The basics of personal finance can be summed up in less than 10 words.
Spend less than you earn and invest the difference.
It’s a very simple concept. It’s part of the reason why this site is called Money the Simple Way.
But simple doesn’t mean easy. It takes an enormous amount of discipline to spend less than you earn in a world designed to tempt you to spend more (and willing to freely extend you credit to allow you to do so).
And let’s face it, as humans, we generally prefer the easy way out. The path of least resistance. It’s unpleasant to do things that are hard. There’s much less friction involved in watching Netflix.
So it’s worth asking, is spending less than you earn optional? Isn’t it just an alternative strategy to immediately spend every penny that you earn? Or even to spend more than you earn? Won’t you get more enjoyment this way? Be able to live life to the fullest?
It’s tempting for me to waffle here. To try to appease everyone and say that there’s no one right way to do things and that everyone’s approach is valid for them.
But I can’t do that, because it’s not true.
“Spend less than you earn” is an ironclad first law of personal finance.
Today we’ll look at some of the reasons why.
A Fragile Approach to Finances
The first problem with immediately spending every penny that you earn is that it’s a fragile approach to managing your money.
We all understand the concept of fragile. It means sensitive to shocks. When you drop a glass, it shatters. It’s fragile. I’m not saying that plastic cups are superior, but they’re clearly the better option if they are going to be dropped.
Immediately spending everything you earn is a fragile system. It is highly sensitive to shocks. There’s no margin of safety.
Let’s take a look at the main categories of shocks you need to watch out for.
Shocks of Supply
I’m borrowing a term from economics here. In this case your money supply is your income.
Let’s imagine you are making $50,000 a year. Unfortunately, you get laid off and can only find a job paying $45,000. Here’s what that looks like if you had limited your spending to $40,000 a year:
That is what resilience looks like. Let’s contrast it with the picture of what would have happen if you were spending everything you earned:
This isn’t nearly as pretty a picture.
But wait a minute, you might be thinking, if you can just go on spending $50,000, what’s the big deal? Stay tuned for the next section where we look at freedom vs. bondage.
Shocks of Demand
When you spend everything you earn, you are also vulnerable to unforeseen expenses. You have to take your car into the shop. Your roof starts leaking. The garbage disposal breaks. You get the idea.
Shocks of demand can sometimes be completely handled the moment they arise when you spend less than you earn:
When you spend less than you earn, many unforeseen expenses can simple be covered by your positive cash flow.
Let’s look at the alternative:
When you immediately spend everything you earn, there’s no money available to handle an emergency.
Building an External Buffer
Wait a minute, you might be thinking, spending less than you earn can’t guard you against every unforeseen expense. Sometimes something will happen that’s so expensive that you can’t cover it with your cash flow:
You’re completely right.
But here’s another benefit of spending less than you earn: You can build an external margin of safety. Let’s call it an emergency fund.
The idea is that some of the money that comes in during normal months gets stashed into a savings account where you hold it in case you ever need it. When an expense comes along that you can’t cover with your income, you pay for it in cash out of your emergency fund.
Spending less than you earn lets you layer in multiple margins of safety.
Freedom vs. Bondage
Money can buy many things, but the greatest thing it can buy is freedom.
Spending less than you earn leads towards freedom. Spending more than you earn leads towards bondage.
The ability to save money gives you options. When you have a hefty emergency fund, you don’t need to endure ill treatment at a job you hate. You can simply quit knowing you can cover your expenses while you look for a new job.
If you have a pile of debt instead of a pile of savings, you can’t afford to quit. Or get fired. You’re stuck in a very fragile spot.
Financial independence is when you don’t need to rely on working to earn a living.
It’s impossible to know how exactly much you need saved up to make this a reality. But a good rule of thumb is the 4% rule, which says that once your portfolio is big enough that you can cover your annual expenses by withdrawing 4%, you are financially independent.
So reaching financial independence is determined by the size of your portfolio relative to the size of your spending, but what determines how quickly you get there?
The answer is your savings rate. This is the ratio of the amount you save vs. the amount you earn. And of course, what you save is simply what you don’t spend.
Here are the calculations I ran on how long it takes to reach financial independence at various savings rates when I reviewed Mr. Money Mustache’s shockingly simple math (this table assumes a 5% rate of return and starting net worth of $0):
|Savings Rate||Working Years Until Retirement|
And of course, I have a very nerdy deep dive on the savings rate formula in case you want to calculate it as accurately as possible:
Escaping the Rat Race
Financial independence isn’t the only way to escape the rat race.
