Latte Factor vs Saving on the Big Things

If you read books and websites about personal finance (especially topics like early retirement, financial independence, etc.), you might have seen articles about how much money you can save by consistently saving on little things, like your daily coffee.  One personal finance guru has an online calculator.*

Then there are others who say don’t sweat the small stuff and focus instead on the big things; instead of trying to save money on by modifying your coffee habit, try to save money on your house and your car.

latte_factorFirst, I want to point out that you need to be careful how you calculate how much you will save.  I’ve heard or read statements like, “Coffee at the Starbucks costs $2.70.  So make your own and you’ll save $1,000 per year”.  How did that $1,000 get calculated?  It looks like they took $2.70 per day and multiplied by the number of days in a year, $2.70 × 365 is $985, and then rounded to $1,000.

What’s wrong with that savings of “$1,000”?

  1. Can you produce coffee at home for free?  If not, then your daily savings aren’t going to be equal to the cost of the coffee you buy away from home.  Coffee made at home costs something.  Your savings will be the cost of the away-from-home coffee minus the cost of made-at-home coffee.  Let’s say $1.00 is the cost of the made-at-home coffee.  If so, then your savings are $2.70 – $1.00 = $1.70.  You savings will equal the cost of away-from-home coffee only if you give up coffee completely.
  2. Do you really buy away-from-home coffee every day of the year?  If you only buy one cup of coffee on days you work, and you don’t work every day of the year, then you probably don’t buy coffee more than 250 times per year.  (That’s 5 days a week × 50 weeks per year.)  Of course, if you buy coffee twice a day, …
  3. Does the coffee at Starbucks really cost $2.70?  If you order something less expensive, you’re annual savings aren’t going to be less.  (On the other hand, yes, if your coffee costs more than $2.70 per day, then you can save more.)

Don’t get me wrong!  I still think that you can save a significant amount of money by avoiding convenience and doing as much DIY as possible, but it’s also important to do our calculations honestly and make sure our expectations are in line with reality.

Second, there are some people who say that they give up the away-from-home coffee, but they don’t see the savings.  Problem is, there are so many other expenses.  Some come irregularly or change from one month to the next.  It’s personal finance chaos!  The made-at-home coffee savings signal gets drowned out among all the financial noise from all the other expenditures.  This, however, doesn’t mean that there are no savings.  There are.  It’s the accounting that is the problem here.  If you’re actually spending $1.00 per day instead of $2.70, then you need to take control of that money and ensure you don’t spend it on something else.  Take that daily savings of $1.70 and literally put a dollar and a few quarters in a jar every day.  Or move $8.50 from out of checking and into your savings account each week.  Whenever you’re developing new habits to save money, you need to really save that money.  Be careful not to let it just sit around telling you to spend it on something else!

Now that we’ve taken care of that …

The “Latte Factor” is one presentation of the little-things-add-up-to-big-things philosophy.  “Watch the pennies and the dollars will take care of themselves” is another way to say it.  This way of thinking has plenty of proponents, myself included.

As mentioned above, you’ve probably also seen articles about how much you can save on the big things.  At least one expert says, “forget all that little stuff, I’ll show you how to do big things and once you do them you won’t need to worry about the little things” [my paraphrase].  Save on the big things, and you won’t have to worry about the little things, the thinking goes.

So, we have a debate: Which is better?  Saving money by consistently reducing or eliminating spending on a small purchases (e.g., fancy coffee like latte that you might purchase 200 to 250 times per year) … or … saving money on a big purchase (e.g., a car or your house that you might have only several times in your life) and the semi-big expenditures like cable television, telephones, and credit-card interest?

Well, it seems to me, it’s not an either-or proposition.  There’s no reason you can’t save on both the small things and the big things.  In fact, in my opinion, saving on the small things is good training for saving on the semi-big and big things.  Kind of like in professional sports, start in the minor leagues and then move up to the majors.  It reminds me a bit of the sentence in “The Richest Man in Babylon” where Arkad says, “If I set for myself a task, be it ever so trifling, I shall see it through. How else shall I have confidence in myself to do important things?”

Set yourself the task using your habits of frugality, efficiency, and economy to save money on the small things and you’ll find you can also save money on the big things.


* I’ve experimented with the calculator at http://davidbach.com/latte-factor/ and have found that the weekly and monthly calculations do not match (aren’t even close) to results I get with other online compound earnings calculators.  However, the daily calculations are consistent with other results.

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Remember the Ant and the Grasshopper

A few years ago, I saw “The Grasshopper and the Ants” (Disney’s short film of 1934, also available in various book, audio, and video formats, based on Aesop’s fable, “The Ant and the Grasshopper”) and I was reminded how well Aesop’s fable, even in Disney’s presentation, teaches a valuable lesson.

grasshopper_and_ants

Aesop observed nature, which to him seemed to show that ants are industrious insects who work all summer and thus have plenty of food set aside for winter.  Grasshoppers, on the other hand, spend their summers frolicking and making music, and come winter are seen withered and dead.

