Saving is easy - how do you spend?

The strange thing about saving money is that it is pretty straightforward - there are only so many options. You can save it in the bank (cash), or invest it into an asset that you hope will go up in value over the long term (shares, property, bonds, Lily with her Faberge eggs). You can only really save a portion of your income too.

Figuring out how to spend money to me is much harder. For a naturally penurious (read tight-arsed) person like myself it has been difficult to wrap my head around being able to spend money. One of the fascinating things about saving and investing in volatile assets like shares is that eventually (hopefully) you end up with a decent size nest egg, at which point your salary from your job and even how much money you spend (within reason) kind of becomes irrelevant. To invert the great Peter Bernstein's classic book, you're now "With the Gods". Here's how it works:

When you have no savings, your salary and ability to spend are perfectly correlated. If your salary is $500 you can spend $500. If you spend less than that you are saving money, if you spend more than that you are going into debt. The former is essential to get ahead, the latter is dangerous and can get you into serious financial problems. 

If you have savings in a bank account which has interest at roughly the level of inflation, then the money you have saved already is neutral. In 10 years time it will be worth the same amount in terms of spending power. So again, if you spend less than your salary you are saving money and your assets are increasing. However, now if you spend more than your salary you are not necessarily going into debt as you have some money saved up. What you are doing though is reducing your savings as the money you have saved up is going down. 

So far it has been all straightforward. Where it gets interesting is if you have that money invested into assets like diversified shares. After adjusting for inflation, the US share market has had a capitalised annual growth rate of nearly 7% from 1972 to 2021. The key part here is after inflation, as this means that any money you have invested in US shares in this period has "on average" gone up around 7% each year more than it was worth at the start of the year. So here's how you can spend more than your salary, or even spend DOUBLE your salary, but still be saving:

Marsha has $1,060,000 invested in US shares. She earns $60,000 per year after tax in salary from her job. Marsha is jealous of Lily's Faberge egg collection and decides she must get her own. Marsha has a year where she goes nuts and spends $120,000 that year, which is twice her salary, on lifestyle and trinkets. To do that she takes $60,000 out of her shares at the start of the year to fund her lavish lifestyle. Her remaining $1,000,000 shares go up the "average" amount that year. At the end of the year despite this heavy spending she has:

$1,000,000 * 1.07 = $1,070,000.

So in a year when Marsha spent WAY more than she made from her job she still managed to finish the year with more money even after accounting for inflation. Isn't that awesome!

However.....

The average real return over this period was around +7%, but the standard deviation was around 16%. This is where the "With the Gods" comment comes in. Let's look at 2 different scenarios:

The Gods DON'T like a spendthrift Marsha:
Instead of getting the average return, Marsha gets a return of -25% which is 2 standard deviations BELOW the average. While not a common occurrence it definitely can happen on rare occasions. So Marsha now has:

$1,000,000 * 0.75 = $750,000.

In a year when she decided to splurge and spend an extra $60,000 her savings have gone down by $310,000! That has to hurt.

The Gods DO like a spendthrift Marsha:
Instead of getting the average return, Marsha gets a return of +39% which is 2 standard deviations ABOVE the average. Again, while not a common occurrence it can happen on rare occasions. So Marsha now has:

$1,000,000 * 1.39 = $1,390,000.

In a year when she decided to splurge and spend an extra $60,000 her savings have gone UP by $330,000! That has got to feel great!

Understanding this has made it much easier for me to spend money in a purposeful way. In some ways this variability as helped me psychologically as I now understand that so much of it is outside my control. The somewhat "extreme" example of spending double your salary in a year, but it having a limited impact on your savings relative to the fluctuations in your investments, reinforces that once you have a reasonable net egg small or even moderate amounts of additional spending or saving mean little in the grand scheme of things. If you want to shout a fancy lunch or buy a new keyboard for your students - go for it ;) 

Extra Reading:
Money Dials: analyzing your spending habits with Ramit Sethi (iwillteachyoutoberich.com)
Ramit Sethi has some good stuff about purposeful spending. Spend money freely on things that make you happier, and spend nothing on things that don't. That's why I don't have a fancy car, they make me LESS happy as I'm worried about scratching it, parking it in student car parks etc. My POS car does everything I need, and I'd happily lend it to any friend without any worries about it. It also allows me to spend money on friends, minor extravagances etc. and not even think about it - I figure I save at least $5000 per year on depreciation, servicing, interest, insurance etc. which is around $100 per week. This money can be spent on things which give me a happiness hit like buying flowers for people, building up my library of books, buying lunch for a friend etc.