When I think about investments I tend to think solely about financial investments – I buy a stock/bond/rental property and I hope that, over time, I’ll receive a return on that investment, either through income, capital gains, or both.
Sometimes I need to remind myself that investments can take many forms and provide both financial and non-financial returns. Those returns can sometimes be difficult (or impossible) to quantify
One example of this is the weightlifting set I have in my garage. About 18 years ago I spent about $2,000 for a few Olympic bars, some bumper plates, lots of iron plates, a power cage, a dip stand, rubber mats, and a few other pieces of equipment. Because I can work out at home I’ve saved about $50/month in gym fees. That means for a an initial $2,000 investment I’ve saved $600/month for 17 years. If my math is correct (and it better be, since I’ll be tested on this sort of thing during the CFP exam in July) that works out to an IRR (Internal Rate of Return) of 29.6%.
A 29.6% return per year for 18 years is pretty great, but even more so when you factor in that I actually PREFER to workout at home. I’d workout at home even if it was more expensive than going to a gym!
Then there are other benefits – working out strengthens bones and connective tissue. It makes you a bit more resistant to injury. It’s hard to know how strong this effect is. But, just for argument’s sake, let’s say it makes you 1% more resistant to injury (hurting your back when lifting a box or preventing a broken wrist when you trip on something). What’s the value of that?
The money I save by not needing to pay ongoing gym fees is a direct, first-order effect of working out at home. The second-order effects (like becoming slightly more resistant to injury) are much harder to measure, but can be just as (if not more so) important.
Investing in preschool
I got to thinking about first-order and second-order effects when my wife sent me information about a study on the value of preschool. A paper published in December 2016 found that preschool provides an excellent financial ROI, and the researchers behind the paper were able to calculate this by examining second-order effects.
The paper is called The Lifecycle Benefits of an Influential Early Childhood Program (the authors are clearly better at doing research than they are at naming research papers). Before delving into the details, a caveat – the participants in the study were primarily disadvantaged children of single mothers. It’s unclear how much of these findings would apply to, say, wealthy dual-parent households.
The study involved randomly assigning children to one of two groups – a control group and a treatment group. The program was free to the participants (the children and the single mothers). It started when the children were 8 weeks old and continued until they turned 5 years old (at which point they were eligible for kindergarten enrollment at public schools). The program ran for 9 hours a day – sufficient time for the mothers to work full-time. Finally, the program was designed to be highly enriching – lots of verbal attention, reading, personalized interaction, etc.
The program also included health screening (but not health care). That is, children were routinely screened for health issues, and if an issue was found, the parents were alerted to the need for treatment.
The program was high touch, personalized, and expensive to run. How expensive? The cost to run the program was $18,514 (in 2014 dollars) per child per year. That’s a large investment by the implementors/designers of the program.
What was the Return On Investment (ROI) and how did the researchers calculate it?
The ROI on preschool
Well, the first-order effect would be the obvious, direct savings or increases in income. Because somebody was caring for their children the mothers could work and earn an income. Assume the mothers were able to make $30,000/year (in 2014 dollars). Over the 5 year length of the program that would result in $150,000 in additional productivity by the mothers.
Looking at just the additional income produced a fantastic return – for each year of $18,514 spent on preschool for a child the mom was able to earn $30,000. That’s a 162% return per year. That alone would have been a fantastic return…and that only considers the mom’s first order effects.
Then the second-order effects on the mother would have been things like the value of 5 additional years of experience – higher salary, better chance of promotions, etc.
Here’s the thing – the study didn’t even both looking at the ROI for the mother. It completely ignored the first-order and second-order effects on the mom.
Instead, it focused solely on the benefits for the kids. I’m not sure why – perhaps it’s an easier thing to sell society on helping a child than on helping a single mother? Regardless of the reason why, let’s look at how they calculated the ROI for the kids.
The study was done in the 1970’s and the participants (children) have been tracked ever since. That’s over 35 years of data. This long-term tracking allowed the researchers to look at returns in a variety of areas – reduced health care costs, reduced crime, higher earnings, more education, higher IQ, etc.
That is, the researchers were able to look at the differences in earning power between the treatment group and the control group and add it up over the 35 years. The value of improvements in each area were calculated and the total return worked out to approximately 13%/year.
Sending kids to preschool results in a return of 13%/year for 35 years! The S&P500 has a long-term average of around 10% or 11%, depending on the timeframe being used.
The return from preschool crushes the return from the S&P500. And again, this is just the return for the KIDS. It doesn’t even consider the return for the parents of the children.
This is the purely economic ROI of the direct effects of preschool – it doesn’t factor in the non-financial social benefits. For example, the study found that kids who participated in the program committed less crimes when they were adults. This has an obviously and easily calculated financial benefit – if it costs $30,000/year to keep somebody in prison (around the average cost today), and let’s say that this program leads to 5% lower incarceration rates, then the program would save 5% * $30,000/person/year = $1,500/year.
