“The single largest expense you'll pay in life is interest…because you don't save enough and demand a lifestyle you can't actually afford. The future owns your income.” – Morgan Housel of the Motley Fool
President Obama recently announced a new savings program that will be launched by executive order called the “myRA” in an effort to encourage Americans to save more. The details on the new plan are still a bit fuzzy, but in essence it will work much like a Roth IRA that is solely invested in US government savings bonds. The goal of the program is to increase the savings rate amoung working lower and middle class Americans. Whether or not this program will gain any traction remains to be seen, but the fact remains that as a country, US citizens are not saving enough money for future needs. One of the reasons the savings rate here in the US is so low is because we have become a “microwave generation” armed with credit cards to buy what we want, when we want it, with little to no concern about if we can afford it.
Even though we spend the majority of our time researching and writing about investing related topics, saving must precede investing and is therefore equally if not more important to the overall goal of having a nest egg in retirement. As such, we decided to dedicate this and next week’s Insights to the topic of saving rather than investing money. There are two key concepts one must fully understand and embrace in order to successfully save money for the future.
The key to saving money is embracing the idea of delayed gratification. Delaying gratification means saying no to things that we don’t really need or can’t afford today in order to provide for a better future by saving money rather than spending it. The US savings glut is a relatively new phenomenon. Some of the blame can be put upon the rapid expansion of consumer credit and mastery of human psychology in marketing and advertising.
In generations past, when someone wanted to buy something they had to be very intentional about saving enough money to be able to afford the purchase. Today, it takes nothing more than swiping a piece of plastic. To make matters worse, marketing and advertising firms have become experts in human psychology, which empowers them to refine and craft their messaging in just the right way to spark our desire of want. It is important to note that credit card companies and advertising firms are simply playing their role in a capitalistic society. Nothing they are doing in and of itself is wrong, but their goal is to increase their own revenues by promoting spending rather than saving. All that to say, consumers today face a much tougher challenge when it comes to saving money than generations past. In order to have the discipline to delay gratification, one must understand the second key to saving money.
Miracle of Compound Interest
No one is born with an inherent understanding of compound interest and unfortunately, not enough of us are taught its principles. As an example, if someone were to offer you $1 million dollars or an account with 1 penny in it which doubles every day for a month (30 days), which one would you chose? My guess is that most people, without working through the math, would take the million dollars, but the account that starts out with a penny is worth more than $10 million at the end of 30 days. Now no (legitimate) investment doubles every day, but the metaphor is still a salient example of the power of compounding.
Compound interest works for those that save and invest and against those that spend themselves into debt. The two sides of the compound interest coin were perfectly summarized by Albert Einstein.
Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.
It is very expensive to live a life on credit because doing so not only precludes someone from using compound interest to their advantage by investing their saving, but it also steals from their future as the interest owed on the utilized credit compounds unless it is paid in full. As if paying 20% interest on credit card debt wasn’t bad enough, the real cost of that debt is actually much higher because there is an opportunity cost to dedicating income and savings to paying off debt versus having those savings invested.
To further solidify this statement, let’s look at another example. The table below shows two theoretical income and expense streams for Individuals A and B. A makes a lot more money than B but also spends 10% more than he/she earns for the first ten years before “getting serious” about retirement and drastically cutting his/her expenses down to 75% of their income for the remaining twenty years. B makes significantly less money but lives below his/her means and saves 20% of his/her earnings from day one. For simplicity we assume both the return on the savings and the cost of the debt are the same at 10%. Over the course of 30 years, A overspent by $200,000 for the first ten years and then saved $1,000,000 over the remaining 20 years for a net savings of $800,000 while B saved a total of $450,000 ($15,000 * 30 years). Even though A made more and even saved more money than B over the 30 year period, B’s savings were much higher than A’s due to the miracle of compound interest.
Saving for the future takes a high degree of discipline to say no to our inherent wants and desires. The decision to delay gratification today has an exponentially large impact on the future due to the power of compound interest, but making that decision today means the future won't own your income tomorrow. Next week we explore some tools that can help people save more money by having a better understanding of where money is spent and establishing a budget to live within our means.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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