On Saving
On the financial monorail of life, we either work twice as hard as everyone else just to break even, or we glide easily ahead because our financial monorail gives us a helpful push forward.
In the former case, high-interest debt is the monorail against us. In the latter case, accumulated investments create wealth for us even while we’re resting at our leisure. That’s the whole point of Chapters 3, 4, 5, and 6 summarized in two sentences.
This chapter is about neither the forward nor the backward monorail. Rather, this chapter is about the one thing that allows you to hop off the backward-moving track and shifts you on to the forward-moving track: personal savings.
Now, for all of the tricks and tips written about saving money, saving money is not actually complicated. At the risk of sounding super-pedantic about it, we have to make sure that the amount of money coming into our account per month is larger than the amount of money going out of our account per month. Do this for a while and you will accumulate savings. Do this for a long time and you should end up wealthy.
This sounds kind of basic, I know.
“You can never be too rich or too thin,” goes the old saying, and you might mistakenly think that the route to a svelte body or a fat wallet would involve hidden secrets and sophisticated techniques. Certainly, the Financial Infotainment Industrial Complex would have you believe in secrets and complicated techniques. Stay skeptical.
Nope. A svelte body is accomplished by the same basic method as savings. Make sure you have more calories expended per month than you take in during the month. Maintain this calorie deficit every month, and you will get thinner.
Similarly, with a money surplus every month, you will build savings. That is all.
But wait. That is not really all.
Since 90% of us don’t feel we have a svelte enough body for our liking, nor enough accumulated savings for getting wealthy, my simple rule can’t really be all.
The key to accumulating savings lies partially in the above basic truth and maybe more importantly in the complicated realm of human psychology.
In the second part of this chapter I’ll review some of the specific techniques that could work for you if you are beginning to save, or if you want to increase your savings. What works for you, however, depends mostly on your own mind, because the biggest barrier to savings is in our mind.
I know, I know, that sounds crazy. Because you might be under the impression that the biggest barrier to savings is that you don’t make enough money. Fine, you have a point. You don’t make enough. I agree.
But allow me to let you in on a little secret about saving money: nobody feels like they earn enough to save money. I really mean nobody.
Now, that’s an odd thing to say, because you’ve no doubt read about public figures who earn extraordinary paychecks.
Take, for example, 13-year NFL veteran star Warren Sapp, who earned millions of dollars as a successful football player, and then transitioned to a television commentator and Dancing with the Stars contestant earning over a million dollars per year after his playing career ended. Or perhaps you remember boxing champion Mike Tyson, who earned $300 million from his fights. Or popular music stars like Billy Joel, Natalie Cole, or Michael Jackson. Surely they made enough money?
All of those big-time earners named in the paragraph above declared bankruptcy or were wiped out by tens of millions of dollars in debt, despite tens, to hundreds, of millions in earnings.
For them, there was no amount of money sufficient to cover the costs of their lifestyle. The problem was never their thin paycheck, but rather their fat expenses.
On the other end of the earnings spectrum, somehow people manage to save money while earning comparatively little. What I mean is, if you make $50,000 per year, you probably live near someone who makes 20% less than you, say, $40,000 a year.
Now, you have no money left over at the end of the month at $50,000 per year. I know.
It sucks. Somehow, however, your neighbor making $40,000 has figured out how to pay all of her bills. She even socks away an extra few hundred dollars every month! How does she do it?
I don’t know how your neighbor does it. I mean, I have a few guesses. I’ll share them later in this chapter. Oddly enough, however, your neighbor earning $40,000 also knows somebody getting by on just $32,000 a year, and can’t figure out how that’s done. Meanwhile, in another part of town, a family of four is unable to save any money on $160,000 per year. Their debts just pile up. It’s weird. This is the point: it’s not really about the amount of money you earn.
The margin for error is obviously much smaller for the $40,000 earner. Many more people can build up savings making $160,000 per year, but also many can’t. As incredible as it sounds to someone making $40,000 per year, it’s quite easy to have zero savings on a $160,000 salary per year.
The point is to notice the mystery of savings has less to do with raw earning power and more to do with personal behaviors and lifestyle costs. It has to do with what and how you spend. Just like the key to weight control is limiting calorie intake, the key to savings is limiting money outflow.