But what this calculation doesn’t include is the value of the change in happiness in society by preventing that crime from taking place. Committing a crime impacts the person who was robbed/killed/assaulted, etc. The victim’s family is less happy. The perpetrator of the crime (assuming they are caught) will be in prison, where they will be less happy. The inmate’s family is less happy. Preventing a crime increases the happiness of a large number of directly and indirectly affected people in society.
I’m not sure how to (or even if it’s possible to) quantify the value of an improvement in overall happiness in society, but there’s clearly value there.
First and second order effects of losing weight
Let’s look at an example of this type of analysis in something most of us struggle with – losing weight. The CDC (Center for Disease Control) estimates that a 10% weight loss could reduce an overweight person’s lifetime medical costs by $2,200 to $5,300.
That is only the direct, first-order benefit of losing weight. That is, a 10% weight loss leads to less medical care and that saves $2,200 to $5,300, on average, over the person’s lifetime. But there are a ton of other benefits as well. All other things being equal, a lighter person eats less food than a heavier person. Let’s say that by losing 10% of their bodyweight a person now eats $.50 less food per day. Well, that’s $182.50/year. Let’s say the person lost the weight when they were 40 and they live until they are 90. That’s 50 years of savings. That $182.50/year invested at 8% results in $47,277.81.
Think about that – losing weight leads to eating slightly less food per day. This tiny incremental change leads to having more than $47k over the course a person’s lifetime.
There are other effects as well. At least some of that additional $2,200 to $5,300 in lifetime medical costs must be from doctor’s visits, or surgery, or other events that would mean missing at least a few hours of work. Overweight people take more sick days. That time off work has a very tiny, almost imperceptible effect on your career. Maybe you miss an important call, or a discussion at a meeting that could help you with an account. It’s a small effect and possibly impossible to measure, but it’s there.
Another effect – the sad but true fact that attractive people make anywhere from 3-4% to 10-12% more money than average looking people. And studies have found that overweight people are consistently rated as less attractive than “normal” weight people. Losing 10% of your weight might result in making a few percent more money over the course of your life. That could easily add up to hundreds of thousands of dollars over the course of a career.
Making more money and being found more attractive also increases happiness. How much is that happiness worth?
We all know that income tracks closely with education, and it turns out that happiness does as well. I’m sure that some of this increase in happiness is due to the increased income. After all – higher incomes lead to higher happiness. The question is whether or not education is directly increasing happiness or if it’s only indirectly increasing happiness because education increases income and higher income increases happiness.
Personally, I think it’s both. I enjoy learning new things. I love science and math, in part, because I love understanding how the world works. But I also enjoyed learning about philosophy. I liked learning Aristotle’s thoughts on what is a good life (eudaimonia) and how to achieve it. I think that these ideas help provide a framework, passed down from great minds throughout history, on how to think about and understand ourselves and our fellow man. This education can’t help but increase our happiness.
Another interesting fact about the link between education and happiness is that the effect is more profound as we age. The older we get the bigger the happiness gap between different education levels. This is, in effect, compound interest on happiness.
And compound interest is, of course, the magic that makes investing work.
Investing in education leads to a wealthier, happier person and this effect compounds over the person’s life.
First, let me state very clearly that I’m not a big fan of socialism. During the 2016 Presidential election I rolled my eyes whenever I heard Bernie Sanders propose making all public universities free. The very idea of making public universities free immediately caused me to start asking a ton of questions:
“Who was going to pay for this?”
“Why would students value something that’s provided to them for free?”
“What would be the benefit to society of turning out a bunch of 17th Century Russian Literature majors?”
(I’ll also admit that my next thought was that if Bernie was elected I’d buy as much Diageo stock as I could afford. If kids weren’t spending money on tuition they’d have a lot more money available for beer.)
But, after reading about the ROI of preschool, then thinking about the second-order effects of weight-loss and education, I’m starting to change my mind. It’s entirely possible that society’s ROI from these investments in human capital would be huge.
The problem is that it’s impossible to quantify all the second-order effects and thus create an exact ROI to justify these expensive social policies. A lot of these effects are interrelated and it’s tough to tease out just the effect of whatever variable we’re looking at.
This reminds me of one my favorite quotes:
“You don’t have to know a man’s exact weight to know that he’s fat.”
– Ben Graham
Ben Graham meant it in the context of stock valuation. If a stock is trading at $100 and you think the intrinsic value is somewhere between $40 and $60, you don’t need to know if the exact intrinsic value is $48.53 or $57.62 to know that the stock is undervalued.
Similarly, I don’t think we need to exactly quantify every benefit from preschool education or losing weight to know that it provides an excellent ROI.
There are few investments that provide better returns than investments in human capital. A great stock investment will provide solid financial returns for years or decades. An investment in human capital can not only put money in someone’s pocket but a smile on his face for a long, long time.
Are there other examples of great investments in people (yourself or others) that I haven’t listed above?
What’s the best investment you’ve ever made in yourself?