More on "psychic value"

In Malcolm Gladwell's piece on the "psychic value" or "Picasso value" of owning a sports team (which I talked about here), there was a reference to an academic study (.pdf) that tried to find the psychic value of owning a painting. That study found that psychic value to be around 28% of the value of the painting.

Well, that makes no sense. Paintings don't return a stream of income (unless you charge admission to see them, which isn't the case here). The only benefit to owning the painting is the intrinsic, subjective value you get from owning it. So the "psychic value" of owning the painting can't be 28% of its value. It must be 100%.

The confusion, I think, comes from the fact that, sometimes, you can sell a painting at a profit. That makes it seem like there are two benefits to the painting -- the psychic benefit of ownership, and the potential capital gain at the end. But, really, there's one benefit: the psychic one. Sure, the *value* of that psychic benefit will likely rise over the years, and, when it does, you can sell that benefit to another buyer at a higher price. But you're still selling only joy.

The "profit" is actually something you can expect, and it's built into the price of the painting. Suppose owning a Picasso is worth $100K a year in "psychic value" to the person who likes it best. And that value rises every year by the rate of inflation -- say, 5%. And suppose interest rates are 10%.

The buyer then expects:

$100,000 worth of psychic value the first year
$105,000 worth of psychic value the second year
$110,250 the third year
$115,763 the fourth year
... and so on.

How much is he willing to pay for the painting? Well, at a discount rate of 10%, it works out to $2 million. By buying the painting for $2 million, the buyer forgoes $200,000 in interest that he would get otherwise. In exchange, he gets $100,000 in psychic value the first year, and the painting appreciates by $100,000.

But if you were to look at the fact that the psychic value equals the appreciation, and conclude that only 50% of the value of the painting was psychic value, you'd would be incorrect. Psychic value accounts for 100% of the value of the painting. The appreciation comes from an increase, over time, in the rate of return in psychic value.

What you CAN say is that, of the first year's forgone interest on the value of the painting, 50% of that represents the psychic value consumed that year, while 50% represents appreciation of the remainder of the psychic value. But that's not that brilliant an insight. It's true for everything you buy: the "psychic value" must be at least the forgone interest minus the appreciation (or plus the depreciation, which is negative appreciation). If you buy a TV for $1000 at 10% interest, and it loses 20% of its value every year, the first year's "psychic value" must be at least $300, or you wouldn't buy it.

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Another thing that's confusing is that sometimes paintings appreciate a lot more than inflation, which makes them look like a good investment. But that's got to be random. If it was known in advance that the painting would appreciate more than stocks, the price would go up immediately as buyers bid up the price. Those stories you hear about buyers paying $500 and selling for $1,000,000 ... well, those are outliers, like winning lottery tickets. In a reasonably efficient market, the sum of the psychic value, and the appreciation, must be close to the return you can get from other (similarly risky) investments.

But life is random, and it's possible that values increased much more than expected in the past. The art world may have thought that psychic value would increase only with inflation, but, as more and more billionaires were created, the psychic value rose even faster. That would certainly have caused prices to rise faster than expected, and would make paintings look like a good "investment". But the market would adjust to the new expectations. Indeed, as it did, prices would rise even faster! They'd rise once for the fact that psychic values are now higher, and they'd rise again for the fact that psychic values are accelerating over time.

In retrospect, that may have made paintings look like they were a better than average investment (which I guess they would have been). But that's not because paintings have two benefits -- psychic, and non-psychic. It's because they have one benefit, psychic, and the value of that benefit increased sharply. If you buy a painting as an "investment," you are speculating in the value of its psychic benefits. And you are betting against the market. Unless you have much, much better speculative skills than anyone else, you're probably going to break even in the long run, before taking into account auction fees, and such. And "breaking even" includes psychic benefits. If you don't like art, the expectation for your overall experience is strongly negative, compared to other investments.

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Another way to look at it: suppose you hate paintings, and the fame that comes with owning them. You buy a Picasso for a million dollars as an investment, but laws are passed that prevent you from ever, ever selling it or renting it. Now, the value of the Picasso to you is zero. You might as well have never bought it. You have a loss of a million dollars, as if you spent your money on a big bag of manure.

Now, suppose you instead buy a million dollars worth of McDonald's stock. And, again, suppose you are prevented from ever selling it. You won't care that much. Because, McDonald's is going to keep making profits, and sending you ever-increasing dividend checks every quarter. The present value of all those dividend checks works out to a million dollars.

When you buy a painting, you're buying a stream of quarterly "dividend checks" of 100% psychic value. When you buy a stock, you're buying a stream of quarterly dividend checks in 100% cash.

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Now, a sports team is a combination of a Picasso and a McDonald's. It produces psychic benefits, but it also produces profit (perhaps negative profit). So, *now*, it's a real question to ask what percentage of a sports team's value is psychic value, and what percentage is investment value. The answers are no longer 100% and 0%, like they were for a painting.

But it depends on the team. For a big-market profitable team, the investment value might be 70% or more, and the Picasso value 30% or less. For a team that loses money, the Picasso value might be greater than 150% or 200% of the total value.

But, again, that percentage doesn't mean much in the real world. What matters the ratio of annual Picasso value to cash losses. Because, if that goes over 100%, it means the owner is losing more money than he's prepared to lose. It means the owner is not bluffing when he says he's bleeding too much money.

If an NBA team loses $25 million, is that a problem big enough that the players should have to take a pay cut? It depends. If the owner's Picasso value is more than $25 million, then the players can say, "no way". If the Picasso value is less than $25 million, the players need to at least consider that the owners are in a financial situation that they don't consider sustainable.

Because, suppose nobody in the world is willing to pay more than $25 million a year for the thrill of owning a team. And suppose that team is perpetually losing $30 million a year. Then, the team becomes, literally, valueless. It becomes in the owner's interest to fold the team entirely. It is in the interests of the players to figure out if NBA teams are approaching that point, and, if so, what should be done about it.