Now, I know this is all very theoretical and maybe you’d like to get a bit more practical. Like, how do you actually save money?
The Role of Budgeting: Hawthorne Effect
At this point in the savings narrative, many would-be financial advice-givers start to get very pushy about the importance of budgeting. Not being a budgeter myself, I feel unprepared to advocate it for others. Personally, I don’t find budgeting a sustainable activity in my life. Maybe you do. Or maybe you will. That’s fine. I’m not going to get pushy about it.
However, if you do have trouble limiting your lifestyle costs, I do think budgeting at least for some period of time can create a positive psychological effect, by what’s known as the Hawthorne or observer effect. Scientific researchers have long known that observing phenomenon can change the thing you observe. The very act of observing something, such as keeping track of your budget, can change your behavior. Specifically, if you start tracking every expenditure—including Tic-Tacs in the checkout line and $0.99 iTunes downloads—you probably will reduce your actual purchases. It’s a small trick, but it might be a way to make budgeting useful to you. The Hawthorne effect is kind of the main point of budgeting, in my opinion.
Although that’s not the entire story.
The Latte Effect
I once did a little experiment in budgeting, for just 1 week, which you might want to try yourself.
I decided to track—through an iPhone app—the amount I spent per week just on premium coffee. If you’ve got a similar addictive vice like mine to caffeine, maybe you’d like to attempt a little budgeting experiment like this. I knew I frequently spent money on coffee, but I hadn’t bothered to add up all of my teensy tiny little expenditures.
I was stunned to learn at the end of the week that I’d spent $40.14 at the coffee shop. Some of that was the coffee, some of that was the extra unnecessary muffin to accompany the coffee, and once it was the lunch I grabbed because I happened to be in a coffee shop.
I’m wholly convinced that we all have these little unnecessary expenditures. Your thing might not be coffee, but it’s probably something. Only you know what that something is. Try tracking it for a week or month to see the cumulative effect of your little “nothing” expenditure.
Now, $40.14 in a week seemed like much more than I expected. But at the same time, was it large enough to matter in the grand scheme of things? The amount of $40.14 per week isn’t the difference between being rich and poor, is it?
Spoiler alert: it is.
The personal finance author David Bach, who coined the term “latte effect” to describe my (as well as your) unnecessary $40.14 addiction, urges us to become aware of our own latte effects, whatever they may be.
Chapter 4 on compound interest gave us the tools to figure out the difference that $40.14 can make on a life of savings and investments. So let’s do some very quick math using compound interest. I know from the 1-week budgeting exercise that my “latte effect” is $40.14 per week, which adds up to $2,087.28 after 52 weeks.
What if, instead of satisfying my caffeine addiction, I saved the latte money one year and invested it in a mutual fund that tracked the stock market. If I did this single prudent thing at age 25 and managed to earn a 6% return every year until I turned 75 years old, I’d be how much richer?
Recall that compound interest can be calculated as FV = PV ∗ (1 + Y)^N, where the PV is $2,087.28, the Y is 6%, and the N is 50.
So the future value of 1 year’s latte effect savings, 50 years later, is $38,448.02. That’s pretty good, although I’m not sure it’s life changing in retirement.
If I earned 10% in the stock market, 50 years later I’d be $245,027.58 richer. Now we’re closer to life altering. You should plug those numbers into your spreadsheet and verify the compound interest math. I’ll be right here until you get back.
OK, welcome back.
Now maybe you don’t think a 10% annual return is reasonable. You might be right. Although just so you know, the broad stock market represented by the S&P 500, including reinvestment of dividends, has earned more than that per year over the course of my lifetime. So, a 10% return is admittedly optimistic, but also realistic, based on my own observable experience.
And that’s all just from one single year of savings and investment discipline. But what if I had never become addicted to caffeine in the first place? What if I managed to save and invest my latte affect amount every year between age 25 and 75?
To answer that question I’d create a spreadsheet list of 50 years’ worth of compound interest calculations. The first year, earning 6% on the original $2,087.28 for 50 years, becomes $38,448.02. The second year, earning 6% for 49 years, becomes $36,271.72. The third year, earning 6% for 48 years, becomes $34,218.60, and so on for the next 50 years.
At the end, by age 75, my spreadsheet tells me my net worth is higher by $642,373.07. All from cutting out a tiny amount of savings—a single vice!—from my daily habits, and investing it.
