Financial planning 101 includes understanding the concept of compounding returns and power of saving and investing earlier rather than later. For example, consider two scenarios:
1. At age 22 Carl invests $5,000 per year and continues to invest that amount for 15 years and then stops adding to his portfolio. If Carl earns 7% on his portfolio, at age 72 Carl’s $75k of total investment ($5k x 15 years) will have grown to $1,435,362.
2. Carrie waits 15 years (until age 38) to invest $5,000 per year and does so every year for the next 35 years. Carrie’s total investment by age 72, assuming the same 7% rate of return, will be $739,567, nearly $700,000 less than Carl even though she will have invested $175,000 in her portfolio vs. Carl’s $75,000 of investment.
This sort of analysis makes it seem obvious that saving more earlier is a no brainer. But there is another view that takes into account the utility of money at various ages. That other view suggests it’s a more complicated decision than the numbers suggest.
I first heard of this contrarian view on the Freakanomics podcast about a decade ago. Steven Levitt, an economist at the University of Chicago, said that as a young economist his mentor told him that it’s not a good idea to scrimp and save when you are young if you expect to have the sort of career where your earnings go up dramatically over time. He said that you should look at the quality of your life at various stages and decide what you want to do when. Maybe having more money in your 20s and 30s and less during retirement is a better decision. Steven Levitt said he followed this advice and is happy he did so.
A recent conversation with a friend gets to the heart of Steven Levitt’s point. Right after college my friend and his new wife took a year off and traveled the world. He funded the trip with his entire savings and all the money they got as graduation gifts. If you think about that from a purely financial perspective it seems like bad decision: he spent all his savings and they missed out on an entire year of earnings at their jobs, some of which could have been saved. If they had saved rather than spent that money, it would have grown into a nice sum today.
But looking back nearly 20 years later it was a great decision. He traveled the world in his 20s. He and his wife have great memories. It strengthened their relationship. It sparked a love for travel (he’s now visited 55 countries). Seeing different cultures shaped his perspective on the world. And financially, its not that big of a deal that he didn’t save that money because he’s been very successful in his career.
Deciding what to save vs. spend is a balancing act. Maybe saving less in your 20s and 30s but taking more trips with your significant other, friends, and family when you are young is better than having more money when you are old. Going back to Carl and Carrie – let’s suppose they both have successful careers financially: nice salaries, good bonuses, equity grants in their companies. Because of their financial success both end up saving a lot later. Let’s assume that in addition to the $5k they each invest at different times, each of them begin adding an additional $75k to their portfolios in year 15, when they are 38. Here’s what their portfolios look like vs. how much they invested under that scenario:
Carl has a bigger portfolio, but not by much. And what if Carrie took a fun-filled vacation every year for 15 years in her 20s and 30s and Carl didn’t? Or what if she had more dinners out with friends and developed deeper relationships? What if Carl died when he was 50? I bet he wished he had lived more and invested less.
The point of this thought experiment is not to encourage young adults to just spend more and save less, but rather suggests that deciding to save more when you are young isn’t the no-brainer the financial planning industry makes it out to be. And what you spend your money on matters. If Carrie had just bought a nicer car with the $5k per year she could have otherwise saved, it probably wasn’t a wise decision. Things don’t usually enhance happiness (in fact, “stuff stresses”), while spending money on experiences tends to make us happier. And finally, this scenario depends on having a successful career with accelerating earnings. If your career is not very lucrative, by not saving early you run a risk of being poor in retirement and not having the financial security an investment portfolio provides.
Great post, John. I think there is an offshoot/niche here which is that experiences matter to our quality of life and a middle ground approach when young is NOT to save relentlessly but minimize financial commitments like car/home/etc. This approach gives younger individuals the ability to make decisions to pull back spending when needed since long-term (or even 5-year) debt isn’t driving spending.
Great point. I totally agree.
As a life long saver this was challenging to read with an open mind. Time value of money / wonder of compounding were instilled early in life. Kept thinking “but …” to every point. That said, the idea of living experiences while younger & shifting to consuming experiences vs things certainly resonated with me. The living experiences could certainly be viewed as an investment in your relationships & potential network. With the real potential of increasing your earnings potential.
There is certainly something to be said for establishing habits of savings / investing early in life. As people experience the marginal propensity to consume as their income rises it is difficult to take a lifestyle cut to start saving. Just like an out of shape person can decide to start working out later in life it can be done, but the probability of success seems much lower than a person who developed & maintained healthy eating & exercise habits throughout their lives.
Well another great blog, that made me think outside of my perspectives. Thanks!
Something to think about for 2% of the US population. The other 98%? Open an IRA.
The mayor of St Paul Mn tells this story about his mother — she would say “show me your checkbook and I will tell you what matters to you” — life is tradeoffs — but it is best is we make decisions with eyes open.
Thanks, as always, for starting my day with a provocation to think about.