Over-Investing
Over-investing is a common phenomenon in personal finance, particularly when dealing with assets that serve both as investment goods and consumption goods.
This behavior can lead to spending more on an asset than its true market value and can have financial consequences.
In this article, we’ll look into the concept of over-investing, its causes, and the potential pitfalls associated with it.
Key Takeaways – Over-Investing
- Over-investing is a common phenomenon in personal finance, where individuals allocate more funds into an asset than its actual worth on the open market.
- Over-investing can have financial consequences, such as wasting money on over-consumption and struggling to recoup what was paid in when selling assets down the line.
- To avoid over-investing, it is important to distinguish between consumption and investment decisions, understand the true market value of assets, and carefully consider the costs and benefits of improvements or upgrades.
Understanding Over-Investing
In finance, over-investing refers to allocating more funds into an asset than its actual worth on the open market.
This practice is most frequently observed in the context of personal consumable investments such as houses, automobiles, campers, and trailers.
For instance, if a homeowner invests heavily in home improvements that exceed the market value of similar properties in the neighborhood, they have likely over-invested.
The neighborhood effect, which refers to the impact of surrounding properties on the perceived value of a home, can devalue the house to the point that it is worth less than the amount invested.
Similarly, spending amounts on a used car to the point where the total investment surpasses the vehicle’s market value is another example of over-investing.
Example of Over-Investing
For example, let’s say a used car in its current “fair” condition is worth $8,000.
And say the owner invests $10,000 into personal upgrades to get into “good” condition.
However, he then finds out that the most that comparable vehicles of that make, model, and year in “good” condition are fetching is $14,000.
If he’s only able to upgrade the value by $6,000 after spending $10,000, he over-invested by $4,000.
Causes of Over-Investing
Over-investing typically occurs when an asset has both investment and consumption components.
Investment goods are assets that the purchaser expects to resell in the future, whereas consumption goods are those that the owner can use and enjoy while they own them.
Houses and cars exemplify these dual characteristics.
People often over-invest because they make decisions based on factors other than purely financial ones.
They may be willing to spend more on an asset due to the perceived benefits derived from using it.
This confusion between consumption and investment can lead to over-investing compared to what would be the case if the investment were clear.
Example #1 of Over-Investing in Housing
Let’s say someone wants to install a swimming pool in their yard for $20,000.
They decide to do it because they like swimming and also think it’ll add value to their home, so they might assume it’ll essentially be like getting what they want for free or even benefit from it financially.
However, if/when they choose to sell the home in the future, not all prospective buyers value a swimming pool. In fact, it might even be a negative.
For one, it increases the operating costs of the property. Swimming pools take money to clean, heat, and maintain.
Prospective buyers may also not like the height, width, depth, shape, location, or other features associated with the pool.
Generally, the more features to a home, the more it becomes specific to a certain type of buyer.
Some might value the “investment” made, but others may not value it all or even make them value the property less, given the time/money cost associated with maintaining it, aesthetic reasons, or other reasons.
Example #2 of Over-Investing in Housing
Many types of home improvements simply replace what was already there and don’t add new value.
For example, if a homeowner replaces a roof for $20,000, that generally isn’t going to add a new $20,000 in value to the home.
It’s simply replacing the old roof and not usually adding new intrinsic value. But it can prevent needing to sell at a discount if an appraisal would single it for needing replacement.
The Pitfalls of Over-Investing
There are several financial risks associated with over-investing.
By spending more on an asset than its true market value, individuals inadvertently waste money on something they would not normally purchase.
This excess consumption results in over-investing by over-consuming.
Moreover, over-investing can have long-term financial implications.
For instance, homeowners who over-invest in their property may struggle to recoup their investment when it comes time to sell, as the neighborhood effect/comparable property valuations may prevent them from realizing the desired return.
Similarly, individuals who over-invest in a vehicle may find themselves unable to recoup the funds spent on repairs and upgrades when they eventually sell or trade the car.
How Do I Know If I’m Over-Investing?
The purpose of an investment is to at least preserve the owner’s purchasing power over time. So after-inflation returns are most important.
Take the returns you’re getting on an asset. Now compare them to the sum of the rate of inflation and the costs being invested into an asset as a percentage of its nominal value.
If you receive income from the asset, take that into account as well.
For example, take an example case of a homeowner:
- Their nominal annual returns are 3% per year.
- The long-run inflation rate is about 3%.
- Their operating and all-in costs (maintenance, repairs, taxes, insurance, etc.) on an annual basis are 5% of the notional value of the home (e.g., $25,000 on a $500,000 home). They get 1% of that back from tax breaks.
- They receive no income from their home.
From this: +3% – 3% – 5% + 1% = -4%
This is the loss accrued.
Some look at the +3% and think that’s their returns and may mistakenly think that they’re “investing” when they’re putting more in than they’re getting out.
The real value in this situation is in living in the home.
Conclusion
The general idea of this article is to not confuse investing with consumption.
To avoid the pitfalls of over-investing, it’s important for individuals to distinguish between consumption and investment when making financial decisions.
Understanding the true market value of an asset and weighing the costs and benefits of improvements or upgrades can help prevent the negative financial consequences associated with over-investing.
By making informed decisions and exercising caution, individuals can maximize the return on their investments and avoid falling into the over-investing trap.