We are going to show you how to be healthy and wealthy today. To this end, we start by discussing how to be convex to time. After showing you the power of convexity, I will show you how to use it in a healthcare example. For our example, I will introduce a sublime risk concept called moral hazard. I will show you how to defeat it by ‘de-moral hazarding’ and creating skin in the game for your healthy life.
About the author: Jeff Hulett is a career banker, data scientist, behavioral economist, and choice architect. Jeff has held banking and consulting leadership roles at Wells Fargo, Citibank, KPMG, and IBM. Today, Jeff is an executive with the Definitive Companies. He teaches personal finance at James Madison University and provides personal finance seminars. Check out his new book -- Making Choices, Making Money: Your Guide to Making Confident Financial Decisions -- at jeffhulett.com.
First, con-vex-ity is a critical concept for long-term life investment. While convexity is a math concept, I will focus on its intuitive power. Today, we focus on your health and wealth as quintessential long-term investments. I assume you would like to have a fat investment fund waiting for you when you retire. Also, I assume you want to live a LONG AND HEALTHY life. Meaning, you want to be SO healthy to potentially live to triple digits! You want health allowing you to smile often, be mostly pain-free, and roll around on the ground with your GREAT grandchildren!
By the way, the shape of this curve is the same as the curve for the time value of money we use in finance. In fact, health and wealth are LITERALLY 2 sides of the same coin. A convex function increases at an increasing rate if you make regular contributions and have it invested in diversified financial portfolios.
But first, before we get to convexity, we will show you its not-so-good mathematical cousin, called con-cav-ity. Concavity is all about today. Concavity is also very alluring. It starts looking pretty good with some deceiving upward momentum, usually because we like consuming today and are young enough that our health and wealth are not such a big deal.
But over time, that momentum slows, usually because the investments in either health or wealth are not being made. It starts to catch up with us with cracks in our health and long-term wealth.
Then, as we get into our 50s or 60s, the cracks become wide gulfs. We may feel more pain and our wealth is not growing. Unfortunately, at this point, the damage has been done. Sure we can adjust, but there is so much more power if we had made those small investments in our 20s.
The worst side of concavity is volatility. We all know life is volatile, but concavity amplifies volatility to the downside. So, an unplanned fall or some negative health event is magnified by our concave lifestyle.
Now, let’s explore concavity’s superstar cousin, convexity! Admittedly, convexity starts slow. Convexity may be a little uncomfortable at first. By making small health and wealth investments today, you are taking away from your ability to consume today. It is not a huge challenge, but it is annoying. Plus, our society teaches us to “spend now” with “Easy Money!”
But over time, our investments start to pay off. We are more likely to be healthy and our retirement account is growing!
Notice, in our 50s, our health is very positive for our age, our health is moving in the right direction for our age, and our retirement account is growing quickly.
The best part about convexity is that it protects us from downside volatility and EXPOSES us to upside volatility. The author Nassim Nicholas Taleb coined the term “anti-fragile” for this benefit. Being anti-fragile does not eliminate life’s normal volatility. Being anti-fragile means you expose yourself to volatility benefits and protect your volatility downside! So, that is the basic idea and can be applied to many important aspects of our life!
Now let’s work through a health care example. For this example, we will be discussing 2 different medical insurance plans. A low deductible plan that gives you instant, no out-of-pocket cost access to almost any doctor to help you stay productive at work. This access and convenience comes at a cost. It does have higher premiums.
On the other hand, please consider a high-deductible plan. This means you pay out of pocket when you get mildly sick or have a small accident. The policy does cover your big expenses and protects you from the big risks if you have a major accident or a major medical challenge. This plan has a lower premium.
Which one of these plans is more convex for you? It turns out – the high deductible plan is – even if your employer offsets the higher premium as a benefit! Let me show you why.
We start with an important risk concept with a strange name - moral hazard! This concept is used by insurers for the TRUISM that a low deductible policy encourages people to behave in a way that increases the risk of being insured. I’ll let that settle in. Again - A low deductible policy encourages people to behave in a way that increases the risk of being insured.
Think about it, if you rent a car with full insurance and no deductible, you are MUCH more likely to treat the car poorly, rag it out, or drive more dangerously. Why? Because you know if anything happens, the rental car company will come pick it up at no expense to you.
Health care is the same way. If you do not have skin in the game, you are less likely to take the extra steps to have healthy behaviors today to take care of yourself. Higher out-of-pocket costs cause you to be more vigilant. Behavioral economists call a high deductible plan a “commitment device.” Because the higher payments cause you to COMMIT to your health to prevent smaller losses.
Back to our insurance example, the high deductible policy has a LOWER MORAL HAZARD! You are more likely to take care of yourself to prevent an out-of-pocket loss. All the while, you feel secure in the knowledge that your risk of ruin is covered at the high end. I call this De-moral hazarding. It is taking ownership of your healthy behavior with smart commitment devices!
Also, with lower premiums, you can save more. The low deductible premiums are so much higher because the insurance company knows you will be less healthy.
Think of the difference between the premium and savings you can put toward your convex retirement! This is the ultimate win-win! A high deductible policy gives you an incentive to be healthy for the long term AND it helps you save more today for more wealth to use with your healthy older self. Yea!!
Finally – a word about getting insurance as a work benefit. Almost all other countries in the world do NOT support health insurance as a company benefit. Most countries provide means to get insurance directly without being tied to a company. In many ways, tying insurance to a company is like handcuffs, which makes it more challenging to change companies because of the fear of losing medical insurance. The reason why pensions changed to 401ks is to make retirement savings portable. Hopefully, someday the U.S. will BOTH catch up with the rest of the world, AND the U.S. retirement savings defined contribution approach will be better for our health care. BUT - Until then, you can STILL get the benefit of a high deductible policy, whether directly or via your employer.
You’ve Got This!