Critical thinking is in short supply in our society. Before we blame modern technology, the weather, or those darn kids these days, we need to look in a mirror. Critical thinking has always been a dear commodity from the beginning of time. You can’t force critical thinking on another man, but you can take steps to incorporate critical thinking into your approach to any problem and life in general.
School rarely teaches you to think. Schools are built to ingrain conformity. Most people are broke because they were indoctrinated into the poverty mindset. Hell, economists define economics are the allocation of scarce resources. The message: there is not enough to go around so we will have to find a way to distribute the limited [fill in the blank] resource.
There are no shortages! We complain we have limited water resources when 71% of the planet is covered by water. What really happens is we piss in our own cup and complain our water is polluted. The problem is not a shortage of water; our problem is dangling our junk over our drinking cup.
I could go on with a plethora of additional examples, but you understand my point. Huge, world changing issues, require leaders willing and capable of critical thinking! Unless you are one of these world leaders you have limited influence.
Critical thinking is vital in your personal life as well. Decisions made with faulty, or worse, no thinking, are the root cause of most problems in our lives.
Everyone needs a bit of accountant in them. Everything (or so scientists have discovered) can be boiled down into a mathematical formula. We don’t need a master’s degree to make sound decisions based on critical thinking. A few simple ideas can give us all the tools we need to live a happy, prosperous life.
The Boring Math Stuff Made Fun, or How Value is Created
How do you create value? Better yet, define value for me. Haven’t thought about that before, have you? Let me expand the thought. If you own your own business, own investment properties, or invest in stocks, how do you go about determining if your investments are creating value if you can’t define value?
Ohhhh, you don’t know the answer to that. Then let me ask this. If you can’t define value or determine if value is being created in your investments, how will you ever get value in your life? We are going to fix this right now.
In finance school they teach value is created when the return on invested capital (ROIC) exceeds the cost of capital. I know, I know. A big, bad formula hard to understand. It isn’t that bad. An illustration might make it easier to understand. It looks like this:
- You invest $1,000 in your business which creates 12% profits per year, or $120.
- The cost of capital (the interest paid to borrow the money or the income/gain/profits/ lost by deferring the capital to the investment) is 10%, or $100.
- Your $1,000 investment throws off $120 of profit by investing capital costing 10%. Therefore, $20 of value has been created. If a public company (a listed stock) has a 20 P/E ratio, the additional $20 of value is worth $400.
That last step might have surprised you. You created an instant $400 of value by increasing profits $20 after the cost of capital. Warren Buffet loves watching free cash flow and ROIC. High returns on invested capital are a strong indication of value creation and probably makes the investment sound.
ROIC isn’t everything and we will address that issue in a minute. When dealing with wealth in our life, when working toward financial independence, when using the 4% rule to determine when you can retire, an understanding of ROIC is an important tool to have.
In my home and at my office I reduced normal costs by up to 80% without sacrificing anything. Take my utility bill. At home I use a geothermal heat pump for hot water, space heating, and air conditioning. This is a very energy efficient way to supply heat to a home. However, when the geothermal is working it gulps electricity. I also have a farm where a fair amount of lighting is on 24/7 or at least during the evening hours. I used the formula above to decide when to swap out lighting. Barn lighting and heating costs dropped ~ 80%. Lighting was updated in the house and proper insulation installed where value was created by making the investment.
Before I started the home investment program winter electric bills could approach $600 for January if it was well below normal. Summers electric bills were always low at around $50. Keep in mind this includes a barn with heaters and heating tapes wrapped around water pipes required to keep the water works working in sub-zero Fahrenheit temperatures.
In the barn I reduced the size of the enclosure around the water intake valve and built the wall out of foam insulation. I use an electric heater in the barn to reduce fire risk. By shrinking the area heated by over 95%, the cost of keeping the barn functional in the coldest of weather was small.
Similar improvements were made around the home. Now, even with a record cold January, the electric bill tops out in the $200s. This reduction in the electric bill is even greater considering electric rates are up nearly 40% in the time frame involved.
The same process applied to the office dropped the electric bill a smaller amount since the bill was not that large to begin with. Updated heating and air conditioning units reduced costs and lighting costs are down 95% due to usage of LED lights.
I will not go through the math in each example step-by-step to save time. You can easily use the formula above for your personal projects. The ROIC on the farm was higher due to greater inefficiencies in the barn. The value created in my business was the easiest money I ever made. The lighting updates cost under $300 and the furnace/AC updates were requires anyway due to the age of the equipment. Currently heat and electric rarely cross $200 a month combined, including in the middle of winter. We have six computers with dual screens on every day with a server and plenty of other electronic components used in a business setting.
