If you’ve read any basic personal finance information, have a good amount of common sense or ever listen to Dave Ramsey, you know the basics about saving money and the reasons for it. Our focus here is to move beyond the basics, so when it comes to saving money, let’s quickly get the basics out of the way.
If it’s not obvious, saving money is the result of spending less money than you make. The reasons why saving money is a good thing are plenty: having a emergency fund is useful for unanticipated events and expenses, having financial margin in your life will reduce stress as you go about your life, and of course, saving money leads to things like saving for college, investing and having the ability to retire later in life with some money.
Before we get into why you should view saving money as an economist, no discussion on saving money is complete without some tips on how to save money, right? Fine. let’s throw out a few for your consideration.
Tips for saving money
It’s not hard to find tips for saving money out there, so we won’t spend too much time on the topic. Here are a few bigger picture things to think about as you make your plan to find more money to save.
Focus on the big things.
Yes, managing your spend at Starbucks can be useful, but it’s hard to make headways on latte savings when you’re paying $500 per month on a car that you can’t afford. Start with your major expenses such as housing, auto, health care, etc. Knocking out several hundred bucks a month (or more) right away will create some momentum for you in the area of budgeting. Then, start fine-tuning things like how much you spend eating out, or how often you go to the movies.
Track your expenses like a business would.
If you’re not a detailed numbers type, then you’re not going to love this, but there’s no better way to get a hold of your budget than to track it to extreme detail. Create a spreadsheet with a written budget (one row per category). Then track how much you spend in that category for each month. Each subsequent column should be a month. Adjust your target amounts in your budget based on reality after a few months. Once you know where you’re money is going to a very detailed level, finding more money to save gets much easier.
Work out your differences with your spouse now. Not later.
Fewer things will be more impactful to your financial health than finally getting on the same page with your spouse about your money. Have honest conversations about expectations for current lifestyle, savings goals, travel, retirement expectations and more. Often times, relationships are harder to manage than executing a budget. Some couple wait years or decades before they actually get on the same page. Doing so will make your finances suffer. Do everything you can to work it out now. Get a third-party counselor to assist even if it costs you money. The future ROI on this investment will be huge.
How economists view saving money
Economists view savings typically different than individuals do. Individuals view it as a personal finance action as a result of spending less than you make. Economists view saving as consuming less in the present in order to consume more in the future.
Here’s a simple example from the Library of Economics and Liberty: “to economists, saving means only one thing—consuming less in the present in order to consume more in the future.
An easy way to understand the economist’s view of saving—and its importance for economic growth—is to consider an economy in which there is a single commodity, say, corn. The amount of corn on hand at any point in time can either be consumed (literally gobbled up) or saved. Any corn that is saved is immediately planted (invested), yielding more corn in the future. Hence, saving adds to the stock of corn in the ground, or in economic jargon, the stock of capital. The greater the stock of capital, the greater the amount of future corn, which can, in turn, either be consumed or saved.”
This example illuminates a view of savings with an emphasis toward not just future consumption, but future production.
Too often in personal finance circles, the idea of saving money is limited to saving up for a purchase in the future, or saving up for a retirement where you can spend that money on a retired lifestyle. Future consumption is emphasized.
Instead, I suggest a focus on future production is key to changing the game when it comes to your finances, life and success.
Every dollar you save is a dollar that can work for you. Spending your dollars means literally removing dollars that are working for you. Get enough dollars working for you, and you might not have to worry about money ever again.
I find the endowment approach also an interesting example. When a major University wants to fund a new program that costs $50 million per year, they don’t try to raise that $50 million. Instead, they try to raise a sum of money that funds an endowment that then funds this program in perpetuity. They seek to put enough dollars to work that will produce enough money every year to cover all the expenses of this program. Again, it’s a focus on what your savings will produce for you.
In economics, capital formation refers to the addition of capital stock to the economy. Capital formation is crucial for economic growth. It leads to increased productivity, increase production and the ability to innovate.
Similarly, your savings and investing in productivity is crucial for your financial growth. It leads to increased gain, increased production and the ability to invest in yourself and your family.
A real world example
Let’s make this a bit more concrete.
John Doe makes $115,000 per year. After taxes and life expenses, he’s putting away $1,000 each month toward savings. He also has a 401(k) with his company in which he’s putting away another $800 per month, plus $400 per month in company matching for a total of $1,200 per month. Add it up, and John is saving $26,400 per year (this includes the company match).
John’s 401(k) money is automatically going into long-term investments because that’s how his company’s 401(k) is structured. So, of the $26,400 that he’s saving each year, $14,400 is going into retirement savings and $12,000 is going into a general savings account.
This is a pretty typical situation for a worker making a nice salary, albeit an example that is rather atypical compared to the average person (most people aren’t saving this much). But let’s continue the example to bring home some of the concepts discussed in this article.
Since the 401(k) contributions are spoken for, let’s focus on the $12,000 in general savings each year. As most personal finance pros will tell you, you should have an emergency fund of somewhere in the range of 3-6 months of your regular expenses. This is fine.
What about when you’ve got that covered, and you’re still contributing cash into the savings? This excess savings can be distributed in a mix of the following ways: college savings (if you have kids), more investment accounts, saving for a house/paying down your mortgage or piling up dry powder in anticipation of an investment opportunity.
In an ideal world, you’ve already knocked out college savings and your mortgage, and your focus is just on additional investment opportunities. For most of you, this is probably not the case. As such, finding a good mix on a monthly basis probably makes sense. Maybe its a third toward your mortgage, a third toward your kid’s college fund and a third toward an investment account or a cash pile that’ll eventually get invested.
Let’s now assume that mortgage is paid off and kid’s college is funded. What do we do with excess savings? This is where the production mindset can really kick in…
I like to pile up cash as much as possible (in a high yield savings account) while I wait patiently for high quality investment opportunities. These dollars are working for me, by earning interest. The cash pile is growing in two ways: by my continuous contributions of more cash and by the interest it’s earning.
Meanwhile, I’m on the lookout for better ways to allocate these dollars so they can work even harder for me.
It’s at this point where many of you will likely ask: Why not just put these excess dollars into the stock market via a diversified portfolio like most people? That’s, after all, what investing is, right?
The answer to this question is: sure. That’s not an unreasonable approach. For me, since I’m already put the bulk of my savings into the stock market in long-term focused retirement accounts, I’m interested in being a bit more tactile with this growing pile of cash.
Now, this doesn’t mean that this cash doesn’t end up in the stock market. It very well could. For instance, if the stock market tanks 50%, I’m going to put a large chunk of my excess capital into the stock market. At that point in time, it would be a very nice buying opportunity of the stock market – or, exactly the kind of opportunity I’m patiently waiting for.
Or, I might find an extremely attractive real estate investment. An investment that most people won’t be able to jump on quickly because they don’t have the capital available. I will have the capital available. I’ll be able to move quickly to deploy my capital into areas that will produce for me. This in turn will generate more excess savings and excess capital to invest.
For much of the remaining chapters of this course, we’ll be looking at how to get better at investing and how to find these excellent opportunities to deploy capital. But, we had to start with saving money, because saving money leads to capital, which leads to financial growth for you.