MAKE MONEY ONLINE POSTS: The Incredibly Valuable Role of Frugality in Investing

الثلاثاء، 28 نوفمبر 2017

The Incredibly Valuable Role of Frugality in Investing

My wife and I have no debts at all. We own our own house with no mortgage – we paid off the whole thing. We spend substantially less than we earn.

Taken those facts into account, people always ask why Sarah and I consistently make frugal choices. Why aren’t we going on great trips all the time? Why on earth am I driving a 14-year-old SUV? Why do we buy store brand… everything at the store? Why do we only have one television, one that has a huge flaw on the screen? Why do I wear shirts that are more than 10 years old? Why don’t we live in a McMansion?

The reason we do it is simple: It hastens and improves our retirement without sacrificing anything we really care about.

Our frugality is all about things of lesser importance to us. We actually prefer trips to national parks most of the time. I like driving my current car and hope to do so until it becomes unreliable. The store-brand stuff fulfills our needs. Our television fulfills our needs. My shirts are still in fine shape. Our house fulfills our needs and is already plenty big enough. We don’t need to spend money on “better” versions of things if we’re perfectly happy with what we have.

At the same time, spending less enables us to save more for retirement. Our frugality plays a key role in our retirement planning – in fact, I’d say it’s the single most important element. Not our investment choices. Not anything else. Our frugal choices are the most important pieces of our retirement plan.

People often shrug off that statement as crazy talk. Trust me, I’ve seen it: I’ve talked about retirement planning in casual conversation with people and they simply seem to not believe me at all when I say that frugality is probably the most important ingredient. Their immediate assumption seems to be that there is some super secret investment trick to retirement, or else people are just making a lot more money than they are. While both are helpful, frugality is the secret sauce that makes retirement click for most ordinary Americans.

Let’s dig in and see how this works.

A Normal Non-Frugal Retirement Strategy

Let’s look at Bill’s retirement planning. Bill is 25 years old. He makes $50,000 a year and saves 5% of his income for retirement – $2,500 a year. He puts it entirely in a retirement account that earns a 7% annual rate of return – basically in something like the Vanguard Total Stock Market Index. He does exactly this for the next 40 years. At the end of those 40 years, he’ll have $516,556 in retirement savings.

That’s not too shabby. At a 4% annual withdrawal rate, which should last him through the rest of his life, he can take out $20,600 per year which is a great supplement to his Social Security benefits (which I estimate to be $16,800 a year using this calculator). That means that, for the rest of his years, Bill will have $37,400 in annual income at a very low tax rate.

Pretty solid, huh? Well, let’s change the picture a little bit.

Adding a Bit of Frugality

Let’s now say that Bill figured out how to spend just $5 less per week. Just $5 – that’s like a single stop at Starbucks or taking leftovers to work instead of going out once every other week, or some mix of such options.

Over the course of a year (we’ll give Bill two weeks to spend money as he wishes), that frugality adds up to $250. So, let’s add that to Bill’s retirement contributions. He’s now saving $2,750 a year.

As before, Bill puts it entirely in a retirement account that earns a 7% annual rate of return – basically in something like the Vanguard Total Stock Market Index. He does exactly this for the next 40 years. At the end of those 40 years, he’ll have $568,211 in retirement savings. Because he chose to take leftovers to work once every few weeks and skip a morning latte every once in a while, Bill now has another $55,000 in retirement savings.

Bill didn’t use some secret ninja retirement strategy. Bill didn’t add a bunch of risk to his portfolio. Bill simply ate some leftovers a couple of times a month.

What did that change? Bill now can safely withdraw $22,700 per year rather than $20,600 – more than $2,000 a year more for the rest of his life. All because he skipped two morning coffees a month and drank whatever was in the office instead and brought in his lunch once a month instead of going to Panera or Applebee’s.

The Standard of Living Shift

Here’s another way of thinking about it. In the first example, where Bill isn’t doing anything frugal, Bill is living on $47,500 a year. When he retires in that case, his income will drop to $37,400 a year. (I’m not worrying about taxes in these examples as taxes will change significantly over the course of 40 years.) His income will drop by $10,100 per year.

Now, if Bill takes just a couple simple frugal steps (as I mentioned above), he’s now living on $47,250 a year. However, when he retires, his income will now be $39,500 a year. His income will only drop by $7,750 a year.

