Schrodinger’s Cash

Schrodinger’s Cash

The mathematical justifications for a high savings rate–or equivalently a low spending rate–are shockingly simple. Every dollar saved can be added to your investment portfolio, and financial independence ultimately requires building a large portfolio that can support your draw-down needs over your retirement timeline. But there’s more. Every dollar saved also equals a dollar not spent, which means your annual expenses are lower; people with lower expenses can retire with smaller portfolios. This double effect hugely rewards diligent savers. If you also consider that compounding rewards those who invest more/earlier, the case for saving is even more clear. In this post, I won’t re-hash what has already been shown in the link above and elsewhere. Instead, I want to make a different argument for targeting a high savings rate. 

Schrodinger's Cat

Schrodinger’s Cat is a thought experiment in which a cat is placed inside a sound-, sight-, and smell-proof box with a deadly hazard. The hazard is activated only if a certain probabilistic event, such as a radioactive decay, occurs. Until an observer opens the box, they aren’t sure if the cat is alive or dead, and therefore the cat can be considered both alive and dead in the interim. Once the box is opened, the cat is either definitely alive or definitely dead.

Schrodinger's discretionary cash

Now replace your beloved cat with your beloved discretionary spending cash, and replace a health hazard with a financial hazard, such as a luxury vehicle, and replace the probabilistic event with your discipline. If you crumble and decide to buy the vehicle, your cash is gone and it can’t buy any other goods, now or in the future. You have opened the box, there is no going back, and the cat is dead. However, if you stay disciplined and save the money, it can still buy what you passed up, along with a large number of other goods, both now and in the future. The cash continues on like the cat in the box. The table below summarizes this example and demonstrates the first conundrum of overspending: how can you objectively weigh current “wants” vs. unknowable future “wants?”

Discretionary cashBased on current knowledge, I know what I want to buy But what if something more enticing shows up tomorrow?

The answer is you can’t, so don’t spend any money on anything ever. Just kidding. The answer is to write down your values and goals, and then spend according to those values and goals. For example, we value traveling and have a goal to visit at least one new place each year. Like I mentioned in this post, when we had an opportunity to visit Europe on steep discount thanks to travel hacking, we pulled the trigger

Schrodinger's committed cash

Taking it a step further, let’s also consider financial commitments or obligations, such as housing, food, dependents, healthcare, etc. If you track your spending, you probably know what your current commitments are. But how do you know what your future commitments will be? What if you aren’t planning on having kids, but change your mind in the future? What if you or a family member develops an expensive medical condition? This is the second conundrum of overspending: how can you objectively weigh current “wants” against unknowable future needs?

Discretionary cashBased on current knowledge, I know what I want to buyBut what if something more enticing shows up tomorrow?
Financial commitmentsI know my fixed expenses (because I track my finances) But what if my expenses go up more than I was expecting?

The answer is again to spend according to your values and goals. Using our case as an example, we also had to set financial independence as a value and then set clear savings goals that will help us achieve financial independence. Our financial goals for 2018 can be found here. Our goals are indexed to our annual expenses, so if our expenses go up, we will have to save more. The trip to Europe did not materially impact our savings or expenses for the year, so we were able to take the trip guilt-free.

Schrodinger's yet-to-be-earned cash

Maybe you reason that you have a solid and steady income, so you can delay saving and catch up later. This is poor reasoning for two reasons. First, by delaying saving, you will forfeit compound growth during the delay period and will have to contribute more of your own money to achieve the same net worth. Second, you are assuming your future income is guaranteed, which may be a risky assumption. For people retired in 2019, 43% reported retiring unexpectedly, with a large portion of them retiring due to health problems or company downsizing. This is the third conundrum of overspending: how can you determine whether a purchase is reasonable today when you don’t know what your future income will be?

Discretionary cashBased on current knowledge, I know what I want to buyBut what if something more enticing shows up tomorrow?
Financial commitmentsI know my fixed expenses (because I track my finances)But what if my expenses go up more than I was expecting?
IncomeI know my income (because I track my finances) But what if my income is reduced or eliminated?

The answer is to set aggressive savings goals to achieve financial independence early, and then spend according to those goals. Achieving FI early reduces the risk of a disability shortening your career because your career can naturally be shorter. It also reduces the risk of being unemployed or underemployed due to downsizing; If you have a shorter working career, you naturally have less exposure to a market, industry, and company downturns. You also reduce the risk of your skills and experience becoming outdated, and the corresponding likelihood of seeing a declining paycheck in your later years.

Consumer debt has no uncertainty

Hopefully you can see that increasing your savings by decreasing your discretionary spending makes sense due to the unknowable wants, needs, and resources you’ll have in the future. Unfortunately, many people not only take on unnecessary risk by under-saving, they double down by living beyond their current means and financing optional purchases. When you take on debt, you are spreading your future self’s (unknown) resources thinner. This is the fourth conundrum of overspending: if you can’t currently afford an optional purchase, what makes you think you’ll be able to afford it in the future, especially with the additional (and usually high) interest payments? The answer: you most likely won’t be able to afford it in the future either, so avoid consumer debt at all costs.

Wrapping it up

When you make optional purchases, you are prioritizing your current wants over your unknowable future wants, needs, and resources. To evaluate a purchase objectively, you first need to establish what you value spending money on. I used the example of travel. Then you need to determine how much you value financial independence, and set corresponding savings goals. Finally, you need to see if spending the money will compromise your savings goals. For example, if we can afford taking an awesome trip, and can still meet our savings goals for the year, we can purchase the trip because it satisfies both values. In contrast, purchasing a $80k luxury vehicle would not agree with our spending values and would also derail our savings goals; we would not even consider such a purchase (especially if it was going to be financed!).

To know whether a specific purchase will compromise your savings goals, you obviously need to track your finances (see my blog post on why I prefer to use Personal Capital). Setting this up takes a little bit of work, and you will need to track your finances for several months to get a reasonable picture. So in the meantime, here is another way to evaluate a purchase: envision making the purchase and then three months later losing your job. Would you regret the purchase? If so, you probably shouldn’t purchase it because it is either not important enough and/or too expensive for your current financial situation. If you have a high savings rate and a net worth that far exceeds your annual expenses, you can better tolerate hardships, and may actually be able to buy more stuff via this simple heuristic (although you probably won’t actually buy more, since you have developed discipline along the way). This is just another example of the famous quote:

Easy choices, hard life. Hard choices, easy life.
J. Gregorek

Make a few hard choices now, and your future geezer self will thank you immensely.

No cats were harmed in writing this blog post… although both of our cats mysteriously avoided me the entire time I was writing…

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