An old song says “Love is like a faucet … it turns off and on”.* I’m not so sure about love being like a faucet, but I do know that spending is like a faucet. It can be turned off and on. Or it can be set to any level between the off and on extremes.
We can extend the imagery a bit. Let’s say the spending faucet is attached to a water tank.
- Income is like water flowing thru a pipe into the tank.
- Spending (in other words, buying things that are sure to decrease in value, such as automobiles, clothes, food, furniture, etc.) is like water flowing out of the tank through the spending faucet.
- Wealth, the accumulation of money, is like the amount of water in the tank.
Spending = Income
Is your situation like the first image? Money is flowing into the tank (as income), but it’s flowing out (as spending on things that quickly decrease in value) just as quickly. The tank will never be filled. There will never be any accumulation of wealth. This will be true as long as Spending = Income.
Note that as long as Spending = Income is true, the tank will never be filled — no matter the amount of income. This first image could represent a person with an income of $20,000 per year and spending of $20,000 per year. Or it could just as well represent someone with an income of $20,000 per day and spending of $20,000 per day. No matter how high the income, people who spend all they earn — people who are unable to live below their means — will never have wealth.
Sadly, this is how many people live their whole lives. They wonder, like Senator Hoar, why they can never get ahead. In some cases, I believe, people are doomed to financial failure because they can’t even imagine that there is any other way to handle money. Perhaps because they’ve never been taught. Perhaps they had no mentor, no example.
Consider the case of many former professional athletes. There are hundreds of former professional athletes who each earned many times what I will earn over the course of my entire life. Yet just a few years after their playing careers were over, they had no money. Incredible as it seems, my net worth (a relatively small amount of money) is more than theirs and there’s a good chance that the net worth of these former millionaires will never again exceed mine.**
Spending < Income
The second picture is clearly different. The tank is filled, representing an accumulation of wealth. Look at the picture for a moment and you’ll see why the tank is filled, and will stay filled: The spending faucet has been adjusted so that spending has been reduced. Spending is now less than income (Spending < Income).
Also notice that the tank has another pipe. The new pipe leads to saving and investing. We can think of the tank as a checking and emergency savings account at a credit union or bank. The saving and investing pipe leads to retirement savings accounts, stocks, bonds, IRAs, 401-Ks, and other investments. (It’s a good idea to have different accounts for money that is intended for different purposes.) Buying shares of stocks or mutual funds might be thought of as “spending” but there’s an important difference: it’s buying things that have a good chance of increasing in value and paying dividends or interest.
If your personal financial situation is like the second picture, then you have learned the lesson of living below your means and allocating part of your earnings for savings and investment. If your situation isn’t like the second picture, then there’s an important lesson you need to learn. Start today.
Here’s another image, which is the best way to think about your financial plumbing. It’s basically the same as the second picture. You can see that Spending < Income because the tank is full. But, by using the pipe at the bottom to represent saving and investment, and the pipe at the top to represent spending, the third picture represents the application of another important principle, which is, “Do not save what is left after spending, but spend what is left after saving” (Warren Buffet).
** There are also people who are even worse off than those who spend all they earn. There are people who are in the category of Spending > Income. Through borrowing, they actually spend more than their income, finding themselves with debt and compounding interest on the debt. I can’t find a way to illustrate this with a picture of water going into a tank. Spending > Income may be possible for a short time but is completely unsustainable over the long term. The sooner they stop spending more than they earn, the better off they will be.