Tag Archives: Spending Money

Opportunity Costs

When it comes to getting the most value for your money, it makes sense to measure the opportunity costs linked to where your money is being dispensed.  Opportunity costs are based on a theory from microeconomics.  It is based on making decisions that provide the best value for your money.

Many economic theories are just theories to the average person.  They are discussed in the classroom or in the financial media, but the average individual investor does not receive too much practical application from most of these theories.  They can be discussed, but not really applied to everyday life.  The theory of opportunity costs does not fall into the category of academic mumbo-jumbo.   It can easily be applied to the management of your personal finances.  Paying attention to opportunity costs can totally change how you think about money.

Total Cost

What do you think about before you buy something?  Most people only look at the direct cost.  When most people decide to buy something, they just look in their wallet to see if they have enough money to pay for it.  Some people don’t think at all and make the purchase with credit and just take on more debt to make the purchase. 

The only time people tend to give any serious thought to what they are buying is when they are making major purchases.  A good example of this is when someone decides to purchase a house.  The potential home buyer will have their credit score checked, shop for the best interest rate, analyze how much they can afford in monthly payments, as well as many other considerations. 

This type of thinking is not the most prudent form of financial management.  Managing the finances around major purchases is important.  Getting the big purchases right can make or break your financial situation. 

Death from 1,000 cuts

The lesser financial decisions are also important.  Not thinking about day-to-day spending can equally jeopardize a financial plan.  The little costs add up quickly if a person is not mindful about their spending.  They are like death from 1,000 cuts.

It is easy for small amounts of spending to get out of control.  A couple of lunches out per week can add up to $100.  Watching a movie at the cinema with snacks can cost $25 per person.  Taking your kids to an indoor water park on the weekends can add up to hundreds of dollars.  Without being mindful, the wasted spend can add up quickly and so do the wasted opportunities for that money to be put to use in a more prudent way.

When money is spent without thought, that is a sure way to not get the most value for the energy that you are exerting to earn it.  To be successful with your personal finances, a consumer needs to be intentional.  Otherwise, they are missing out on maximizing the opportunities that are available.   

Always run the numbers

When making a financial decision, opportunity costs are based on weighing the pros and cons of how money is utilized.  An example would be when you decide to buy a new car.  When you establish the budget do you decide on buying a $30,000 car or a $20,000 car?  If you decide on the $20,000 car, the additional $10,000 that you decided not to spend can be used to pay off debt or to be added to savings?  Buying the $30,000 car would have $10,000 in wasted opportunity costs.

Being mindful of opportunity costs is a great way to maximize the value of your money.  If you are trying to reach financial independence, getting the most bang for your buck needs to be front and center whenever you must spend money.  By always evaluating the opportunity cost of a purchase helps to develop a savers mindset.

Investing

Tracking opportunity costs also have a role when it comes to managing investments.  There is an opportunity cost involved with being too conservative with your selection of investments.  If an investor kept all their savings in a money market account from 2007 until 2017, they would have earned less than 1%.  If that investor put their money in an S&P 500 index fund, they would have earned almost 10% during that same time period.  If an investor was not comfortable investing 100% in equities and wanted to invest in a more moderate allocation, they would have still earned 7.3% in the Vanguard Star Fund (VGSTX) that has an allocation of 60% in stocks and 40% in bonds.

Conclusion

If reaching financial independence is your goal, measuring the opportunity costs of all your purchases will help you get there.  After you start to practice measuring the opportunity cost of every financial transaction for some time, it becomes like second nature.  It is useful no matter where you are in the journey toward financial independence.  If you are new to this way of life and working on paying off debt, it will help to curb your spending.  If you are in the saving and investing phase, being mindful of opportunity costs will help you to free up more money to be used to build wealth.  If you are entering retirement, keeping track of opportunity costs will help you to spend less and preserve your wealth.

Whenever I must spend money, I think about the opportunity cost tied to that purchase.  I credit that thought process as helping to establish a high savings rate.  It is a fun mental game to play.  By being aware of how I am spending my money, it helps me to not miss out on all the better opportunities that are available for my money.

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Saving: The Foundation for Financial Success

Is your goal to reach financial independence?  Do you want to retire early?  If you have an ambitious financial goal, there are many things that you must do correctly.  For example, you need to always be working on improving your ability to earn more money.  You must live below your means.  You must invest wisely in stocks and bonds.  It is also important to take advantage of tax-deferred accounts like a 401K or IRA.  Yes, all those steps are important, but in my experience, having a high savings rate is the most important step to becoming financially successful.