If I run the same compound interest math but use a 10% return, my latte effect over 50 years nets me $2,672,343.29. Now, who wants to be a millionaire?
What Is the Real Point?
You might misinterpret this whole exercise as an anti-caffeine screed. Nothing could be further from the truth. You could no more successfully separate me from my coffee than you could pry a baby kangaroo from its mother’s pouch. Don’t even try it with me.
I’m not saying you should never spend money on things that give you joy. As coffee does for me.
What I’m really saying is that very small changes in weekly and monthly savings, dedicated to a good investment plan (for that, see Chapters 13 and 14) over the long run, make an extraordinary difference in terms of net worth. The amount of $40.14 per week is nothing. Really. It’s just $5.73 per day. Do you have that amount you could save per day?
The point of doing a budget, for me, is to figure out if you are spending $5.73 per day more than you need to. Or maybe $3 more than you need to. Or maybe $73 per day more than you need to. I don’t know which one is more true for you. I mean, I’m pretty sure it’s something.
So while I don’t think you should have to cut out caffeine (or your own vice of choice) necessarily, nor do I think you should budget for your whole life, I do think budgeting, as a way to identify where and how a few dollars a day of savings could be found, could be the key to savings. It could be the key to becoming a millionaire over your lifetime.
Automation
Having gotten this far into the savings discussion, I have yet to mention the single most important technique for actually building up savings. We haven’t yet described the best way in which you should take your $3, or $5.73, or $73 per day and actually save it. Now, it is time. Are you ready?
I only know of one nearly foolproof way to save money, and that’s to automate the savings. What I mean by that is to create a “set it and forget it” rule with your bank account. A rule something along the lines of “every paycheck I whisk away $x into a saving account that I can’t easily access.” Or, every day, I move $3 from my checking account into a savings account, ideally a savings account that I can’t get to very well.
Automatic deductions force us to do something nobody wants to do, which is forgo spending all of our money today for the benefit of some uncertain tomorrow.
Admittedly, automatic deductions are not strictly “rational.” Why should it matter if money sits in one checking account or sits in a separate savings account? Nothing has changed except where the money sits. And yet, everything is changed. For some reason, if we can remove money from our typical “spending account,” we can avoid spending it.
Technology allows us to accomplish this mind trick more easily than ever. Your bank very likely allows you to set up a rule for moving money on a regular, automated basis. It doesn’t matter which rule you set, but you should try some “set it and forget it” rule. Try every week, or every paycheck, or every month. Just try something in an automated way. It works.
A funny mobile app named Qapital takes the same principle of savings through automation and extends it into clever paths. You can move a set amount of money from your checking account into a savings account whenever your favorite (or least favorite) politician tweets. You can automate the movement of money whenever you hit, or don’t hit, a certain fitness target. You can move the “roundups” or spare change from your debit card purchases, on a weekly basis. Or when you shop at a store. Or buy your latte. Qapital is just the latest way to build on the true insight that automation is the best way to accumulate savings, to “set it and forget it.”
Automated savings always start out small and seem like they might not lead to much over time. I’d urge you to remain optimistic, however, and remember the compound interest effects of small amounts of money. That optimism will make your fortune.
While automation works better than anything else I know, a few other high-value techniques might work to help you save money as well.
Paying Cash
Some people swear by this, including two variations on the original theme I’ll describe below. In its simplest form, paying cash forces you to only spend what you literally have at present, rather than charging purchases on a high-interest credit card that will be paid in the future. If limiting your purchases to cash helps you avoid credit card fees and interest, I’m all for it.
Some people take out a set amount of cash from the bank at the beginning of a month, and then try to survive by only spending their physical cash. At the checkout counter, with just $12 in hand, they can’t impulse purchase above the $12 limit. If that helps as a reminder that money is finite, that’s fine by me, too.
A variation on this all-cash theme that some people swear by is the “envelope trick.” With this, you label physical envelopes things like “Grocery Money,” and “Entertainment,” and “School Supplies,” and withdraw a set amount of cash from the bank to fill the envelope at the beginning of the month, or at the beginning of a pay cycle. If the money in the envelope runs out, you just have to do without that category of expenses, until the next pay cycle.
