of $0.10/mile. Maintenance isn’t as simple to calculate, and will probably vary over the life of your car, but most estimates put it around $0.10/mile for a standard commuter car.

Using both these numbers, the marginal cost of driving should be around $0.20/mile, rather than the $0.58 figure from the IRS and other numbers higher than $0.30/mile that are typically cited when talking about the overall cost of driving. Using this $0.20/mile figure, it’s definitely cheaper for us to drive in to Boston for a weekend trip – it’s about 20 miles round trip, or $4, which is less than a round trip fare for one person on the subway.

For our use case, if we’re only focusing on the cost of subway fare vs. the marginal cost of driving, we should almost always drive. But that’s not necessarily the only thing to consider. Other factors that could change the math include:

  • The effect on the environment
  • The parking situation
  • The difference in time
  • The difference in comfort
  • Getting some exercise

Going through each of these bullets, in order: one obvious difference between driving and public transportation is that the latter is much better for the environment. If that’s something you care about (and it is for me), it’s probably worth factoring it into the math as well. There are different ways you could calculate the value, but I think adding 5-10 cents/mile to the cost of driving is a reasonable way to quantify this factor. It doesn’t drastically change the math, but it does push us closer to favoring the subway (especially if you were driving one person and not two).

Depending on where in the city we’re going, a huge factor is parking. There are some trips we make where there is ample, free parking, and that doesn’t add any cost/inconvenience, but there are some places in the city where free parking is almost impossible to find, and lots might cost around $25. This is obviously a huge factor, and if we’re going somewhere with expensive lots, we’re much more likely to take the subway. If you’re paying for parking, that cost can be factored in directly. If you’re spending a significant amount of extra time looking for parking, that brings us to the next point.

In practice, the main reason people drive over taking public transportation is probably that it’s faster, and (when it’s true) that’s a good reason. The less time we spend traveling, the more time we can spend doing things that actually matter. A decent starting point would be to value your time at your hourly wage, but there are fair arguments to be made to push that up or down. In any case, driving to Boston on the weekends usually saves us about an hour round trip compared to taking the subway, so that’s a huge factor in favor of driving. For normal commuting hours, driving to Boston might actually take longer, and give an edge towards the subway, so it definitely depends on the specific situation.

It’s also worth factoring in the difference in comfort between the options. If I’m traveling with my wife, the car is slightly nicer: we’ll probably chat and listen to music, whereas when we take the subway together we’re a bit more likely to sit in silence. If I’m traveling alone, the subway is much nicer: I can relax and listen to a podcast, compared to focusing on driving (and probably getting annoyed by other Boston drivers) when I’m in the car. On this point I’d probably just add a mostly arbitrary bonus to the one I prefer: maybe adding a $5/hour discount to driving when I’m with my wife, and adding a $20/hour discount to taking the subway when I’m by myself.

It could also be worthwhile to consider the difference in exercise between options. In the example I’ve been using (driving vs. taking public transportation) it doesn’t matter much, since the only potential exercise would be a short walk to and from the subway stations, but if you’re deciding between driving and biking this will matter more. If you’re someone who would benefit from more exercise (which basically all of us are), then time spent exercising should be valuable to you, and time spent driving should not. A decent starting point would probably be to value time spent exercising at your hourly wage, but again, there are reasonable arguments to be made to shift this up or down.

In general, I try to avoid driving, and I default to thinking it’s the wrong option, but going through this exercise and looking over this list of points does give me some confidence that it’s not the worst decision in the world when we drive into Boston on the weekends. As long as we aren’t paying $25+ for parking, it seems like paying for the marginal cost of driving those extra miles is worth it.

Wealth and Income are (Almost) Interchangeable

With the democratic presidential primary elections starting to take shape, financial inequality is one of the biggest issues, if not the biggest issue, being debated. I remember similar arguments during the run up to the 2016 election, which were essentially the entire impetus for Bernie running for president. I also remember a specific conversation I had during that time, where an acquaintance of mine was making the case that wealth and the estate tax are the wrong way to target inequality – they argued that the source of wealth is income, so the best solution would be increasing income taxes.

