It’s Whatever Wednesdays and this will be a short post (for real this time!) to illustrate a simple concept.
There ain’t no such thing as a free lunch. (TANSTAAFL)
When I was a kid, I knew very little about the world or money. All I knew was that my dad and mom worked very, very hard. We had moved to California when I was three and my dad was a young professor at California State University at Long Beach (CSULB) teaching and publishing to try to get tenure as soon as possible. My mother was doing lab work at the same time related to Chemistry research. I went to preschool from 3-5 years old and met my best friend (who is still my best friend by the way) there.
Then, at 5 years old, I went to kindergarten in the morning from 8-noon. At that age, you don’t really understand many things. However, one thing was crystal clear to me:
Monday-Thursday, My mom drove me to school and picked me up. Like clockwork.
Friday was different. My mom would drop me off, but my dad would pick me up.
I didn’t understand until much later that this occurred because my mom had to work late on Fridays. Anyways, back to the point of my story:
My dad would take me to McDonald’s on those Fridays. I looked forward to those days because my dad would buy me a Happy Meal and he would buy a Big Mac for himself. So to me, every Friday meant a new toy. This was back in 1986, when McDonald’s toys were pretty awesome.
I remember enthusiastically telling my dad. “Dad, McDonald’s is so great. They give me these toys for free if we get the Happy Meal.”
My dad replied, “Walter, there is no such thing as a free lunch.”
Mind you, I was 5 years old at the time so I was extremely confused. I hadn’t said anything about free lunch, and obviously our lunch wasn’t free… I saw my dad pay for Happy Meal and Big Mac myself. So I replied, “Dad, I don’t understand.” And then he said, “Somewhere, someone is paying.”
Now remember… I’m still 5 years old here, so I don’t understand what he means at all. But I just nodded my head and said “Ok, Dad.”
Fast forward a few years and…
Now I am in elementary school, I think 3rd grade. Like most kids my age, I brought lunch sometimes, but eventually I started eating school lunch. I still remember the tater tots and the “pizza” disguised as cardboard with ketchup on it. It was pretty good back then when I didn’t know any better though.
It was during this time that I heard the term “free lunch” again. Some of the kids in my class received a “free lunch”. I then remembered what my dad told me and was even more confused. Then I remembered the second part. “Somewhere, someone is paying.”
So I asked my dad. “Dad, who pays for the ‘free lunch’?”. He must have forgotten that he had told me that because he seemed confused by my question. However, after some thought, he answered, “Everybody pays. We all help out a little bit.” It was only much, much later that I learned about the National School Lunch Program (NSLP).
***Note: Technically the free lunch program and the adage TANSTAAFL are not really related concepts at all. I am just trying to illustrate that when I was a kid, I was trying to take these two concepts and understand them together because they sounded similar. My dad, who knew they were not related, tried to explain the concept in a way I would understand.
The real concept he was trying to explain was the “free toy” concept from McDonald’s. Back in the 1980s, McDonald’s Happy Meals didn’t make any money. The idea was that the kids would want a happy meal but then mom and/or dad would get their own meal. They would make money off of mom and dad, but not the kids. However, profit is profit. Essentially, every time my dad took me to McDonald’s he was more or less subsidizing my Happy Meal with his Big Mac.
Ok, so what was the point of that story?
Well, basically it served as an introduction to explain the adage: There ain’t no such thing as a free lunch. (TANSTAAFL)
Also, it explains why kids have difficultly understanding abstract concepts at young age.
Ok, but I’m an adult. I understand the concept… even if you never told me the adage before.
I agree and I think most people do understand this concept even without ever hearing it. However, the adage serves to remind us every time we hear the word “free.”
Let me provide a more complex example:
You’re a young resident physician at ABC Hospital. One of your co-residents tells you about this “free steak dinner” at Morton’s or Ruth’s Chris, or whatever fancy steak place is in your area. If you’re a carnivore, you’re ecstatic. A poor resident like you living month-to-month would have great difficulty affording a steak dinner. So you sign up for this “free dinner” and “information session”.