Because most large expenditures are due monthly, like car payments, housing payments, personal loans, insurance, and utilities, I think creating envelope budgets only makes sense on a monthly basis.
I’ve experimented with the envelope trick in my family and have admittedly never gotten it to work properly. But hey, it might be just the thing you need to kick-start your savings program. Like I said, some people swear by it.
Bargaining with Cash Only
Another variation on the cash-only theme is the idea of withdrawing a set cash amount in advance of a large purchase, like furniture, or a used car. Employed correctly, this technique absolutely works for saving money.
You’ve spotted a couch you need to buy at the store. Or you have a good lead on a car at the dealership. Or a washer-dryer set at the appliance store. Setting a top-limit budgeted amount ahead of time, and holding that precise amount of cash in your hands, gives you an unusual bargaining position with the person selling. Whatever the listed price, you can try offering less money, in the amount that fits your budget. Most brick-and-mortar stores that sell higher-price items, like cars and furniture and appliances, expect and allow some negotiation on prices like this, even if they do not advertise it.
If your $600 offer for an $800 item gets turned down initially, you might just want to remove the cash from your pocket. “I’m sorry,” you might say, waving the bills, “but I only have this amount of money saved up for this purchase. I can give you this $600 and you can make the sale today. If not, I have to walk out today and end up buying from someone else.”
This does not work every time, of course. It won’t work either with the increasing amount of shopping we all do online. But it will work more often than you expect with in-person purchases at brick-and-mortar stores. You may feel squeamish, initially, about this hard-nosed technique. You may decide, however, that $200 in savings is worth 10 minutes of squeamishness. I mean, would you spend 10 minutes on your hands and knees uncomfortably trying to fish out $200 in bills wedged into the tiny space underneath the front seat of your car? I know I would. Think of earning that $200 through a little temporary discomfort. I mean, $200 for 10 minutes is a pretty good rate.
Also, never forget that the salesperson who accepts your offer for $600, sighing heavily all the way, secretly is thrilled to have made the sale. Otherwise your offer would not have been accepted. Paying with just the limited amount of cash literally in your hand at the store is what makes your offer credible, and effective.
Finally, paying cash encourages a more modest purchase. If you limit yourself to $600 in cash for the furniture set, you have just saved yourself from the $2,400 splurge on a fancier, flashier furniture option that was available only with high-interest credit. Modesty, as always, aligns well with wealth building.
Emergency Fund
Finally, a few words about the classic personal finance trope on saving money: “First,” the advice goes, “build an emergency fund.”
Count me as deeply skeptical of that advice.
In my experience, people who need an emergency fund rarely build one. Of course, it would be nice to have a little extra money in a savings account. Because having money is generally better than not having it.
But realistically, people who are given the advice “build an emergency fund” typically suffer from high-interest debt, like credit card loans. Paying down a credit card balance, typically charging 12% or 18% or 25%, is a far better idea than building up an emergency fund. If you have high-interest credit card debt at present, then you shouldn’t have an emergency fund. You should work on getting your credit card balance to zero first. That zero-balance credit card with an unused available line for borrowing actually is your initial emergency fund.
On the other side, people who have zero balances on their credit card, or who are pretty good about saving money, don’t really need one. Emergency funds are inefficient. They hardly earn any interest, generally, since they can’t be invested in any risky way that earns a meaningful return.
You don’t really need an emergency fund. What you need is “emergency liquidity.” Meaning, if you can borrow the money in an emergency and pay it back within a reasonable amount of time—with a 3-week credit card loan, or with a HELOC1 for a longer period of time—then an emergency fund is not only irrelevant but also expensive.
The need for “emergency liquidity,” not an “emergency fund,” partly illustrates the value of low-interest debt—the topic of the next chapter.
For Further Reading
Among the simplest and most powerful books arguing for the application of the power of compound interest, plus the power of automated savings, is by David Bach, The Automatic Millionaire: A Powerful One-Step Plan to Live and Finish Rich (New York: Broadway Books, 2004).
A great description of the weird fact that nobody makes enough money to save, but somehow somebody else down the street earning less money than you is able to do it, can be found in the book by Andrew Tobias, The Only Investment Guide You’ll Ever Need (New York: Mariner Books, 2010). Tobias also has a great section on tips for saving money.
1I define HELOC in the next chapter, on low-interest debt.