This was long before I had done my dive into personal finance, so I hadn’t spent much time thinking about wealth vs. income, and didn’t argue against this view. If someone made the same argument to me today however, I would be more inclined to push back. With a very simple idea (which I was very familiar with at that point, but apparently hadn’t thought about in any substantial way), we can see that wealth and income are essentially interchangeable. That idea is interest.

We’re all familiar with interest. The most common scenarios where it comes up are receiving interest on a bank account or paying interest on a loan. But what you might not have realized, at least not explicitly, is that interest is a way of transforming wealth into income or vice versa. When you take out a loan, you are giving up some of your income for access to wealth. And when you invest or lend money, you are receiving income in exchange for giving someone else access to your wealth.

Of course, while interest provides some mechanisms to convert between income and wealth, it does not make them identically equivalent. There are a few important differences from a more explicitly personal finance perspective, but I’ll save those issues for another post.

The important difference I’ll cover today comes from how the government (at least in the USA) sees and taxes income vs. wealth. For the great majority of people in the US, the main way they are taxed is via their earned income. When they perform labor that earns them money, a percentage of it goes to the government. The percentage depends on different factors, but the most important one is how much you earn. Someone earning a modest salary might be taxed between 10-20%, while someone earning millions of dollar annually would be taxed at almost 40% (at least in theory – in practice there are tricks for them to pay less).

However, if you are very rich or part of a very rich family, there are two other taxes that will apply to you: capital gains tax and the estate tax. The capital gains tax applies to income that you make from your money (i.e., investments) rather than your labor, and the estate tax applies to wealth transferred to heirs after a rich person dies. These taxes work in a similar way to income tax, where higher “earners” pay higher rates.

I won’t go into detail about the estate tax here, since it is harder to compare to the income tax, but for capital gains it is fairly apples to apples. In both cases, you are taxed on money received, it’s just the source of the money that differs: the income tax affects money you received for performing work, while the capital gains tax affects money you received for having money and investing it.

So how does the government see wealth and income differently? The income tax rates are roughly double the capital gains tax rates. In terms of how much you owe Uncle Sam, it’s much better to “earn” your money through having wealth than to earn it by working. This is one piece of the puzzle of why wealth accumulates and inequality grows, and why inequality is now such a central issue in American politics.

There are a few high profile tax proposals on the Democratic side at present aimed to address inequality:

  • Raising the top marginal income tax rate (publicly championed by Alexandria Ocasio-Cortez)
  • Raising the estate tax (publicly championed by Bernie Sanders)
  • Introducing a wealth tax (that is, a tax on net worth above a certain threshold – publicly championed by Elizabeth Warren)

I think all of these would be beneficial for the country, but of the three I’m most enthusiastic about the wealth tax. It addresses the reality that wealth is more powerful that income, and cuts directly to the problem of wealth inequality most directly.

I’m a bit surprised no one is championing an increase in the capital gains tax (at least, no one that I’m aware of). That would be another more direct route to addressing wealth inequality, and wouldn’t add any tax burden to the majority of Americans.

Effective ROI for investments with recurring costs/earnings

Edit: I finally found the existing term for the idea I was exploring in this post. Basically, this post was an exercise in re-deriving Internal rate of return (IRR) and giving it a worse name and acronym.

In my last post, I discussed how to analyze the “investment performance” of buying goods in bulk or on sale, by applying the idea of ROI (or more accurately, CAGR) to those purchases. As a refresher, ROI can be calculated from the follow formula, and traditional investments are typically expected to have an ROI of ~5-15% long term.

ROI = (\frac{\textrm{final value}}{\textrm{amount paid}})^{(\frac{1}{\textrm{years invested}})} - 1

One point I briefly mentioned in that post was that it’s more valuable to receive payouts from an investment earlier, but for simplicity we treated the payouts from buying in bulk as being received in a lump sum once everything had been used. This wasn’t just for the simplicity of that post, it was also because (as far as I know) there is no version of ROI that accounts for an investment with recurring costs or recurring earnings. If you look for how to calculate ROI/CAGR, the equations all assume a single starting value and a single final value – there’s no room to account for extending or unwinding a position over the course of holding an investment. If you continuously buy and sell shares of a stock, for instance, you can track the ROI of a particular share by pinpointing the date you bought and sold it, but there’s no equation to to figure out the overall ROI that all the shares of that stock have provided you.