I see savings as the foundation for being financially successful.  Without savings, there is no money to invest.  It is the foundation for one’s financial house to be built upon.  For a house to last, it needs a solid foundation.  If you skimp on the sand or mortar, the foundation will not be suitable to support the structure that you are dreaming about constructing.  If you are not saving enough money, you will not have enough to support a high quality of life when you retire and draw from your savings to pay your expenses.

Savings Rate

This will probably not come as a big surprise, but American’s are not saving enough.  The current national savings rate is just over 5%.  As recent as the 1980’s, the saving rate in the United States was over 10%.  If your goal is reaching financial independence and ultimately early retirement, a savings rate of 5% is not enough.  Even with compound interest, it would simply take too long to grow into a substantial enough nest egg to cover your living expenses.

How Much is Enough

In the classic personal finance book The Richest Man in Babylon, a savings rate of 10% is suggested.  I feel 10% is the bare minimum that the average American should be saving.  I do not think that is nearly enough if your goal is early retirement.  It might be suitable if your goal is to reach financial independence by age 65, but not if you want to retire at age 50.

If you are just entering the workforce, start by saving 15% of your salary.  Work on increasing that rate every year.  Try to increase it by at least 1% annually.  Increase it with every annual raise or bonus.

Spending

Spending is the opposite of savings.  Spending is the enemy of wealth creation.  Spending leads to lifestyle creep.  The more stuff you buy, the more stuff you will want.  There is always something new or better than what you own.

Marketers earn a living by trying to convince you to buy what they are selling.  When you see that your friends or neighbors have the newest products, you will want to upgrade your stuff too.  This is a vicious cycle without an end.

The secret to winning this game is to not play.  Every dollar that you spend puts you one dollar further away from financial independence.  On the other hand, every dollar you save goes towards buying your freedom.

Debt

Debt is created when you spend more than you earn.  Some debt is not as bad as other debt.  Student loans provide you with the funds to get an education to obtain the skills to earn a higher salary.  Taking out a mortgage enables most Americans to be homeowners.  You still must use extreme caution before you incur any type of debt.

Bad debt comes in the form of credit cards, auto loans, and payday loans.  All debt, however, prevents you from saving as much as you could be saving.  When you take on excessive debt, you become a slave to your creditor.  It is possible, but difficult to escape from the bondage of debt once you start to slide down that slippery slope.

Why Save So Much

Once you take on the mindset of a saver, you will never be a spender.  Personal Capital is a free online platform that is great for tracking savings.  That feeling of accomplishment of watching your savings grow is far greater than any new product that you can buy.

After you become a saver, you might notice a mental twist occur.  Once you reach a point in life when you could afford luxury cars and upgrade to a larger house, you will realize that you do not want to waste your money on any of that stuff.  Buying new stuff will become unimportant.  You will see it as being wasteful.

At that point, spending is viewed as an opportunity cost.  You will want your money to keep growing.  Financial independence will become the most import thing that your money can buy.  There is no product or service that is more appealing than having mastery over your own life.

As a saver, you will always be trying to optimize your spending and to live on less.  It is fun to try to stretch a dollar as far as it can be stretched. This mindset will greatly help you on your journey toward financial independence because you will need less money to live on.

For example, if you can live on $40,000 per year, you only need to have $1,000,000 saved based on a 4% withdrawal rate.  What about if you want to live on $100,000 per year?  You would have to have $2,500,000 in savings at a 4% withdrawal rate.  The more money you require, the further away you are from freedom.

Compound Interest

Compound interest works no matter what your saving rate is.  It is just math.  It just works better if you have a high savings rate.  For example, Joe saves $800 per month and Bill saves $2,000 per month.  Their savings both grew by 8%.

How much will Joe have in savings after ten years?  He will have over $147,000 saved.  That is a nice sized nest egg.  It is a solid foundation to build upon.  However, he is still a long way from financial independence.

How much will Bill have saved?  Bill will have over $368,000 in savings.  Bill is well on his way to reaching financial independence.  He is starting to see the light at the end of the tunnel.

As you can see, compound interest worked out well for both Joe and Bill.  Joe has a nice financial foundation.  Bill, on the other hand, has almost 10 years of living expenses stashed away assuming he can live on $40,000 per year.

Conclusion

Start saving early.  Save as much as you can.  Always try to save more.  Don’t be fooled into thinking that you are missing out on anything because you are saving too much.  Once you become a saver, you will have established the required foundation that is needed to fuel the wealth building process.

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