You pull together some decent clothes that don’t smell like the hospital and show up the fancy steak place, ready to eat some steak and tune out whatever these guys are saying. So you sit down with your co-residents, order off the prix fixe menu and relax. A guy comes out and starts talking to you. He seems like a nice enough guy, and he starts telling you about compound interest and saving money and things like that.
This is great, you think to yourself. This dude can take care of all this stuff for me that I don’t want to deal with. Also, this steak came out great… and yes I will have another glass of the free wine, my co-resident is driving me home and isn’t drinking.
At the end of the meal, you give them your information and set up a meeting for them to sit down with you one on one and discuss your financial future.
As you leave the meeting, you ask your co-resident, “Oh, hey, when are you meeting with them?” He replies, “Dude, I’m not.”
Puzzled, you ask “Why not?” Your co-resident replies, “Who do you think pays for that dinner?”
Ok, now let’s zoom out:
Let’s say there are 20 residents at the dinner. Let’s make the math easy and make the prix fixe menu be $100 a piece. So 100×20 = $2000. Include tip and feeding the guys giving the session and let’s just round the total cost to $2500.
Let’s say out of the 20 residents, only 1 of them (you in this case) actually goes to the one-on-one session and then starts letting them manage their money. These guys are financial advisors, and are almost 100% relying on the Assets Under Management (AUM) model. So let’s say they only take 2% as an AUM fee. However, you are a poor resident, so you only give them like $5000 for them to manage during the course of your residency. 2% of $5000 is $100 a year.
However, the next year you are an attending. They encourage you to save 20% of your income (which is good). So you max your 401k for $18k and then they suggest you also put it in another $1000 a month for them to manage. Then, after one year, your previous balance of $5000 is now $17000, assuming no change in the market and you pay the $340 fee for that first year.
Let’s even assume that they are able to cover the AUM fee with the interest (for simplicity). So:
$39000, and $780 fee in year 2.
$51,000, and $1020 fee in year 3.
$63,000, and $1260 fee in year 4.
And so on.
So, in year 5 out of residency, you can effectively call your co-resident up (and the other 18 residents) and say,
“Hey, you owe me dinner. I was the one who paid for that steak dinner way back when.”
The adage just serves to remind us all, that somewhere, someone is paying.
And it may not be the current you, but it may be the future you.
The steak dinner was simply a cost in order to acquire you. The act of acquiring you pays off significantly more than a $2500 steak dinner, even if only 1 person actually signs up to have their assets manage out of the 20… or even 40 or even 60. The term for this is Customer Acquisition Cost (CAC). In this example, it cost them $2500 to acquire one customer out of 20.
The second term to understand is the Customer Lifetime Value (CLV). If you sign up with them, you may stay with them for anywhere from 1 year to 50 years. Obviously, the longer you stay with them, the higher your Customer Lifetime Value is to them. If they are able to make this metric tilt more toward 20 or 30 years, then the Customer Lifetime Value trumps the Customer Acquisition Cost quite easily.
In my example, over a 20-30 year period, you would pay tens of thousands of dollars, or even hundreds of thousands of dollars to the AUM fee (assuming a 6% return on average). $2500 to acquire 1 customer who is worth between $200-$200,000… Their chance for a favorable Return on Investment (ROI) is high.
However, you wouldn’t know it because it’s a slow bleed, and it’s money you never even saw or knew you had.
Obviously, the ROI is much better as long as you can retain your customers for 10+ years. For this reason, once you are with a particular financial advisor, they will do whatever they can to keep you from leaving because you are worth way more as your retirement fund increases.
There ain’t no such thing as a free lunch.
Somewhere, someone is paying.
It may not be current you… but it may be the future you, or even the past you.
***by the way… my “short post” was ~1600 words again. *Sigh*
Agree? Disagree? Questions, Comments and Suggestions are welcome.
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