In other words, because Bill made just a couple small frugality adjustments in his life, he’s suddenly in a position where retirement becomes much less of a shock and he doesn’t have to give up nearly as much of his quality of life as he otherwise would. In fact, once the cost of going to work is eliminated, Slightly Frugal Bill will probably have very little lifestyle change at all, whereas Not Frugal Bill will likely have to pinch some pennies and give up some real things.

Again, all because Bill found a way to spend $5 less per week. He literally just cut out the least important $5 of his spending each week and it made an enormous quality of life difference in the last thirty years of his life.

Kicking It Up a Notch

Let’s say that Bill is really excited by this. He goes through his spending habits and realizes that he’s spending about $40 a week in ways that are completely forgettable. He stops drinking so much soda. He switches to store brand dish soap and hand soap. He stops buying the expensive shampoo that his barber shop pushes and finds that, with his short hair, inexpensive shampoo and conditioner do a great job. Just little things that are almost completely forgotten in the big scheme of things.

So, rather than cutting his spending by $5 a week, Bill is cutting back by $40 a week. Over the course of a year, that adds up to $2,000 in additional retirement savings on top of the $2,500 he was already saving.

What does this change about Bill’s financial picture? After 40 years of investing in the exact same way as in the story above, he’ll now have $929,801 in savings for retirement. That’s almost a million dollars.

If he takes the safe withdrawal rate of 4%, Bill will be able to take out $37,200 a year. Add that to his Social Security benefit of $16,800 a year and our friend Bill will have $54,000 a year in income. More Frugal Bill will actually be bringing in more money when he retires than when he was working.

In fact, if Bill just wanted to match his current income (after retirement savings) of $45,500 a year, he could retire at age 62 – three full years earlier – and take all of his living expenses out of his retirement savings for the first three years, then have a safe withdrawal rate for the next 30 years supplemented with Social Security to “bring home” $45,500 a year. (He’d have lower taxes at this point, too.)

Our pal More Frugal Bill is retiring three years earlier than expected and will have no drop in income for living expenses for the last 30 years of his life, and all he has to do is take a few little steps like buying store brand dish soap and cutting back on his soda.

What About Other Steps To Improve Retirement Savings?

Investment books and articles tend to focus on two other strategies as the main way to improve retirement savings.

One is simply to invest smarter. Countless articles and books have been written about various retirement investment strategies. In the end, however, they usually require one of several things that most individual investors don’t have: access to a hedge fund, early access to information (by the time the book is written, the strategy is probably played out), tons of time to spend on research, or a great deal of luck.

I tend to subscribe instead to the “index fund” philosophy, which basically says that the best strategy is to shoot for exactly average with the fewest fees possible. In other words, you ride the stock market as a whole all at once and do it as cheaply as possible. This means that you won’t experience tremendous spikes in value, but you also won’t lose your shirt – instead, you’ll stick very closely to the overall average of the stock market. Many investment houses offer index funds that allow you to do this at a very low cost – they essentially just buy everything in roughly equal amounts and thus it doesn’t cost much to manage them. An example of this type of investment is the Vanguard Total Stock Market Index.

Another common strategy is to simply use a Target Retirement Fund, which essentially follows the same philosophy. Target Retirement Funds are typically invested very broadly in a wide array of things and with little hands-on management – it doesn’t take a whole lot of management to just “buy everything.” The difference here is that these shift over time, moving your money from more risky things like stocks into less risky things like bonds as you reach retirement and start withdrawing. An example of this is the Vanguard Target Retirement 2050 Fund.

In other words, “investing smarter” for most ordinary people involves investing in something very broad based and cheap and just sitting on it. You’re going to be hard pressed to consistently beat that strategy, let alone beating it by enough to do better than being even a little frugal and putting that savings aside.

The other avenue for saving more for retirement is earning more so that you can save more. This is a very solid approach, but it often requires a long time to build to a higher income. You can’t just magically flip a switch and be earning 20% more – if that were the case, we’d all be earning millions a year.

Working toward improving your income is absolutely a laudable goal, and success in that goal is incredibly valuable and useful for retirement goals. However, it’s not immediate. The advantage that frugality has in this case is that you can start being frugal immediately. There’s literally nothing stopping you other than your own behavior and your own desires in your head.

Remember, one of the best possible strategies for retirement savings is to start saving now, because the power of compound interest will never be as powerful as it is when you are young. Every month, every year that passes by, the less powerful compound interest becomes.

Frugality is the only strategy that can amp up your retirement savings immediately through your own actions and choices. There’s really nothing else like it.

