Stop Stealing Money from Yourself
I was reading Mr. Jonathan Clements’ great finance blog the Humbledollar.com the other day and two articles struck a chord stronger than usual. The first, titled Subsidize Me, discusses different ways people in society might be considered to be financially subsidizing others. For example, if we pay for car insurance and never get in a car wreck subsidize those who do utilize their insurance, or how people who carry credit card balances subsidize the “rewards/points” people who pay off their credit cards each month get.
I thought it was a really interesting idea. And that got me thinking about how the choices we make today might subsidize our future (or require our future to subsidize us today).
By saving for retirement and paying down debt, we are actively working toward making our future-life easier; at the expense of going without something we want/need today.
And the opposite is true as well. If we overspend today, we are putting our current-self in a hole and risk throwing our future-self into the same hole with us.
Humans are naturally irrational creatures; as anyone who has looked at Twitter replies, YouTube comments, and Facebook messages surely knows. Evolution-wise it makes sense – we want to live for today since tomorrow we might not have food, die by tiger-attack, or disease. While we are definitely the top of the food chain, dress up nice, and follow society’s rules (most of us at least); deep down we just want to run around in a field hunting and chasing things (or being chased, in the unfortunate cases). This quality makes us great problem-solvers and decision-makers, and even enables us to sing in public despite ample evidence supporting our silence.
Unfortunately, this irrationality usually leads us into making poor financial decisions since we don’t often properly weigh our future relative to the present. This idea is explored a bit more here on qz.com, but thinking about this brought an odd idea into my head:
Why do we find it so easy to steal from ourselves?!?
Maybe it’s because we haven’t really spent the effort to visualize our future-self? Maybe we’d find it harder to steal from ourselves if we spent more time envisioning what we want our life to be – rather than living from moment to moment? We should definitely keep in mind that we won’t necessarily live forever and I’ve written recently about how we can’t save our way to happiness. But we need to be mindful of the true cost of what we are spending and putting off purchases for a year or two is distinctly different than putting off spending “forever”.
Can you estimate the value of a $1 saved today in 15, 30, or 40 years?
This is reasonably easy to estimate with Excel or a couple-second Google search for a calculator. What I’m asking is what would $1 be worth if invested in a fairly simple, diversified portfolio of stocks and bonds?
Actually, let’s wait one second. I want to introduce one concept before I dive into some numbers.
The Rule of 72
Read more here at Investopedia.com. Briefly, it is a quick way to estimate how long it would take your money to double based on a given rate of return. So, your money would double in 8 years with a 9% rate of return (72 divided by 9). It’s a neat idea and an idea I like to think about when comparing rates of return or how much something will cost me (or earn me!) in the long-run.
What would the value of $1 invested today be with returns of 4 or 5%?
Why 4 or 5%?
I like to assume a reasonably simple, diversified retirement portfolio would return ~7% over the long term for thought experiments like these (and I assume ~2% inflation); that leaves ~5% return.
Now you might want to assume a higher or lower return and/or higher or lower inflation, but let’s use 5% for this example. The main point is using 8-12% might be a bit rosy, generally speaking.
With our Rule of 72 we can estimate that our $1 will become $2 in about 14 years expecting a 5% rate of return (72 divided by 5 = 14.4). And double again (AKA quadruple) to $4 in about 28 years.
If we do the real math (not shown here, but email if you don’t believe me!), we find that the Rule works pretty well:
|Investing $1 @ 5% rate of return|
I think this exercise is pretty interesting because while it may be hard to visualize yourself amassing one-to-two million dollars over time. Thinking about each dollar you invest today being worth over $7 in retirement (in today’s dollars!) seems a lot easier to me.
Let’s be honest. Saving initially is pretty boring and de-motivating (and spending on a fancy car or big house sounds WAAAAAY BETTER). Imagine the hypothetical new graduate, they are putting the maximum into their 401k ($18,500) each year and investing it wisely.
At year 3, so proud of themselves they can barely stand it, they log into their 401k website knowing they’ve put in $55,000 total. They’ve read all the websites and all the books. They picked a decent, simple portfolio and got a decent 5% return.
So how close to a $1 million are they!?!?!
They have $61,000…
Yes, it’s true. At year 3 you probably won’t be floored by your returns, but remember we are in this for the long haul and we need our money to keep compounding. The second article from Humbledollar.com that really inspired me was one titled The Tipping Point.
