We are constantly told that you must save for the future and while hearing this advice gets old fast, there is no doubting that it’s true. However, when you try and take action on this advice, it can often seem futile in nature. This is because most people use the wrong strategy when trying to save money and this misguided approach keeps them in financial straits for the majority of their lives. Because of this, I want to share with you the real reason you can’t save any money so that you can reverse course if presently you’re on the wrong saving path!
When most people start their savings journey, they take it slow and begin to cut out small expenses. One of the expenses that takes a lot of flack is your daily Starbucks coffee and in my opinion this is an expense you can definitely do without. So, for those who see saving as a bigger priority than getting an expensive caffeine fix, these types of expenses are the first to go. However, for many hopeful savers, these menial expenses are the only ones to get cut as they try and adopt the latte factor approach to saving and investing. But, why is that?
Author of popular personal finance books like the Automatic Millionaire and the Latte Factor, David Bach, suggests that simply cutting a routine expense like your Starbucks latte is enough to dramatically change your financial future. He argues that using that coffee to invest, when earning a 10% return, will grow to $950,000 in 40 years. Now, obviously this advice doesn’t just pertain to lattes. You could cut out the cost of buying your lunch one day a week or eliminate your weekly cigarette habit. At the core, Bach is not wrong by advising people to lower their costs however when taking this exact advice at face value and not diving into the intricacies of this plan, it can set many savers up for failure.
In fact, there are three primary reasons why only cutting small expenses will not grant you the riches you were led to believe you would eventually have. The first is the cost of the item you are eliminating. This investing method and promised $1,000,000 future value depends on you saving and investing $5 a day. However, unless you are ordering a deluxe drink from your favorite café then chances are you are not going to be saving a whole $5 but $2.50 or $3 instead. And based on simple logic, if you aren’t saving and investing the same amount of money that this calculation requires you to then there is no way you will have that $1,000,000 you’ve been promised 40 years from now.
The second factor when trying to save an appreciable amount of money via minor expense cutting is what you invest that money into. Under the $1,000,000 in 40 years premise, the expectation is that you are putting all that extra money into stocks however as you already know, a well-thought out portfolio will include a mix of different assets as holding only stocks is rather risky by nature. According to the “rule of 110” used by most experts today, the percentage of your assets you have in stocks should be roughly equal to 110 minus your age, adjusted up or down based on your risk tolerance. Even a 22-year-old wouldn’t start out with 100% in stocks, and no one would remain 100% invested in the stock market over the course of 40 years. And if you aren’t investing as aggressively as is recommended in this plan, then you will not achieve the returns you desire which again reduces how much you can save over time.
The final element are inevitable financial factors of inflation and taxes. Over the timespan of 40 years, your investments could erode due to inflation by up to 67% so even if you could achieve the returns you would need to accumulate $1,000,000 by cutting small costs, that $1,000,000 would not have anywhere near the buying power it has today. Not to mention if you are investing through your 401(k), when you pull out the money you will be taxed which again detracts from the money you can take out and enjoy.
If you correct all these errors, the total return on your latte elimination strategy looks a lot less impressive. Let’s start out by assuming your daily latte costs $3, not $5. You divert this money into a balanced portfolio of stocks and bonds, which has an average annual return of around 7%.
Take out 15% for taxes, and after 40 years of diligent saving, you’ll have about $80,000. Adjust for inflation of 3% per year, and the actual buying power of your investment shrinks to around $24,500. That’s nowhere near the $950,000 we initially talked about — and not much to show for 40 years of caffeine deprivation.
Another fundamental flaw with taking the approach of reducing your frivolous spending in order to build your wealth is assuming you are making these purchases in the first place. You see, many people simply cannot spend $3 or $5 on lattes every day meaning that this is not an area they can use to increase their savings. Sadly, many Americans can barely cover their core expenses and these expenses should be the starting point when trying to save an appreciable amount of money.
You see, if you want to save a considerable amount of money, you need to leverage the 80/20 principle. This means considering what 20% of your expenses make up 80% of your costs and using those costly items to try and build up your savings efforts.