Introducing ROIRCE

In this post I’d like to propose a method for characterizing the performance of an investment that has recurring costs/earnings (or more broadly speaking, doesn’t have a single fixed purchase date and a single fixed sell date). I’m sure someone else could come up with a much better name and acronym, but here I’ll call this metric Return On Investment for Recurring Costs/Earnings, or ROIRCE. ROIRCE borrows from how Net Present Value is calculated, in terms of how it discounts costs and earnings in the future.

The ROIRCE value is chosen such that the following equation holds:

 \sum \frac{\textrm{cost}_i}{(1+ROIRCE)^{t_i}} = \sum \frac{\textrm{earning}_i}{(1+ROIRCE)^{t_i}}

where t_i is the time in years from the beginning of the first investment where the associated cost is incurred or the associated earning is collected. The left side of the equation is the effective total cost of the investment, while the right side of the equation is the effective total earnings from the investment, with each discounted based on how long they took to realize.

Unfortunately, this is an implicit function, which makes it inconvenient to solve, and probably precludes ROIRCE from popular use. Here is one algorithm we could use to solve for ROIRCE:

  1. Guess a value, and plug it into the ROIRCE equation
  2. If the left side of the equation is greater, you need to reduce the ROIRCE value, while if the right side is greater, you need to increase the ROIRCE value
  3. Repeat steps 1 and 2 until the two sides of the equation are effectively equal

(For a more specific approach for raising/lowering the ROIRCE value, you could try a bisection method.)

An application of ROIRCE

The reason I was reminded of this idea (which I had intended to write about since I wrote the last post, but never got around to) was a post on the personal finance subreddit about whether after winning a lotto jackpot, one should take the lump sum or monthly payments. Unfortunately I can’t find the exact post anymore, but the options were either to take $60k in a lump sum, or $1k/month for 10 years (which totals to $120k). The actual post was full of good advice about practical concerns like which option is more advantageous from tax and psychological perspectives, but in this post we’ll consider the options in a simple, tax-free world, and approach the choice purely mathematically.

One response argued that it’s better to take the lump sum of $60k, since if you invested it you could expect to have >$120k by the time you would’ve received the last monthly payment. Another pointed out the flaw in this reasoning, which is that with the monthly payments you’re not sitting on them until the 10 years is up, you can invest that money and earn from it in the mean time. I agree with the second poster, since the first poster falls victim to the same oversimplification we made last post.

We can calculate the traditional ROI required for the lump sum to be better than receiving $120k ten years later through the following calculation:

ROI = (\frac{\$120k}{\$60k})^{(\frac{1}{10})} - 1 = 7.2\%

From a simple ROI perspective, if you can earn better than 7.2% returns annually on your investments (which is not a sure thing, but is definitely reasonable), then you should take the lump sum.

However simple ROI doesn’t consider that we could invest each of our monthly $1000 payouts as soon as we receive them. If we invest each monthly payment over the course of the 10 years, we calculate a ROIRCE value of 17%, a very hard investment to beat! The only common reason I can think of where it would be beneficial to take take the lump sum when considering ROIRCE was if you had a significant amount of credit card debt. This is because getting rid of debt is like investing at the debt’s interest rate, and credit card interest rates can exceed 20%.

ROIRCE for buying in bulk

Using ROIRCE doesn’t add much to our analysis of buying goods on sale, since each incremental item will be held for a different amount of time, and that amount of time can be used in the traditional ROI calculation. We can calculate an overall ROIRCE for buying on sale, but we should still use the individual ROI of each increment to decide how much to buy.

Deciding if it’s worth buying in bulk, on the other hand, can benefit from ROIRCE. Take the example we used in the last post where I can buy a year’s worth of toilet paper for $100, which would cost $120 if I bought my toilet paper month by month. Buying toilet paper in bulk here is like buying an investment that pays me $10/month for a year. While the toilet paper itself isn’t money I can use, each month the $10 I would’ve budgeted towards toilet paper is freed up so I can spend it on whatever I want. Using traditional ROI, we found that in this case buying in bulk provided a 20% return. However, using ROIRCE and taking into account that I can do something productive with my freed up $10/month over the course of the year, the return on buying toilet paper in bulk is 41.3%! The return is almost twice as high when considering the effect of our recurring “earnings,” so for buying in bulk we can analyze our opportunities much more accurately with ROIRCE than with traditional ROI.

