Level I: It’s not just about spending
Get yourself a nice, crisp one of these:
Or one of these:
Or one of these:
Now prop it (or them) up on the table in front of you, or in your imagination, and give some thought as to what it means to you. For instance….
- You might think about what you could buy with it right now. $100 buys a very nice dinner for two at a good restaurant. A fancy pair of sneakers. A tank of gas for your big-ass pick ’em up truck. A few bags of groceries. Maybe a nice sweater? I dunno. I don’t buy much stuff, so this is hard for me. I did just buy a $119 LL Bean bed for my dog. It’s going back. He won’t sleep in it.
- You might think, Hmmm I could invest this money. The stock market returns somewhere between 8–12% a year on average. I could spend that each year and still always have my $100 earning more for me.
- Or you might think, but inflation and market drops are a concern. Hmmm, I’ll invest my $100 but only spend 4% a year. Any extra earnings I’ll re-invest so my $100 grows and the money it throws off keeps pace with inflation.
- Or you might think, I’ll invest this money and I’ll re-invest what it earns and re-invest what that earns and years from now, after the power of compounding has worked its magic, I’ll think about spending.
You can probably come up with other variations (and if you do I hope you’ll share them in the comments) but looking at these it’s easy to see that one view will keep you poor, one will get you in the middle class, one will elevate that a bit and the last will make you rich.
Consider: Mike Tyson
Mr. Tyson was one of the most intimidating and formidable boxers of all time. Few have mastered the Sweet Science better. The Dismal Science, not so much. After earning some 300 million dollars, he wound up bankrupt. A lifestyle reputed to cost some $400,000 a month didn’t help. And as is always the case with the suddenly wealthy and financially unaware, I’m sure he was surrounded by sharks looking to bite off chunks of that fortune for themselves. But the root problem is he apparently only understood money in terms of buying stuff.
I don’t mean to pick on Mr. Tyson. (I’m not NUTS after all.) In this, he is not alone. The world is filled with athletes, performers, lawyers, doctors and business executives and the like who have been showered with money that flowed right off them and into the pockets of others. In a sense, they never really had a chance. They never learned how to think about money.
It’s not hard. Stop thinking about what your money can buy. Start thinking about what your money can earn. And what the money it earns can earn. Once you begin to do this, you’ll start to see that when you spend money, not only is that money gone forever, so it the money it might have earned. And the money that money might have earned. And so forth.
Clearly, none of this is to say we should never spend money. Rather it is to fully understand the implications when we do. Consider buying a car for, let’s say $20,000. For even the least financially sophisticated it should be obvious that if you buy the car you no longer have the 20 grand. I sure hope so, anyway.
But, distressingly, it appears that most people don’t understand that in choosing to lease or borrow money to buy the car they are basically saying, “Geez. I don’t want to pay twenty thousand dollars for this car. I want to pay much, much more.” My guess is that if you are reading this blog you are already more financially aware than most and you get that. Debt makes anything cost more.*
Level II: Consider Opportunity Costs
But what you might not have considered, and what I’d like you to look at today, is the concept that even paying cash, that car is going to cost you far more than $20,000. There is an opportunity cost to no longer having that money available to work for you. And it’s easy to quantify.
All you need do is select a proxy for how the money could be invested and earning for you. Since I am forever talking about VTSAX, let’s use that.
Since VTSAX is a total stock market index fund and the market provides average returns of 8–12% annually, we have a tangible number to compare. Let’s use the lower end of the range: 8%.
At 8% 20k earns $1600 per year. So your 20k car actually costs you $21600. But that’s just the first year, and of course you are suffering this opportunity cost every year. Over the 10 years you might own the car, that’s $16,000. Now your 20k car is up to 36k.
But that’s really still understating things. We haven’t even considered what those annual $1600 chunks could have been earning themselves. And what those earnings could then have been earning. And what those….
Oh, should you not already be depressed enough about all this, remember that the $20k is gone forever and so is the $1600 in lost earnings year after year with no end. Expensive damn car.
You have probably heard of The Magic of Compounding. In short: “The money you save earns interest. Then you earn interest on the money you originally save, plus on the interest you’ve accumulated. As your savings grow, you earn interest on a bigger and bigger pool of money.” It’s a beautiful thing.
Think of Opportunity Cost as its evil twin.
One of the beauties of being financially independent (FI) is that by definition you will have enough money so that the power of Compounding is greater than the Opportunity Cost of what you spend. Once you have your F-you money, all you need do is make sure you continue to reinvest to outpace inflation and keep your spending below the level your stash can replenish.
But if you are not yet FI and you see this as an attractive goal, you’ll be well served to look at your spending though the prism of opportunity cost.