When I first heard this fable as a child, I am sure I grasped the idea that we need to work during the summer so we have food in the winter.  My mother grew up on a farm and I visited her parents’ farm enough to get some idea of the cyclical seasons of farm life.

But when I saw Disney’s  “The Grasshopper and the Ants” recently, from a vantage point well past life’s mid-point, it suddenly seemed clear that the message, the real moral of the story, doesn’t pertain only to the seasons of a single year, but rather to the seasons of an entire life.  During the spring, summer, and fall of life, you work, gather, harvest, and save (you know, pay yourself first) … and during the winter of your life, what you have set aside provides security and enjoyment.  Or, be like the grasshopper: play, spend and set nothing aside when you should and suffer the consequences later.

One more thought: Some commentators say that the Disney version changes the meaning of Aesop’s original fable because instead of leaving the grasshopper to starve, the ants invite him in to share their food and hospitality.  I think this is partially moderated by two things.  One, sharing is part of the enjoyment that can be derived from having.  Two,  in return for his supper and a place by the fire, the grasshopper is obliged to make music for the ants, literally to sing for his supper; this shows he might have finally learned the fable’s moral.

Here’s an English translation of Aesop’s original:

aesop_ant_grasshopperaesop_ant_grasshopper_2

Accounting For Different Kinds of Accounts

savings_bank

Different kinds of accounts where you can keep your money … and how to use them.  This is the way I do it.

Checking account (for day-to-day expenses).  Even if it’s only used to fund ATM withdraws, debit-card purchases, and online bill paying, everyone should have a “checking account” — despite the fact that many people don’t even have blank checks these days, and the last time I purchased blank checks I probably got enough to last the rest of my life.  A checking account is for your usual day-to-day bills.  It should have enough money to cover transfers to your savings account (pay yourself first) as well as your regular monthly expenses, such as the rent or mortgage payment, and bills for utilities, groceries, transportation, and other things that you pay for every month.  Whatever spending comes out of your checking account should be replenished by income coming in.  (Did you see the post about how the money in your checking account is like a tank of water?)

In addition to your checking account for expenses that come due every month or more frequently, you should also have separate accounts for expenses that come less often.  The first three, like the checking account, should be at a bank or credit union.  The last one should be with a mutual fund company so the money can be invested in stocks.

Short-term savings (once-per-year expenses).  Money set aside for foreseeable and predictable expenses that come once per year, such as birthdays, holidays, and vacations.   

Medium-term savings (once every-several-years or just a few times per lifetime).  Money for foreseeable, but perhaps not predictable, expenses that come less often than yearly, such as an automobiles, refrigerators, heating and air conditioning systems, washers and dryers, or new roofs.  Other medium-term savings goals might include weddings, houses, college educations for your children, or starting a business.   

Emergency savings (unexpected expenses).  For unforeseeable expenses: accidents, medical problems, periods of unemployment, and special opportunities.

Long-term savings (once in a life).  For foreseeable expenses that come just once in your life, such as buying your dream house and retirement.

“Compound Interest” vs “Compound Earnings”

dividend_stocksRepeatedly I see the term “compound interest” used to describe the growth of stock market investments.  I think this is incorrect.

Strictly speaking, you only get interest from bank deposits and bonds.  If you invest any interest you earn by depositing it in the bank or buying more bonds, then you earn interest on the interest — and that’s compounding.

If you invest in stocks, you (might) earn dividends.  If those dividends are reinvested by using them to buy more stock, then you will start earning dividends on the dividends  — and that’s compounding.  But because there is no “interest” earned on stocks, I don’t think it’s right to call it “compound interest”.

Henceforth, I suggest we use “compound interest” only for investments in bank deposits and bonds … and we use “compound dividends” for investments in stocks.  We can also use “compound earnings” in a general way to refer to any investments that grow as their earnings are reinvested in the same investment.


A little further explanation:

The interest you get from bank deposits and bonds arise from a contract: you deposit your money in the bank or you buy a bond (in both cases you are, in effect, lending money and the borrower is agreeing to pay you interest), and the bank or bond issuer is legally obligated to pay you the stated interest and return your money (the principal) to you.

The dividend you get from owning stock is a portion of the profits to which you are entitled because by owning stock you become a partial owner of the company in which you purchased stock.  However, dividends are not guaranteed as there might not be any profits or what profits there are might be used for something other than dividends, such as expansion or development of new products.

The “Nest Egg”

People use the term “nest egg” to refer to their life savings, their retirement savings, what they will live on after they stop working.  “Nest egg” can also refer to any long-terms savings that are accumulated over time for a specific purpose.  I wonder how many people know the origin of the phrase.

nest_eggsAmong people that raise chickens, especially those in the egg business, it has long been known that leaving an egg in the nest will encourage hens to lay more.  Maybe even get a hen started if she hasn’t laid yet.  The practice of leaving an egg in the nest gives us “nest egg” — the nest egg is the egg that’s left in the nest.  Nest eggs don’t necessarily have to be real eggs.  Wooden or ceramic eggs seem to work just as well.  The principle is the same: the egg farmer doesn’t eat or get rid of the nest egg.  The nest egg is quite similar to “seed corn”, the seed that is saved from one year’s harvest for the next year’s planting, rather than being sold or otherwise used.  (Maybe there’s some reason we don’t refer to our live savings as our “seed corn”, but I don’t know what it is.)

