If you’ve read anything about retirement planning, you’ve probably seen the “skip the latte” example. The numbers vary, but it goes something like this: Assume you buy a latte every day at work for $5. If you skipped that latte and invested the $5 in an account that averages 4% return per year, you would have over $95,000 after 35 years. The example is meant to inspire you to make small changes in your spending habits to secure a glorious retirement. If you are capable of absorbing the example and using it to alter your spending habits in one fell swoop, congratulations. You don’t need to read the rest of this article. But I wasn’t able to do it so easily. And I couldn’t figure out why $95,000 was not sufficient motivation to get me to make such little changes until I realized buying coffee isn’t a $95,000 question. It’s a $20 question.
You see, you can’t make a real decision to skip 35 years’ of lattes. Rather, you have to make 9,100 separate decisions to skip a latte over the course of those 35 years. And when you’re making that decision tomorrow morning, you won’t be deciding between having $95,000 in 35 years or having nothing. You’ll be deciding between having $95,000 in 35 years or having $20 less than that. Because that’s how much the single decision to have a latte instead of investing $5 will cost you: $20, 35 years from now. In economic terms, the marginal cost at retirement of buying a single latte now is $20 or less. And $20, 35 years from now is simply not very motivating to most people.
This realization crystalized for me what I consider to be the central problem of personal financial planning: success or failure depends on the cumulative effect of thousands of decisions, most with a tiny individual effect on the outcome. This is the first in a series of articles that will describe a system of personal financial management aimed at increasing the effectiveness of motivation at the margin. The first goal is to increase your awareness of the effect of each individual financial decision you make. In effect, you will learn how to create a personalized set of skip-the-latte techniques. This involves choosing the proper measuring stick, such as money saved at retirement or time until you are debt free, and knowing how to judge individual financial decisions against that measuring stick.
But knowing is only half the battle. The second goal is to set up your finances so that you have fewer decisions to make that will only have small, far-future marginal effects. Rather, you will feel small effects before your next paycheck. When you walk by that Starbucks on the way to work, you’ll know that if you do buy a latte, you can’t grab a beer at the next happy hour. Of course, you could decide to do both anyway. That’s why you’ll structure your finances so that you’re not deciding to spend an extra $5 from your wallet or put an extra $5 on your credit card. To buy both the latte and the beer, you’ll have to decide either to spend $5 less on something else that week or take money out of savings. If you’re like me, you’ll need less motivation to resist raiding your savings.
The key to making this work is a financial management system that makes it easier to save than overspend. This provides more than just a secure retirement. It also allows you to enjoy how you spend money now. Rather than guessing if you can afford a vacation or a new car, you’ll know. If you’re still interested, start to gather the latest statement for each of your assets (such as savings, mutual funds, stocks, bonds, retirement funds) and debts (such as credit cards, student loans, mortgage, car loans). The next article will describe how to calculate and track your net worth, the first step to increasing the visibility of the effects of your financial decisions.