The Hedge Fund in Your Pantry

Hardly, says Scott Baker, an associate professor of finance at the Kellogg School. New research from Baker and his collaborators Stephanie Johnson and Lorenz Kueng (of Rice University and the Swiss Finance Institute, respectively) shows that many households “invest” surplus cash in an inventory of common household consumables—everything from canned goods and breakfast cereal to boxes of tissue and rolls of toilet paper.

By managing inventory in savvy ways, these households actually realize “returns” on their investment (in the form of cost savings) exceeding 20 percent, and sometimes as high as 50 percent. That’s competitive with top-performing hedge funds. In other words, when a household is able to put a dollar toward the cheaper cereal from the big-box store today, it can save them a lot compared with buying it at the corner store for a higher price next month.

Obviously, household inventory management won’t yield the kind of real returns that let people purchase yachts or endow universities. But according to Baker, such inventory does form a significant—and, until now, mostly invisible—“asset class” that contributes to a household’s measurable wealth.

“It’s not [worth] tremendous amounts of money—we estimate on the order of $1,000 or so,” Baker says. “But for many of these households, this is a very substantial chunk relative to their observable financial assets. So even if they’re not investing in stocks, they are acting in quite a sophisticated way to obtain high returns to maximize their consumption.”

Invisible trade-offs

The researchers began by examining a household’s total financial assets in the same way they would look at a firm’s assets. Much like a company relies on working capital—not just revenue and investments—to maintain its solvency, ordinary households have their own version. Baker and his colleagues defined this “household working capital” as the combination of liquid assets and inventories of consumer goods.

The former is straightforward enough to measure on a balance sheet, just like a firm’s. “It’s cash on hand—a buffer in my bank account such that if I go to the store and find some really good deals, or [decide] it would make sense to stockpile some stuff, I can do that,” Baker says.

However, all that stuff that people keep in their pantries and medicine cabinets—the consumer goods held as household inventory—isn’t as easy to observe as cash. “For firms, how much inventory they’re holding gets [reported] because it’s a big component of value. But for households, it’s been kind of invisible,” Baker says. “People don’t necessarily know. And it’s hard to say in surveys, ‘Go through your pantry and list everything.’”

Baker and his colleagues created estimates of household inventory by using Nielsen data, which tracks the purchasing patterns of roughly 60,000 households—“grocery items, pharmacy items, basically most things with a barcode,” he says. This data only directly measures what people purchase, not what happens to it after that. But by aggregating these consumption patterns over time, and by matching them against other financial data like household income, the researchers could construct a reasonable picture of which kinds of products were “invested” in as inventory.

“It’s not that households consume the same exact brand of cereal or kind of fruit every day, but they do always consume some fruit and they do always consume some cereal,” Baker explains. “Based on the flow of these products, we can basically [reconstruct] their inventory at any given time, while also allowing for reasonable depreciation. Naturally, you’re going to have more of a stockpile of canned goods or toiletries than fresh meat or produce.”

Next, the researchers had to define how managing this inventory generates a “return” for households in the form of cost savings. Their model, says Baker, assumes that households employ two inventory-management strategies.

The first relies on taking fewer shopping trips and buying in bulk in order to reduce prices. “You invest a bigger amount upfront, but you’re going to use those [goods] over time and therefore pay a lower price over time,” Baker explains.

In the second strategy, a household makes more-frequent trips to multiple stores in order to take advantage of any temporary sales or deals that may be in effect. “Lots and lots of types of goods will be subject to periodic price cuts,” says Baker, “so if you go to the store every day, you can just buy the things that are on sale and stockpile those. On average, you’ll be paying a lower price per product than if you only went to the store once a month.”

Each inventory-management strategy has downsides that constrain potential returns. Buying in bulk requires more upfront capital and makes households less able to take advantage of deals. “I can’t stockpile meat and vegetables for months and months, so if they’re not on sale the day I shop, it’s too bad for me,” Baker explains. Meanwhile, the deal-focused strategy incurs extra costs from more-frequent shopping trips. According to Baker, households “trade off between these mechanisms of savings” to optimize the return on their household inventory.

Beating the market

Baker and his colleagues found that on average, households are holding about $725 worth of inventory at any given time. Richer households tend to hold more quantities of inventory, but their financial assets also comprise a much bigger portion of their overall wealth. Lower-income households, meanwhile, “might hold basically no financial assets at all, but $1,000 worth of household inventory,” says Baker. “This is pretty sizable with respect to their total spending.”

In fact, some of the highest returns from household inventory management were achieved by those households with the lowest levels of working capital. For example, if a lower-income household spends about $5,000 per year on consumable goods and holds $250 worth of cash and inventory as their “household working capital” at any given time, the marginal return—that is, the return on investing additional money into inventory—is about 55 percent, according to Baker’s model.

“When that household buffer is really low, the return on loosening your budget constraints in order to [stockpile] is really high,” he explains. “Sometimes you’re at the store and there are really good deals, and if you spend a little bit more upfront to take advantage of them, it can pay off a lot.”

Average returns on household inventory are high, too—about 50 percent for the typical household in the researchers’ sample. Again, the effect was magnified in households with lower levels of working capital. According to the model, if a household that spends $7,500 a year on consumable goods maintains a working capital stock of $725 of cash and inventory, the annual savings would be equivalent to a 100 percent return on the investment.

“It moves the needle more for households that don’t have a lot of financial wealth,” Baker says. “You can think of it relative to what you get in the stock market. Would I rather take a thousand dollars of inventory and put in the stock market, where it would earn 8 percent? Or should I keep it here, ‘earning’ much more? We see that households are doing this, and that it really pays.”

Ordinary people

Baker notes that he and his collaborators didn’t actually survey anyone about making a choice between investing in stocks or in household inventory. Instead, he says their research provides empirical evidence that everyday households “are optimizing [their economic resources] in often quite sophisticated and fairly detailed ways,” even if those assets aren’t literally financial in nature.

“There are a lot of papers that show the mistakes that consumers are making with various sorts of financial products,” Baker says. “Our paper is pointing in the other direction. And maybe we can try to track some of this stuff better—especially for lower-income households, where it’s making a bigger difference in understanding their financial health in general.”