Thus, the next egg is something akin to what economists call “capital”: money or some other asset that is used to make money.  Eat your nest egg, and you’ll have fewer eggs.  Eat of your seed corn and there’s no crop next year.  Spend your retirement savings, and it won’t be there to provide for you when you need it.

The Saving Road to Independence

Here’s inspiration from a century ago from The Baltimore and Ohio Employees Magazine (February 1916):

The Saving Road to Independence

For Men and Women of Limited Salary

DEBTS accumulate rapidly. Savings accumulate just as rapidly! It’s therefore a matter of determination, first, whether it shall be savings or debt.

Money will either serve or rule you. The minute you save your first dollar and begin to think of safe investments you are master of the situation. So reflect NOW. Do not regret later.

saving_roadMany people today are closing the door of opportunity by failing to lay aside some part of their earnings—thus condemning themselves to a life of continuous hard work. Your problem is one of persistence, not one of existence. So be up and doing!

Saving is the springtime of prosperity. To be effective, it must be practiced daily. It’s the steady, consistent, aggressive saving that makes men and fortunes. Save to the limit of your possibilities!

It is not enough to make money. You must make your money work for you. Putting your money to work means investment, and investment cannot begin until you have learned, or until you have an earnest desire to learn, to save.

Economize, but in the right manner. Avoid foolish, extravagant expenditures; save your money and invest it carefully while saving. You will always be in a position to live well and view the future complacently. Isn’t it worth while? A man who has always intended to start tomorrow has nothing. He is a slave to pay day.

Every dollar you save and invest brings you just one dollar nearer the goal of prosperity—the time when interest on your investments will provide for your comforts.

Prosperity begins when a man invests his savings or surplus capital intelligently. The man who saves his money will always have an opportunity to invest it. If he invests wisely, he will soon become a man of means and of credit.

Be prepared! Being prepared is half the battle. More men and women learned the value of ready money during the last financial depression than ever before during a similar period. Cheap investments abounded on every side and a man with ready money was master of the situation.

What of tomorrow? Are you prepared for it? For any emergency that may arise? Commence TODAY to fortify yourself against sickness, misfortune or financial difficulty, by saving and investing your money systematically. There is no time to begin like now, which, spelled backwards, means success.

Work hard! Plenty of work is your greatest need. It keeps your mind clear, your body strong and your appetite good. And see that your work accomplishes something. Your days are numbered— your earning period is short. Make each day show a satisfactory result. The best results are obtained when you save, invest and realize.

Nothing makes a man feel safer, happier and more courageous for life’s battles than a nest egg in the shape of good investments. It destroys fear of a rainy day and enables him to grapple with the big things.

If you have failed so far to lay aside any money, try again today.

To be a capitalist it is not necessary that you have several thousand dollars in the bank. A man with five dollars is a capitalist just so soon as he decides to make that five dollars work for him—to place it so that, with other sums he may add to it regularly and systematically, he will save, invest and realize in the shortest space of time consistent with safety.

Remember that interest in our work means interest on your money. Get the habit of doing things! Go it alone! You can succeed.

Net Worth, Year II

A year ago I wrote a post about my net worth and the convenience of having it automatically calculated in an online financial tracker.  Reminder: your net worth is the value of all your assets minus all your debts, “what you own minus what you owe”.  net17

Since last year, my net worth has increased by over $140,000—from about $706,000 to about $850,000.

About 80% of the increase (~$117,000) has been in the investments category.  This is mostly the result of the mutual funds in my retirement account going up along with the stock market over the past year.  Also, all the dividends that those shares have earned have been used to buy more shares.  Of course, I’ve made additional contributions during the past the year.  Breaking it down, the amount of the increase in investments from appreciation and reinvesting dividends was between $90,000 and $100,000 and the rest was additional contributions.

About $13,000 of the increase in my net worth is an increase in the (estimated) value of my house.

Another $8,000 of the increase is the reduction in the amount I owe on my home mortgage.

The remainder of the increase is a temporarily large amount of cash in my checking account.

Last year, I included my old used car (which was worth only about $2,000) in the “Property” category.  I have removed it, after recently buying a “new” pre-owned car.  However,  I have not added that car nor the debt which I will temporarily incur.  The value of the car and the debt would more-or-less offset each other.  I will probably pay off the car debt next month by borrowing roughly $15,000 from one of the retirement investment accounts.

This may be the first time that my net wealth has shown an over-the-year increase that is larger than my annual income.  (I wasn’t watching closely in previous years.)  This seems like quite a milestone on the road to retirement.