Calculating ROI of buying in bulk/on sale

I recently saw a video on YouTube with advice from Mark Cuban on how to get rich. I found one piece of advice particularly interesting: that buying non-perishable consumable goods in bulk or on sale is going to give you a better return on investment than any traditional investment opportunities (stocks, real estate, etc.). Return on investment (ROI) is a financial concept – it’s a measure of how beneficial it is to tie up money in a particular investment. I was curious to calculate the ROI from buying goods in bulk, and the only example I found online of someone attempting the same calculation used a bizarre and almost certainly incorrect method.

First, we can define ROI for traditional investments. ROI is typically given in percent per year: if a certain stock has an ROI of 10%, that means that if you buy $100 of that stock, you could sell it one year later for $110. The simplest ROI calculation can be made as follows:

ROI = (\frac{\textrm{final value}}{\textrm{amount paid}})^{(\frac{1}{\textrm{years invested}})} - 1

Note: technically the term for this financial concept is Compound Annual Growth Rate (CAGR). I will use “ROI” throughout this post since it’s an acronym that gets used much more often than CAGR – even though CAGR is the better measure and they’re fundamentally trying to measure the same thing: investment performance. Also, I assume Mark Cuban meant CAGR even though he said ROI.

We can see that plugging in the numbers from the stock example above (an amount paid of $100, a final value of $110, and being invested for 1 year) indeed gives an ROI of 0.1, or 10%. A slightly more complicated example might be that you buy a rental property for $200,000, the property has a net income of $1,500/month, and after 8 years you sell the property for $300,000.  Plugging in these numbers (final value = 300,000 + 1,500*12*8, amount paid = 200,000, and years invested = 8) gives an ROI of about 10.5%. This would indicate that the rental property was only a slightly better investment than the stock. Most traditional investments that don’t require a large amount of capital will have ROIs from 5 – 15%, so that’s the target that buying in bulk should beat if Mark Cuban’s advice is sound.

It should be noted that this ROI calculation assumes you pay the total cost up front and collect the total value at the end of the investment. In reality, the rental property is more valuable than we’re calculating with this simple formula, since you collect rent over the course of owning the property, not in a lump sum at the end. This means you could be reinvesting that rental income as you receive it, and you could be earning additional returns in the meantime that we’re not accounting for. Even so, this ROI calculation is still useful for comparing different investments, and we’ll ignore this timing shortcoming for now.

ROI of buying in bulk

Buying in bulk isn’t exactly an investment, but it follows the same principle since we’re tying up our money in something (in this case, non-perishable consumables rather than stocks or real estate) because we think we’ll end up with more money in the long run. As an example, suppose that I typically buy a $10 package of toilet paper which lasts me one month. In a year, I’ll go through 12 of these packs, spending $120 on toilet paper. At a bulk supply store, I might have the opportunity to buy a year’s worth of toilet paper for $100, a 17% savings. What would the equivalent ROI be? Here the amount paid is clearly $100. For the simple ROI calculation, we can say that the final value is $120, since I’m getting $120 worth of toilet paper compared to my usual shopping habits, and we can say that I’m invested for 1 year, since I have to pay for the toilet paper 1 year ahead of when I’ll finish using it. In this case, the ROI would be:

ROI = (\frac{120}{100})^{(1/1)} - 1 = 0.2 = 20\%

The equivalent of a 20% return, much better than most traditional investments!

ROI of buying on sale

We can also use the same formula to calculate ROI for situations when a product is on sale. Suppose I go to the store one day and the toilet paper I usually buy is $7 a pack (30% off). What’s the ROI, and how much should I buy? In this case, the ROI of a particular pack of toilet paper depends on how far in the future I’ll end up using it. Each pack costs $7 and gives me $10 of value, but the number of years invested depends on how many packs I’m buying. For example, for my sixth pack it will take half a year before I use it, which yields:

ROI = (\frac{10}{7})^{(1/0.5)} - 1 = 104\%

That sixth pack has an ROI of 104%, an awesome investment! Suppose I really go to town and buy 5 years worth of toilet paper. That means for the last pack, I’ve invested that $7 for 5 years, and the ROI is given by:

ROI = (\frac{10}{7})^{(1/5)} - 1 = 7.4\%

While still a reasonable return, a 30% discounted pack of toilet paper that I don’t use until 5 years later isn’t necessarily beating traditional investments.