The basic concept of the article was you’ll reach a tipping point in your saving when the numbers start to really move (SPOILER, it isn’t year 3…). Mr. Clements stated that it takes to about year 12 for the compounding to really start compelling moving your 401k balance. Using 5% return – it is Year 12 of maxing your retirement that your balance goes up about double what you personally deposit.
At year 12, you are still putting in $18,500, but the overall balance increased over $36,000 – which is pretty cool. The reason I bring this up is that it takes time to feel like you are getting results, much like how you won’t feel like a marathon runner two weeks after getting on the Treadmill. I know I wasn’t “happy” to see my balance until about year 12-13, but I hadn’t thought about it as the Tipping Point until that article.
Now let’s think about that Car Payment (or another big purchase)
Let’s say you just graduated and got your first real job and paycheck. You’ve been driving a “beater car” for the last 5-8 years and you’ve earned a new car! You head down to the Lexus dealership and buy an entry level (but still nice!) SUV for $45,000 with zero down payment.
|List Price – (who pays this?!)||$45,000|
|Price Paid – (what a great negotiator you are!)||$40,000|
|Interest Rate – (what a deal! It’s like free money!)||2%|
|Monthly Payment – (seems doable!)||$590|
|Total Annual Payment – (lame….)||$7,080|
Imagine that $7,000 working for your future-self. Rather than buying a car that will feel good for a couple months and then revert back to being merely a way to get from A-to-B… $7,000 could grow to near $53,000 in 40 years (each $1 equals ~$7.39 per our above assumptions, remember).
With one year of saving (and keeping it invested until retirement) you’ve already put yourself on a path to have 50% of the average TOTAL retirement balance for working families in the US and quite a bit more than your nearest age peers. Per the Economic Policy Institute, the average retirement balance across all working families is only $96,000 and is only $32,000 for those between the ages of 32-37. Now, $53,000 definitely isn’t enough to retire on – but having $53,000 more in retirement merely for delaying buying a new car for a year sounds pretty good to me.
We aren’t even counting the next 5 years of $7,000 payments you’ll send to Lexus in order to pay the car off. Imagine the benefit your future-self will receive if you delay buying that nicer car for just a few years (or make a permanent decision to buy a cheaper car and own it for as long as possible).
How about an even larger purchase?
Now imagine the difference between buying a $350,000 house with 5% down ($17,500) and a $225,00 house with 8% down (still $17,500)
That one decision, to buy a slightly cheaper house, could net you an extra $600,000 in 30 years or over a $1 million dollars in 40 years. All you had to do was buy the smaller house and invest that $8,052 annually in your 401k.
Are you comfortable stealing almost $1 million from yourself?
The damage can be even more severe if you don’t experience significant wage growth over your career. The U.S. Bureau of Labor and Statistics (via cnbc.com) has 25-34 year olds averaging ~$40,000 annually and peaking around $50,000 in their 40s and 50s. Hopefully, if you are reading personal finance blogs, you are more entrepreneurial or are able to earn more than the average through your guile and ability.
But what if you are in a profession (like being a pharmacist, as I am) and your wage starts relatively high, but doesn’t increase. If you spend to the maximum your income allows and then grow your income over time (say from $40k/year up to $60k/year) you might be able to make up for your younger mistakes and future-you won’t be too hard off.
Now think about someone who might start off making $100k/year, but never makes more. If you spend maximally (biggest house possibly, nicest car you can afford, etc) and your wage never increases – it’ll be very difficult to work your way out of the mess and your future-self will be out a lot of potential retirement (or other) savings.
We know that we need to save for the future, pay down our debt, and live within our means. So why don’t we? Humans tend to be bad at rational decision-making and tend to go with our “instinct”. While that is actually a positive attribute in many cases, we need to be mindful that it can lead us astray when it comes to our finances.
The mental model or tool I’m offering is to try to think about your future-self when you make the big purchases (and get those purchases right), make sure you are saving for retirement, and consider following a budget. Delaying a big purchase for just a year or two could have a massive impact on your future – don’t discount it. Delayed-gratification sounds miserable to some people, but delaying temporarily can be very powerful. No one is saying to never buy a Lexus or the Dream House – just hang on a bit and get some money working for you and your future-self first.
I struggle with this too and it definitely helps me when I visualize my future-self and think about what I might be taking from him when I contemplate these larger purchases. Hopefully it’ll help you or someone you know too. Let me know below!
What do you think? Would your future-self be saddened or brightened by your spending habits today?