20 Things You Can Do to Boost Your Retirement Savings Now (and You Only Need to Pick Three of Them)

The best part about frugality is that it’s an a la carte strategy. You can check out a huge list of frugality tips, ignore 90% of them, implement the other 10% that are easy and fit into your life, and save yourself $50 or $100 or more a month.

The key, however, is that you must actually do something productive with that savings. If you take on some frugality strategies that save you $100 a month, you should immediately go to your workplace and increase your 401(k) contributions, or immediately increase your Roth IRA contributions, or open a Roth IRA and contribute $100 a month to it. Don’t let the savings go unused or you’ll find yourself spending that money on other relatively unimportant things.

So, here’s what we’re going to do. I’m going to share 20 really good frugal strategies. Each of these will cut a person’s spending each month by a notable amount. I want you to skip 17 of them. That’s right – if they sound hard, skip them. Choose three of them that feel like they would have very little impact on the quality of your day to day life.

Make those three strategies a reality. Keep track of how much you save following those strategies in a month, then simply adjust your retirement contributions by that much. That’s it! That’s all you have to do!

Even if the change is just $10 or $20 a month, it’s going to end up making a profound change in your retirement savings over time, provided you do it now. That’s the advantage of frugality – you can do it now. There are no excuses. You have the power.

Here are 20 straightforward frugality steps you can take.

#1 – Make a bunch of meals in advance, freeze them, and use them. Once a month, spend a Saturday afternoon making a quadruple batch of one of your favorite casseroles or soups. Put three of the batches in the freezer and eat them in the future on nights when you’d otherwise eat out – all you have to do is thaw them and finish warming them up, so it’s really easy. This eliminates three (or so) meals eaten out per month, so it adds up to significant savings.

#2 – Replace some of your routine household purchases with store brands. For most of your household supplies, like dish soap, dishwashing detergent, hand soap, shampoo, conditioner, shower soap, toilet paper, paper towels, and so on, try buying the store brand version instead of the name brand. You’ll save about $1 per item that you switch, on average. If you find that the store brand isn’t good enough, switch back next time, but for most of them, you won’t notice a difference.

#3 – Switch to all LED lighting at home. As you replace light bulbs around your house, buy LED bulbs instead of incandescent or CFL bulbs. LED bulbs last far longer and eat a lot less energy than incandescents, thus quickly recouping their higher initial cost. Compare your energy bill to a year ago and start socking away the difference.

#4 – Put a weather strip along the edge of any doors that leak air. If you have any doors that let in cold air in the winter or warm air in the summer along the edges, add a weather strip to block that air flow. It’s a simple DIY project that’ll take just a few minutes and it’ll significantly reduce your heating and cooling costs. Again, compare your energy bill to a year ago and sock away the difference.

#5 – Caulk the edges of any leaky windows. If you feel any cold air (in winter) or warm air (in summer) leaking in around the edges of windows, apply some caulk to the area where those leaks are occurring. Again, this is a simple project that takes just a few minutes and it can make a surprising difference on your energy bill. As before, comparing your bill to the bill from a year ago will show you the approximate savings.

#6 – Take leftovers to work. After supper, put together a simple meal in a reusable container such that you can just pop it in the microwave the next day, then sit that container in the fridge. The next day – or the day after – grab it on your way out the door to work, then eat it at work. You’re immediately saving several dollars versus going out to eat for lunch, having something delivered, or hitting a food stand or other convenient food option nearby.

#7 – Make coffee at home. There are tons of ways to make coffee at home in a convenient fashion that will drastically cut down the number of times you stop at a coffee shop to pick up coffee. Both a drip coffee pot and a cold brewing setup are incredibly convenient and make delicious coffee at home for a fraction of the cost of buying it at the coffee shop. If you can replace even one coffee shop stop per week with making a batch of cold brew at home, the savings are going to add up very quickly.

#8 – Drink filtered tap water instead of bottled water. We have good tap water here, so I almost never buy bottled water. Instead, I tend to fill up water bottles, keep them in the fridge, and grab them as needed. It’s cold and refreshing and costs just a penny or so. If you don’t have the best tap water and drink a lot of bottled water instead, you’ll save money very quickly by installing an under-the-sink water filter, which makes your tap water much better, or using a filtered water pitcher. The cost of replacing filters is far cheaper than the cost of buying endless bottles of water.

#9 – Use the library for “book shopping” or “movie shopping.” If you’re tempted to go shopping for a book or a movie or an audiobook, head to your local library instead and “shop” there. You can borrow anything on the shelves there for free, watch or read or listen to it, and then return it so it’s not taking up unnecessary space in your home once you’re done with it. It’s free, it saves space, and you’re still entertained!

