(Guest post by Matt Alden S.)
We all want to save a bit more money, but it’s not particularly fun trying to pinch every penny. Life shouldn’t be about a list of things to avoid and not do- it should be entertaining! Knowing when and where to spend money, and when not to, is a deeply personal thing, but here’s a really simple “rule” to keep in mind when you’re buying anything.
Instead of keeping a formal budget, this is basically the only frugal rule I follow for myself:
The Ten Rule
Due to the time value of money, and the opportunity cost, the ten rule is this:
Anything you buy today, your future self is paying 10x as much for. So add a zero onto the price tag, and ask yourself if it’s still worth it. If it is, buy it and enjoy it. If not, then forget it!
The math behind it is fairly straightforward. The historical rate of return of the S&P 500, the most common benchmark for the stock market and index funds that follow it, is around 9% per year. Equities are a decent investment to stay ahead of inflation over the long term, since the rate of return is generally superior. This is primarily because when prices rise, it’s those companies that are the ones raising their prices while also using their profits to grow their businesses and pay dividends to shareholders. Jeremy Siegel, a professor of finance at the University of Pennsylvania and author of Stocks for the Long Run, has argued that stocks consistently return around 6.6% per year after inflation over a long period of time. Of course, there will be volatility over the short and medium terms.
If we round down, and suppose that stocks offer a rate of return of 9% while the inflation rate during that period is 3%, then we’re looking at a real annual rate of return on our purchasing power of 6%.
For every dollar you have today that you let compound at a real rate of return of 6% per year, you’ll have slightly over ten dollars in 40 years. This is according to the historical performance (which we can never be projected into the future for certain), and is adjusted for inflation to represent a real tenfold increase in purchasing power.
The opportunity cost of every purchase is that you could have invested it in an index fund or another investment. Every dollar not invested today, is ten dollars that is missing from yourself 40 years from now. If we take care of our health, and live past the average life expectancy, we’re talking a life of 80+ years and still active. (I don’t know about you, but if I’m not skydiving and doing crazy-ass things when I’m 80, then something went terribly wrong.) So 40 years isn’t as long as it sounds.
If you bump the time period down to 20 years instead, then it’s the “Three Rule”- everything is three times as expensive because over a 20 year period of 6% real annual returns, the purchasing power of an investment more than triples.
For a person with a decent income, these decisions throughout a lifetime result in a seven-figure difference in the wealth you’ll have as you grow older.
How Not to Go Crazy
According to the Ten Rule, if you buy a new car today for $20 grand, then your future self is paying $200 grand. That $800 computer is $8,000. The $50 dinner for two is $500. Karate lessons for $150/month are $1,500/month.
This arguably makes everything look like it’s not worth it. It’s easy to see how someone who takes this to heart a little bit too well could go a bit too far over the crazy line into hyper-cheapness.
This is the kind of internal math that wealth-builders do compared to those that never seem to really accumulate a high financial net worth. But wealthier people are not necessarily happier, so it’s important to have the right balance of priorities that fits your goals.
Do a Satisfaction Audit
Figuring out what makes us happy before a purchase can save a lot of money over the long term. Before applying the Ten Rule (or the Three Rule) when making buying decisions, it makes sense to do an audit ahead of time.
For at least one whole week, keep a journal. Personally, I’m not much of a journal-type guy, but I can do anything for a week. So for seven days each evening, write down the happiest parts of your day. What were the peak moments? What were you doing and who were you with? Were the driving forces of that moment material possessions or experiences? During the audit, use an eighth journal entry to look back and write down the happiest dozen or so moments of your whole life. Ask yourself the same types of questions- who, where, what, etc. Were they material things, experiences with friends and family, or personal accomplishments?
Having this all down in writing gives something quantitative to work with. You’ve got hard proof now of what really makes you “tick”. For most of these peak experiences on the list, especially the lifetime ones, they’re experiences you probably wouldn’t undo even if they were more expensive, within reason. Price basically isn’t an issue then. The time you traveled to another country and it changed your perspective on everything- probably totally worth 10x what you spent. The first date with your partner- I doubt you’d eliminate that if it cost 1000x as much, let alone 10x. The guitar you bought and learned how to play on- basically priceless right?
These vary based on your interests of course, but the point is, there are essentially priceless things that blow past the Ten Rule. Looking forward, those are the things that will likely continue to pass the Ten Rule test. If there aren’t a lot of material possessions on these lists, then apply the Ten Rule hard to scrutinize them in the future.
Define “Enough” and Clarify Goals
As you read personal finance blogs and try to save and invest more money, what specifically are you looking to do with the rewards? Retire 10-15 years from now? Become a millionaire?
There are experimental banks where the interest generated from the savings accounts is pooled together and used to offer prizes to a subset of the savers. In other words, rather than earning a 1% return on your money, the bank pools the interest together and says, “three people win iPhones this month”. The goal is to emulate the popularity of lotteries to try to get people to save more. It’s a “no lose” lottery in the sense that their savings are safe; it’s just that the miniscule interest is pooled together in an offer that psychologically may increase savings rates among people.
The way to apply this concept to your situation is to think on the big side. You could just go by the numbers and realize you could be wealthy, you could have more freedom, you could travel more, but these answers are like the 1% compound interest since they’re predictable but maybe not acutely motivating. Another way to look at it is that if you had enough excess capital, you could do things like open your own business, live in another country for a year without thinking twice about the money situation, start your own charitable organization, and big changes like that (the “iPhones”, bigger events). Any of these things can be accelerated based on your risk tolerance or dedication, but having a healthy buffer of liquid wealth and cash flows makes them easier.
By thinking big about your potential opportunities several years from now, it can alter priorities and allow the Ten Rule to work its magic.
What about you? If you do the Satisfaction Audit, or you’ve already known the answer, what are your results? What things are priceless to you?
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Matt is the publisher of Dividend Monk, a blog that focuses on dividend stocks, as well as personal finance, index funds, value investing, and general economics. He’s also working on a new project called Stoic Insights, a personal development blog with an analytical focus on practical things like eating healthy, becoming more fit, enhancing productivity, and building wealth.[Photo by Cappellmeister]