Level III: How to think about your investments
Warren Buffett is rather famously quoted as saying:
Rule No. 1: Never lose money.
Rule No. 2: Never forget rule No. 1.
Unfortunately, too many people take this at face value and then leap to the conclusion that Mr. Buffett has found a magical way to dance in and out of the market avoiding the drops. Not true.
In this interview you can listen to exactly what he says about this: You can’t successfully dance in and out of the Market. My favorite line appears at ~1.34:
“The Dow started the last century at 66 and ended at 11,400. How could you lose money during a period like that? A lot of people did because they tried to dance in and out.”
The truth is during the crash of 2008-9 Buffett lost about 25 billion dollars, cutting his fortune from $62B to $37B. That left over 37 being the reason I was wandering around at the time irritating friends by saying, “Gee. I only wish I could have lost $25 billion!”
What Buffett didn’t do is panic and sell. In fact, he continued to invest as the sharp decline offered new opportunities. As the market recovered, as it always does, so did his fortune. So did the fortunes of all who stayed the course.
Now there are likely many reasons Mr. Buffett didn’t panic as that 25 Billion Dollars and all the potential it represented slipped away. Having $37 billion left surely helped. But another key is probably how he thinks about the money in his investments.
Also rather famously, Mr. Buffett talks in terms of owning the businesses in which he invests. Sometimes in part as shares and sometimes in their entirety. When the share price of one of his businesses drops, what he knows on a deep emotional level is that he still owns precisely the same amount of that company. As long as the company is sound, the fluctuations in its stock price are fairly inconsequential. They will rise and fall in the short-term, but good companies earn money along the way and in doing so their value rises relentlessly over time.
We can learn to think in this same way. Again, let’s use VTSAX in exploring this idea.
Suppose yesterday you said, “Hmm. This idea of owning VTSAX makes sense to me. I’m gonna get me some.” And having said that, you sent Vanguard a check for $10,000. At yesterday’s close the price of VTSAX was $41.16. Your $10k bought you 242.9543244 shares.
If a week from now VTSAX shares are trading at 43, you might say “Hmm. My $10k is now $10,447. Yippee. That jlcollinsnh sure is smart.”
If a week from now the shares are trading at 40, you might say “Damn. My $10k is now only $9718. That jlcollinsnh is a bum.”
That’s the typical way average investors look at their holdings. As little slips of paper or, more accurately in this day and age, little bits of data that go up or down in value. If that’s all they are, drops in the price other people will pay you for them on any given day can be very, very scary.
But there is another better, more accurate and more profitable way. Take a few moments to understand what you really own.
At 43 per share or at 40, you still own the same 242.9543244 shares of VTSAX. That in turns means you own a piece of virtually every publicly traded company in the USA, 3317 last time I checked.
Once you truly understand this, you’ll begin to realize that in owning VTSAX you are tying your financial future to that of virtually every publicly traded company based in the most powerful, wealthiest and most influential country on the planet. Companies filled with hard-working people focused everyday on prospering in the changing world around them and dealing with all the uncertainties it can create.
Some will fail, losing 100% of their value. Actually, they don’t even have to fail and lose all their value to fall off the index. Just dropping below a certain size or what’s called “market cap” will be enough.
Those will fall away and be replaced by other newer and more vital firms. Some will succeed in a spectacular fashion growing 200, 300, 1000, 10000% or more. There is no upside limit. As some stars fade, new ones are always on the rise. This is what makes the index, and by extension VTSAX, self-cleansing.
If I were to seek absolute security (a very different thing than the smooth ride most mistake for safety), I’d hold 100% in VTSAX and spend only the ~2% dividend it throws off. Or maybe a variation like the last portfolio option I describe here.
Nothing is sure, but I can’t think of a surer bet than this.
In Closing:
We live in a complex world and the most useful and powerful tool for navigating it is money. It is essential to learn to use it. And that starts with learning how to think about it. It is never too late.
Oh, and somebody please send Mr. Tyson a link to this site. It’s not too late for him either.
Addendum I:
Over on Street Smart Finance, Shilpan just published a very nice interview with Mr. Money Mustache and me. In the introduction he refers to me as “someone as financially savvy as Mr. Bogle.” That would be Jack Bogle. As in the founder of Vanguard and the inventor of index funds.
While I’m as prone to wallow in praise as the next guy, this is more than a bit over the top. I just write about the things Mr. Bogle created. A candle in comparison to a wildfire. But I’m honored that anyone would see even a candle’s worth of the same flame in me as in him.
If you care to, check it out here.
Addendum II June 30, 2013:
*Shilpan of Street Smart Finance just sent me this great Ted-Talk We Need to Start Hating Debt Again. An 14 eye-opening minutes.
