Mind Your Decisions

How Can You Use Mechanism Design to Improve Your Finances? It’s as Easy as Splitting a Coke

Every Tuesday is a Game Theory article at Mind Your Decisions.

I have to thank my fifth grade math teacher for unintentionally introducing me to game theory. The game theory is hidden in the following extra-credit problem that he asked us:

My mother would often give a can of Coke to me and my two brothers and tell us to split it. Naturally, we all wanted more Coke, but our Mom told us to be fair and split it—without arguing. After we failed, she came upon a solution that suited all of us. What method did we use to split the Coke?

Most of us in the class thought mathematically and submitted answers about pouring 1/3 of the volume into each glass. My teacher told us these answers were incomplete because they described an outcome but not how the outcome would be achieved. Who would pour the Coke? And what order do people pick? And how do you make every one in the group trust each other?

Here is the solution the mom devised: one person was chosen to do the pouring. After the Coke can was empty, the person who did the pouring would be the last to choose his glass. The method proved to be successful–the Coke was always split evenly.

Why does the method work? It is because the method gives the person pouring an incentive to make the glasses as even as possible. If he does not pour the Coke evenly, he will suffer because the other brothers pick the fuller glasses first. Another way of thinking about the solution is that the other brothers are made to trust the person pouring. And this is a remarkable trait because the brothers’ interests are diametrically opposed.

This problem is example of mechanism design theory, which is the study of creating rules and incentives to allocate resources in what the designer sees as an efficient or fair way. The field has gotten attention recently because of the recent American Nobel Prize winners. Mechanism design is the theoretical basis to make markets work then they are not perfect, but it also comes up in many situations, like how airlines creatively price tickets.

The theory of mechanism design can also be used for your personal finances. I’m going to explain a motivational example based on the following simple question:

How should you spend your paycheck so that you can enjoy yourself now, in five years, and during retirement?

How do you answer this question? Or in other words, what is your mechanism for achieving good financial outcomes?

Unless you plan, you are likely to use a greedy mechanism in which you use all of your paycheck (or even go into debt) for instant gratification. You won’t have savings for expected purchases, like a down payment on a house, or for retirement.

This is the sadly the way many people seem to manage their finances. But there is hope.

If you are unhappy with your outcomes, why not change the design of your mechanism? Just as the three boys were made to split the Coke evenly, you can create a mechanism to improve your finances.

In this example, it is instructive to think about yourself as three distinct people: the inner child of instant gratification, the inner teenager who can think at most five years into the future, and the inner adult who wants to have money during retirement. And think about your paycheck as the proverbial Coke that your three “selves” need to split up.

Now it is very clear why people fail without planning: they satisfy only the inner child and leave nothing for the future selves. Their strategy is the equivalent of letting the person who pours the Coke be the first one to pick.

Take a lesson from the Coke mechanism: the person who chooses last needs to be the person pouring. Your retirement self is the one who is picking last, and by analogy, that is the person who should decide how to divide the check. An example might be to deduct 10% for retirement, 10% for the medium term, and the rest for current expenses. This strategy is commonly known as “paying yourself first,” in which you save for retirement and for expected purchases before you spend a cent on other expenses.

This example is only the tip of the iceberg.

There are many things you can do to start building a financial mechanism to achieve better outcomes. Here are a few techniques I’ve written about, which can help you get started:

1. Write your financial goals so you have specific outcomes in mind. Do you want a fancy car? Or to travel? Or do you want more leisure?
2. Pay your (retirement) self first by automatically deducting your paycheck into tax-advantaged options like an IRA or a 401(k). You can also save for your medium-term goals in brokerage accounts.
3. Track your expenses so you know where your money is going. I’m amazed that people spend more than they earn without knowing it. You can download my free and simple expense tracker spreadsheet to see how easy it is to get started–it takes less than five minutes a day.
4. Tame the child of instant gratification by cutting back on your habitual expenses by 10 to 15 percent or more. Not only will you save more, but I argue you will get more value out of money you spend.

The subsequent steps are to invest your savings and insure yourself against risks. I’ll discuss more on these topics in future posts.

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