You can also start a side hustle that turns into a full-time gig. Once your side hustle makes more than your day job, you’re free to walk away. But if you’ve been spending less than you earn, you can walk away much sooner.
In this case your emergency fund essentially becomes a “Freedom Fund.”
You start measuring it in months. How many months of living expenses can I cover with what is in the bank?
So for instance, maybe you decide that you’re comfortable walking away once you can cover one year of expenses. Perfect.
As your side hustle starts earning income, deposit it into your Freedom Fund. As you start to make more money, the amount that you have saved gets bigger, but the amount you need to save gets smaller, because once you make the leap you can cover some expenses with your side hustle income and don’t need to dip into your Freedom Fund for as much each month.
Because I’m a huge nerd, I made a calculator for you:
The Debt Spiral
As promised, let’s talk about the long term consequences of spending more than you earn.
And I say long term consequences, because the short-term consequences are pretty great. You get to spend lots of extra money, and spending money is fun.
Of course, you don’t actually have the money to pay for it, so you cover some of it with credit. You get the credit card bill back, and it seems unbelievably good. You spent $250 that you didn’t have, and your bill is just $15. Why don’t more people take advantage of this?
Sure, your expenses have now grown by $15 a month, but you’ll just cover it with the credit card, right?
Wrong. At a certain point, you run out of credit. No more extra spending.
You used credit to escape the unpleasantness of disciplining yourself when it comes to spending money, but you din’t escape it, you simply pushed it forward a little.
And now the bill is coming due with interest.
At first, it looked like credit would let you spend more than you earned, but in the long run, debt allows you to spend far less than you earn. A portion of every payment is completely lost to interest.
What’s worse, debt is almost impossible to escape from. If you moved into an apartment that was way to expensive for you, you can learn your lesson and move to a cheaper apartment. With credit card debt, you’re stuck. The only way out is to pay it off.
It moved you away from freedom and toward bondage.
The benefits of spending less than you earn and the consequences of spending more consist of more than can be measured in dollars and cents.
If anything, the psychological consequences are more significant.
Being financially insecure sucks. We think of poor people as being financially insecure, but many high income individuals have voluntarily joined the club.
When there’s no margin of safety in your finances, everything in life is a cause for concern. Medical expenses. Car repairs. Your next mortgage payment. What if you lose the house? What if you get laid off? When is this next bill due? How are you going to pay for it?
And of course, things get exponentially worse when there are people you are responsible for taking care of such as children or elderly relatives.
On the flip side, spending less than you earn is unpleasant in the short term but brings enormous satisfaction in the long term.
This is the core principle of all self-help advice: Make short-term sacrifices to win long-term prizes.
Most people never grow because they can’t bear to make short term sacrifices. They gladly pursue short-term comfort at the expense of long-term misery.
We’ve talked about the difference between fragility and resilience. But the opposite of fragile isn’t resilient. It isn’t robust. It isn’t solid.
The opposite of fragile is antifragile.
This is an insight I owe to the author Nassim Nicholas Taleb.
It’s a hard concept to get around initially, because it’s hard to find examples. A glass is fragile, a plastic cup is resilient, but there’s no such thing as an antifragile cup. There are no cups that benefit from shocks to the system.
But if you think about it, the best example of an antifragile system is…you. When you get sick, your immune system gets stronger. When you break down your muscles in exercise, they come back bigger and better.
And when you face challenges, when you do hard things, you grow as a person.
I’m not here to tell you that you’re not antifragile if you shy away from challenges. Unfortunately, it’s worse than that.
You’re antifragile whether or not you act like it. But the downside of being antifragile is that you atrophy and decay without challenge.
In an age of prosperity, voluntary hardship is actually the key to human flourishing.
There’s a Latin phrase that is popular among modern day stoics: Momento Mori. Literally, it means remember death. In other words, your time is limited and precious.
The wrong way to interpret this is “eat, drink, and be merry, for tomorrow we die.” Because chances are, you won’t die tomorrow.
The right way to interpret it is to savor life as much as possible and to steward your time and resources wisely. You do the first part through gratitude. You do the second by making short-term sacrifices to win long-term prizes. This includes spending less than you earn.