Carrying costs and increased consumption

The calculations above neglect some costs which could potentially reduce the ROI on buying in bulk/on sale. The first is carrying cost, which refers to the cost of storing a bunch of stuff that you aren’t using yet. For some goods (like toothpaste) this probably isn’t a big deal, but for the toilet paper example, it likely would be. Suppose I bought 2 years worth of discounted toilet paper, as in that case the last pack would still have an ROI of almost 20%, which is a very solid return, but I only have enough room in my apartment to store 1 year worth of toilet paper. My building rents storage bins for $60/year which would be sufficient to store all the extra toilet paper, so for the first year I have to spend an extra $60 to hold all the toilet paper. In this case, the overall ROI would be given by:

ROI = (\frac{10*24}{7*24+60})^{(1/2)} - 1 = 2.6\%

Since I have to pay extra money to be able to store the toilet paper, it completely kills the savings, and I’m left with a meager 2.6% ROI. Usually carrying cost is more difficult to factor into the calculation than this, but it’s worth keeping in mind that if a large portion of your house is being used for storage, buying in bulk probably isn’t doing you that much good, and you could lower expenses overall by living somewhere smaller without the bulk buying.

Another trap you should be careful of is increased consumption of the good you bought in bulk. In the bulk toilet paper example (12 packs for $100), the value I’m getting is $10/month, since that’s how much I usually spend on toilet paper. If I start using toilet paper to clean up spills in the kitchen since I have so much TP lying around (whereas I used to use reusable sponges), and this causes me to go through 12 packs of toilet paper in 11 months, then my ROI would be:

ROI = (\frac{110}{100})^{(12/11)} - 1 = 11\%

By increasing my consumption by ~9%, the original ROI of 20% is cut almost in half. So while buying in bulk/on sale can provide good ROI, you should be careful about carrying costs and increased consumption, which can negate or even reverse the return.

It’s also worth noting that if you buy something on sale which you normally wouldn’t buy at all, it can’t be treated as having an ROI in the sense we’re looking at here. While you can still get value from it, you’re not saving money since in the absence of the sale you wouldn’t have bought the item, and therefore wouldn’t have spent any money at all.

Some interesting math

There is some interesting math to explore following this treatment of buying in bulk/on sale as an investment. We can rearrange the ROI equation to find how much of a good we should buy when it goes on sale based on the ROI we want to achieve:

 t = \frac{\ln(\frac{1}{1-\textrm{discount}})}{\ln(1+ROI)}

where t is how much of the thing we should buy in years (for example, if the calculation yields t = 2, you should buy enough of the item on sale to last you 2 years). This is plotted for a few target ROI values below:

As an example, if you’re targeting an ROI of 50%, and the laundry detergent you usually get is 40% off, our ROI calculations say you should buy ~1.3 years worth of detergent. If you want an ROI of 100%, you should only buy 9 months worth of detergent, whereas if you are happy with an ROI of 25%, you can buy ~2.3 years worth of detergent. This chart can also be used to decide whether buying in bulk is worth it. In this case, if the bulk point is up and to the left of your target ROI curve, you shouldn’t buy, but if it’s down and to the right, you should. For example, if we can get a 17% discount by buying 1 year worth of toilet paper, that point is located up and to the left of all three of these ROI curves, indicating that it’s a worse ROI than any of those values (we know it’s 20% from calculating it before).

In general is seems like the ROI on buying in bulk/on sale is very good, so why don’t we “invest” more of our money this way? The funny thing about this “investment” is that the better the ROI, the less money we’re able to invest. Looking back at the toilet paper example, for something that has a bulk discount of 17%, the most I’d be able to “invest” for one year is 83% of my typical annual spending. If the bulk discount was instead 33%, corresponding to an ROI of 50%, I’d only be able to “invest” 67% of my typical annual spending. Larger discounts lead to higher ROI, but they also lead to lower investment potential:

 \textrm{investment limit} = t*\textrm{annual spending}*(1 - \textrm{discount})

Typically when you find a good investment opportunity, you want to put as much of your money in it as possible. However with buying in bulk, your investment potential is inherently limited by your normal spending, and is lower the better the discount.