Therefore, let’s look at three large cost categories and how you can find ways to reduce their financial impacts so you can save more money.
Number 1: Housing
Making up 37% of the average American’s monthly costs, this expense category offers the biggest opportunity for increasing your savings. However, unlike more trivial spending categories like entertainment and clothing, housing isn’t a cost you can eliminate completely. It’s for this reason that you need to be smart about your housing decisions. If you currently don’t own a home and are looking to purchase one then my first suggestion is to take on a property you can easily afford. The income rule is a great rule of thumb to follow and it states that you should not buy a property that is any more than 3 times your annual income but just to be sure you can afford it I would suggest you do some quick math on what your living costs would look like if you were to buy that property.
If you are renting, the obvious thing to do is look for a cheaper place. Even when renting, all too often people get sucked into taking on a lease they can’t afford because they want to have a fully upgraded apartment or have one located in the best area of town. While it’s nice to have a high-end living quarters, this benefit needs to be balanced with how it will support you reaching your financial goals.
Number 2: Transportation
We all need to get from point A to point B however not everyone does this in the most economical way possible. It’s for this reason that transportation typically makes up 18% of a monthly budget. Luckily, there are numerous ways to cut down on these unavoidable costs. If you’re looking to buy a car, then what I recommend is to follow the 20/4/10 rule when deciding on which car to buy. This rule states that you should put down at least 20%. Also, you should finance the car for no more than four years and most importantly spend no more than 10% of your monthly gross income on transportation costs.
Another way to keep your transportation costs low is to pay cash and for many people this means buying used. This strategy is great for a few reasons. First, paying cash allows you to avoid paying interest on the purchase which is quite literally wasted money. Second, paying cash means no car payments so each month your beloved used car stays on the road it is essentially writing you a $500 check which is the average price of a new car payment these days.
However, the best way to reduce your monthly transportation costs is to not drive at all. Taking public transit, walking or working from home can all save you a lot of money and in many cases can help you get in some great exercise at the same time. Therefore, there are numerous ways to reduce your transportation costs if you are willing to give up a bit of convenience.
Number 3: College
Besides the ongoing expenses of housing and transportation, one that can act as a massive roadblock in your saving journey is college tuition. Typically, going to college will cost tens of thousands of dollars but gaining an education doesn’t have to be this pricey if you do things right. Some options to reduce these expenses include taking advanced courses in high school to reduce the number of credits you need to complete at college, attending a low-priced community college instead of an out of state school and taking advantage of all available grants and scholarships. Also, don’t overlook the fact that not everyone needs to go to college but if you decide to attend, make sure its for a program that you will not only love but will offer you promising job prospects upon graduation.
Now that you know where to look to start saving more money, you should be well on your way however there are some people that to save faster and for those people I want to offer one final piece of advice. You can only reduce your costs by so much but when it comes to your earnings, the sky is the limit. In short, if you want to start saving real money you need to increase your income.
Having an adequate income can come in a few forms. One way is by taking the right educational path and getting a job that offers a competitive salary. We all know that professions like medicine, law and engineering offer above-average wages and luckily even if these options don’t appeal to you there are plenty of others that might.
However, if you’re already in your career and have realized it’s not a field that will pay incredibly well, you can always see if you can move the needle by discussing the potential for a raise or promotion with your boss. However, in order to pull this off you need to keep a few factors in mind.
First, you need to ask at the right time. Asking for more money when the company is experiencing tough economic times clearly isn’t going to work.
Next, you need to do your homework on what comparable positions are paying in your city. If you ask for an unreasonable raise, your chances of success will be slim to none. Then, you must have a list of all the good work you’ve done. Maybe you’ve increased sales in the past year or have developed ways to improve the processes at your company. These accomplishments will act as the support you will need to convince your seniors to open up their wallets.
Finally, you need to have your negotiation skills finely tuned. Even with all this preparation done, there is a chance your boss doesn’t go for your proposal, so you need to be able to adjust on the fly and drive home why you deserve a bigger paycheck. It’s only once you start earning more money that you can use that extra income to supplement your savings which will have you in a much better financial position than simply cutting out a coffee from time to time.