Especially if you follow various bloggers in the Financial Independence, Retire Early (FIRE) movement, you know that a dollar spent now isn’t just a dollar.
It’s also all the dollars that spent dollar would have brought in had you invested it instead.
If you read my article, Pro Tips for Reaching Early Financial Independence, you realize that this dollar you just spent also risks getting used to spending another dollar like it tomorrow, and the day after, and the day after that… What’s known as “lifestyle inflation.”
The Opportunity Cost of a Dollar Spent
Let’s agree at the outset that certain fixed expenses can’t easily be changed.
Let’s also agree that you may not want to accept the lifestyle implications of changing e.g. your rent or mortgage payments, auto loan payments, utility bills, etc.
However, I’m sure you’ll agree that over the past month, you’ve spent quite a few dollars on things you wanted, but didn’t really need.
I know I have.
If you have 38 years ahead of you before retirement, a dollar invested now will probably be worth about $6 when you’re ready to call it a career, after accounting for inflation.
If you keep adding just one more dollar each year, those will grow to more than $100 in 38 years.
If instead of one dollar, you divert $1000 each year from spending to investing, your portfolio will likely be more than $100,000 richer.
In How Soon Can You Reach Your Personal FIRE Point, I present a table that helps you figure out the real long-term opportunity cost of spending those extra dollars vs. investing them.
For example, if you currently save 20% of your income and plan to live in retirement on 80% of your income (after accounting for inflation), the table shows you need almost 38 years to reach financial independence (FI).
Shift 5% of income from spending to savings, and you’d reach FI about 52 months earlier. If your annual income is $60,000, that means you’d need to reduce your monthly spending by $250 and invest it instead. That’s about $8/day.
Spending an extra weekly dollar costs you about an extra month of work before you can retire.
Spending an extra daily dollar adds over 6 months to your work life.
Your Opportunity Cost Shrinks Over Time
As the image above demonstrates, as your destination pulls closer, there is less difference between the real and perceived size of the tunnel. The same is true for the difference between what your current dollar spend looks like now vs. what it actually looks like when you arrive at retirement (or my preferred term - financial independence).
If you’re at the start of your work life, you still have decades ahead of you for every invested dollar to compound, and for every dollar of lifestyle inflation to bite your wallet and your portfolio. This makes the opportunity cost of a dollar spent much larger than what it looks like.
However, if you’re only 5 years from retirement, you’re almost out of time for compounding to help. That means the opportunity cost of an extra dollar spent is very close to what it looks like. In this scenario, a dollar invested now, rather than spent, might be worth $1.30 in 5 years (after inflation). Investing an extra dollar each year until retirement would add just over $5.60 to your portfolio.
Make that $1000 a year instead of $1, and your portfolio would grow by just $5600. That’s barely more than the $5000 it would add if you put it into a savings account where interest is about the same as inflation.
The Bottom Line – What This Means to You
As a financial strategist, I’d never encourage anyone to waste money. I’d also be careful of suggesting you shouldn’t try to set aside and invest as much as you reasonably can most of the time.
However, what all this means to you is that if you have decades before you may reach FI, now is exactly the time to err on the side of being more frugal rather than less.
When you’re older, closer to retirement, probably making a good deal more money, and maybe past most of your major spending (e.g., down-payment on a first home, raising kids, sending those kids to college, etc.), things change. At that point, the opportunity cost of an extra dollar spent is much lower, so you can err a bit more on the side of spending some more to experience more fun things, even at the cost of investing less than you could if you stayed very frugal.
As my grandmother would say, “Ever since they invented death, nobody is safe in this life.” Nobody promises us we’ll actually live to retire, so make sure to enjoy at least some of your hard-earned cash today. Balance your future self’s needs and wants with those of your current self. But remember that this balance changes over time.
Financial strategy is all about setting financial goals, crafting a plan to reach them, and doing what's needed to start implementing that plan in both your business and personal life. Sometimes that means spending less and investing more; other times it may mean giving yourself permission to spend more. If you'd like to learn what financial strategy can help you accomplish, email me and we'll coordinate a free, no-strings-attached phone call to explore that.
This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.