#10 – Break a “vice” habit. If you smoke, stop. If you take drugs, stop. If you drink alcohol, stop. If you drink soda, stop. At the very least, trim your habit. Such consumable habits are the equivalent of burning your money – it just goes away, leaving you with nothing but worse health in very short order. It’s not worth it.

#11 – Write a meal plan and grocery list before you go grocery shopping. If you need food, spend the time to plan out your meals for the next several days on a sheet of paper or a whiteboard, then make a grocery list based on those meals. Use the grocery list at the grocery store and you’ll spend a lot less time at the store and buy far fewer incidentals and unnecessary items.

#12 – Stock up on holiday supplies right after a holiday instead of before. The best day to buy Christmas supplies like wrapping paper and so on is on December 26th. Everything’s on deep discount, so buy what you’ll need for the following year right then. The same is true for things like big bags of candy for Halloween on November 1 and so on.

#13 – Bulk buy nonperishable things that you use frequently. When buying items that you use frequently that don’t spoil – items like toilet paper or shampoo – buy it in large portions so that the cost per unit is the lowest possible. You can usually save quite a bit by buying 36 rolls of toilet paper at once or a jumbo jug of hand soap. Refill smaller containers out of the large containers of hand soap or shampoo so that you don’t overuse it.

#14 – Use the community calendar first when deciding on something to do. If you’re bored, don’t turn to expensive things like movie listings first. Instead, open up your local community calendar (usually found on your city’s website) and see what’s there. Check the calendar of any local universities as well. Quite often, you’ll find a number of free activities, and if even one of them is enticing, you’ve suddenly got free entertainment for the evening.

#15 – Cut the cable cord. Cancel your cable or satellite service and switch to a combination of Netflix, HBO Now, Amazon Prime, Hulu Plus, and free over-the-air HD television signals. A good strategy is to rotate those subscriptions and not have them all at once so that you can binge-watch all of their offerings, then move to another service, then eventually come back to one you’ve subscribed to before and catch up.

#16 – Switch banks. If you find that you’re not getting much of an interest rate on your checking or savings accounts, or, even worse, you’re getting dinged regularly for account maintenance fees or big ATM fees or other unnecessary fees, look into switching banks. See if there are any in your area that don’t have such fees associated with their account and then switch to that bank. Banks are in competition with each other – use that to your advantage.

#17 – Inflate your car tires to the maximum recommended amount once a month. This is such a simple free step that it’s well worth your time to take advantage of it. Keep a tire pressure gauge in your car, then once a mont, when you refill your gas, pull over to the free air pump at the gas station. Check the pressure in each tire and refill them all to the maximum recommended pressure (listed in your manual). Every single PSI you put into a single tire saves you 1/8% on your fuel efficiency, so if all of your tires are 8 PSI low (which is a common thing), you’re making your car 4% more fuel efficient for free.

#18 – Run your ceiling fans the right way. During the winter months, the blades of your ceiling fan should be running in a clockwise direction when viewed from the floor, while in the summer, they should be running counterclockwise. The direction is typically fixed with a little switch at the base of the fan. Having your fan running in the proper direction aids cooling in the summer and heating in the winter, making it feel more palatable even when the weather outside is extreme.

#19 – Lower your home temperature by a couple degrees in winter (and raise it by a couple in summer). Not sure about this? If you combine it with the previous tip and have the blades turning the right way on your ceiling fans, you’ll barely notice the difference in rooms where a ceiling fan is running. This simple change causes your furnace and AC to both run significantly less.

#20 – Master a handful of very simple “staple” meals. The temptation to order takeout becomes far less when you always have the supplies on hand for a simple meal or two that you love. For example, our family always has a jar of pasta sauce and a box of pasta on hand for a quick spaghetti meal, something we have a couple times a month. It’s a meal that either Sarah and I can assemble quickly, it’s very inexpensive (because we can always buy the items when they’re on sale and stock up), and it’s something our whole family likes. Find a few meals like that for you and your family and it becomes much easier to just make one of those instead of ordering food.

Final Thoughts

A frugal life provides the foundation for investing, no matter what your goal might be. Frugal choices enable you to start saving for your goals now rather than later because you control the action. You make the choice that gives you the money to invest with.

If you feel guilty because you’re not investing for retirement or for other goals, take a few frugal tactics, apply them to your life, figure out how much they’re saving you, and start investing that amount. You lose almost nothing from your quality of life, but at the same time you’re now working toward a powerful life goal and making real strides toward that grand destination.

Good luck!