Utility (and I am not Talking about the Light Bill Either)
Deciding when to update equipment or add insulation is easy compared to non-quantifiable personal expenditures. Spending $3,000 on a vacation will have no real ROIC unless you consider it recharges your batteries so you can work harder when you get back home. Working harder is not our goal; working smarter is. Cars do not create value, either; quite the opposite.
There is another measure of value called utility. Economists know value creation comes from ROIC over the cost of capital. There is another factor called utility which measures how much pleasure we derive from consuming an item or performing an act. Whereas value is created in business and investments, utility creates value in our personal lives.
Measuring utility is much harder. What gives me utility may actually be negative utility to you. Eating one chocolate bar may have immense utility. By the seventh chocolate bar the utility of consuming more in one sitting is turning down.
But you can think of utility the same way you think about ROIC. Consider the invested time and what you give up to undertake the activity giving you pleasure. There is even a better way to gauge utility: Does it make you happy? If it makes you happy it probably creates personal value. The one notable exception is addictions (think drugs).
Utility should also be viewed from the perspective of time. Remember our example above? The one problem you should see quickly involves time. If you invest $1,000 for a $120 increase in gross revenue, it assumes the increase is forever. What if the increased value declines fast after the first year? You might not recover your entire investment, in which case value was destroyed.
Utility needs a similar review. If you buy stuff the utility is many times high at first, but quickly turn negative. A fancy new car that has you all excited can be a burden once the reality of maintenance, upkeep, fuel costs, and insurance start adding up. Then your new car gets its first scratch. Personal utility when applied to things has a tendency to head south in a hurry.
Spending time with family and friends is low cost with high utility. Even an expensive vacation has utility with long-term potential. Remember how your grandparents talked about a major trip they took back in 1978? After all these years the utility is still high and probably higher now than it was at the time they took the vacation.
Investing in experiences has more utility than accumulation of stuff in all but the rarest of circumstances. Investing in the right experiences assures a lifetime of happiness.
The Critical in Thinking
Media blasts messages scientifically tested to provide the results the advertiser wants by tricking you into wanting things that provide limited utility for a short period of time. This requires you keep coming back for your next fix. Our education system does little to help us defend from these mental assaults. They need obedient people accepting shitty jobs they have to work at their entire life for the illusion of happiness from buying all kinds of stuff they never wanted in the first place.
Critical thinking in all aspects of life would improve our world. Most problems vexing the human race can be traced back to stupid thinking. Thinking critically takes effort and we sometimes don’t like what we find. Stupid thinking allows us to blissfully wander the wastelands, unhappy and uninformed.
From now on you will think. Critically. You will not blindly follow the crowd or believe something just because some crazy accountant from Wisconsin wrote it. Critical thinking will increase the happiness in your life. No fancy words like “ROIC” or “utility” are necessary. Wise spending is easy when you involve critical thinking. Experiences providing happiness is where you want to focus your attention. Spending money should create value. It usually takes only a small amount of money or even no money to live an awesome experience.
Now that you understand critical thinking, go do something you can be happy about.
Wednesday 29th of November 2017
I really enjoyed your article and your tone. Especially the last paragraph or so. It was a little ironic that immediately beneath your ending, a pile of books about Critical thinking are blazed at us, the reader. Kind of a chuckle. You have many other fine articles.
Any way, I'm a fan. From Cannon Falls, MN., not too far away + on the same longitude basically as you. Happy Winter!
Saturday 29th of October 2016
You nailed it, Keith. Love the inclusion of financial concepts like "ROIC" and economic concepts like "utility."
Many think critical and independent thinkers are born, not made. In my own life, I grew up with an obedience, non-critical thinking mindset. But then I started working in hedge funds that prized debate and intensely challenged views. I started realizing that I could not just accept what others tell me and had to start developing my own view on investments and needed to develop a strong BS detector. Otherwise I'd be fired. Not a nice and easy work environment, but one that forced me (rather, my brain) to grow up.
Saturday 29th of October 2016
Thinking is in short supply, JT. Critical thinking is not taught. Each of us need our own unique kick in the pants to develop the skills. I also try to include the financial aspect of each issue presented because this is a lifestyle AND personal finance blog. Admittedly different than most, but then again, after a bit of critical thinking I decided I wanted to say something few were saying. Keeps y'all coming back which strokes my tender ego. Nice comment.