Levelized cost of wear

I consider this post a work-in-progress. If there’s any real merit to this concept, I’ll need to come back and clean up the post so that it’s coherent to someone who isn’t already familiar with all the ideas I use to build up the concept.

There’s an idea related to clothes shopping called “cost per wear.” It’s a simple idea for quantifying the cost of different items of clothing that’s (arguably) more useful than their sticker price. To find an item’s cost per wear, you simply divide its cost by the number of times you expect to wear it before getting rid of it:

CPW = \frac{cost}{times\ worn}

You can find plenty of articles about cost per wear (some good, and some which grossly misinterpret it), but in this post I’ll propose an extension to the idea. But before proposing the extension, I’ll recount how I ended up with it. I was first introduced to the idea of cost per wear by my undergraduate research advisor, who claimed that you should never spend less than $2000 on a suit (he always dressed very sharp). The reason he gave was cost per wear: if you buy a cheap suit, you’ll never want to wear it, and you’ll only get a few uses out of it before throwing it away. If you buy a nice suit, you’ll use it as much as you can (for dates, interviews, any vaguely formal event, etc.), and in the long run it will be cheaper – at least in terms of cost per wear. Putting numbers to this, there seems to be some wisdom in his claim. If I buy a cheapo suit for $120, it might last me two years, and I’ll only wear it when I absolutely need to wear a suit (maybe three times a year). This yields:

CPW_{cheapo\ suit} = \frac{\$120}{2 years* 3 wears/year}=\$20/wear

If I buy a primo suit for $2000, it could last me closer to ten years, and I’d want to wear it whenever I had the chance (maybe once a month). Therefore:

CPW_{primo\ suit} = \frac{\$2000}{10 years* 12 wears/year}=\$16.67/wear

Since the nice suit has a lower cost per wear, the argument goes, it’s actually the thriftier purchase. Somehow this idea came up in a discussion with a fellow grad student, and from our perspective it didn’t seem to paint an accurate picture of our situation if we were in the market for a new suit. A point that cost per wear misses is that a dollar in my pocket today is not the same as a dollar in my pocket ten years from now (something that grad students are acutely aware of, as in ten years we imagine our salaries will be at least triple what they are today).

There is another idea, called levelized cost of energy, or LCOE, which is used to calculate the effective cost of electricity from different sources – specifically as a way to compare renewable sources like wind and solar that are “free” once they are installed to conventional sources that required burning fuel which you have to pay for. The piece that’s relevant here is that even if you had a maintenance free solar panel that lasted forever, if you have to pay for the panel initially it’s LCOE would not be zero (i.e., the electricity it generates is not free). This is because even though you get infinite electricity from that panel, it’s spread out over infinite time. And when you consider inflation, the electricity that the panel generates in one or two hundred years has almost no value to you today.

I’m sure this explanation is insufficient for anyone not already familiar with LCOE, but in any case, that’s the idea I borrowed from to come up with “levelized cost of wear” or LCOW, an extension to cost per wear. LCOW is calculated as follows:

LCOW=\frac{cost}{\sum\limits_{t=1}^n \frac{wears/year}{(1+r)^t}}

where n is the number of years you expect the item to last and r is your “personal inflation rate” – nominally we can say that it’s how much you expect your salary to increase annually. LCOW takes into account how the value of money might change over time for an individual, whereas CPW does not. We can revisit the cheap vs. expensive suit using LCOW, using an r of 12% (this would be very high for most individuals, but for the PhD student example, it corresponds to about triple the salary in 10 years):

LCOW_{cheapo\ suit}=\frac{\$100}{\sum\limits_{t=1}^2 \frac{3}{(1.12)^t}}=\$23.67

LCOW_{primo\ suit}=\frac{\$2000}{\sum\limits_{t=1}^10 \frac{12}{(1.12)^t}}=\$29.49

When considering LCOW, the cheap suit is the thriftier purchase. Intuitively this makes sense – my friend and I will have plenty of time to go shopping for nice suits once we have real jobs. In the meantime, it’s a better use of our money to buy the cheapest suit that can get us through graduation.