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Latest posts by Cody (see all)
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This post was inspired by a discussion I recently read in one of my active Facebook groups. Some members of the financial independence community felt targeted by the stereotypes attributed to the “typical non-FI” person. These stereotypes include eating at restaurants frequently, paying for cable, indulging in daily lattes, going out for drinks, and many more.
This discussion really made me think. Are these attributes truly that detrimental to pursuing the FI life? After careful analysis and a lot of thought, I identified what I call the Savings Paradox.
Two Types of Savings
There are two primary ways to calculate savings: relative and absolute. Understanding the difference between them is key.
This method of calculation uses relative value and percentages to determine overall savings. However, citing relative savings can be highly deceiving.
For example, if I purchased a luxury vehicle for $20,000 originally marked at $100,000, I just “saved” 80%! Don’t forget about the 50% savings on the T-shirt I just bought for $75, marked down from its $150 sticker price.
As you can see, these percentages imply that the buyer is getting a great deal. Yet, when we analyze the real value and utility gained in these transactions, the savings appear sub-optimal at best.
This method of calculation uses real dollar value to quantify savings. In my opinion, this is the much more accurate and favorable method.
Imagine a house that is listed at $1,000,000, but I negotiate the seller down to $950,000. Using relative savings, I only “saved” 5% on my home purchase. However, if we analyze this transaction through an absolute-savings lens, I saved $50,000! These savings might be enough to fund my lifestyle for a year or more depending on my annual expenses.
Here’s another case. If you sift through coupon websites for an hour to save 80% on your next purchase of $3.00 toothpaste, is that time really worth $2.40 to you? That’s not for me to decide, but absolute savings can help to clarify which savings strategies are worth your time and which aren’t.
The Savings Paradox
Back to the “Non-FI” stereotypes I mentioned in the opening paragraph. Most of the negative stereotypes I mentioned occurred in the entertainment spending category. However, according to the Bureau of Labor Statistics’ most recent survey, entertainment accounts for only 5% of the average American household spending.
For those playing devil’s advocate, high spending can occur in any of the categories listed in the pie chart above. Restaurants are classified are food. Clothing is categorized under apparel and services. However, all of these seemingly frivolous categories pale in comparison to housing and transportation.
When you actually crunch the numbers, these pleasure-seeking expenditures barely move the needle. The real powerhouses in the savings equation are housing (33%) and transportation (17%) which comprise a combined 50% of the average American household spending.
Crunch The Numbers
Let’s assume that a family spends $50,000 per year. Per the BLS data, this family spends an annual $2,500 in the entertainment category ($50,000 x .05). The following year, this family moves into a duplex and lives on one side and rents out the other half, also known as a strategy called “house hacking”. The income gained from house hacking completely eliminates housing costs. Per the BLS data, this family is saving $16,667 per year ($50,000 x .33).
This family could increase their entertainment spending by 6 times and still decrease their annual expenditure from the prior year. When you actually dig into the numbers, these conclusions are mind-boggling. Think before you judge. Maybe the guy who takes five vacations per year has no housing costs. The girl who goes to the movie theater every week might ride her bike everywhere instead of owning a motor vehicle.
Get the Big Things Right
After reading Set for Life, an amazing book by Scott Trench that highlights the path to rapid financial freedom, the idea of absolute vs. relative savings really stuck with me. He preaches “Get the big things right and then you don’t have to worry about the little things”. This is paraphrased, but you get the point.
If the average family spending $50,000 per year completely eliminates their housing (33%) and transportation (17%) costs, their annual expenses are cut by 50%. Now the occasional Starbucks latte doesn’t seem so frivolous. For people hesitant to start their FI journey from fear of deprivation, you don’t have to cut out the fun! Just get the big things right and watch your savings rate soar.
Stop “Saving” by Spending
This is one of the most misunderstood concepts when it comes to saving money. Even I have fallen victim to this marketing treachery. Saving by spending is an advertising tactic where a company entices you to buy a product or service at a steep discount that you wouldn’t have considered otherwise.
Examples of this are devices like product coupons, entertainment deals, cheap flights and accommodation, and many more. A fatal mistake when analyzing the cost of these products or services is using relative savings instead of absolute savings.
Let’s assume you see an ad for a great deal on an amusement park. You had no intention of visiting that park, but the tickets are marked down from $200 to $40 for next weekend, so you decide to buy four tickets for you and your family. Wow! You only spent $160 instead of the $800 it would have cost without the sale. That’s an 80% savings!
Wrong. Since you would have never visited the park in the first place, this, in fact, is not saving at all! In absolute savings, you’re at negative $160 since your original expenditure on the amusement park would have been $0. These entertainment campaigns can occur in the form of events, attractions, flights or vacations. Don’t get tricked into “saving” by enchanting advertisements.
In my last example, the amusement park amounted to negative $160 in absolute savings. However, the losses don’t always have to be this large. The same marketing schemes are used to get consumers to purchase everyday items and services.
For example, pretend you’re in the grocery store and notice that grapes are marked down from $3.00 to $2.00. They weren’t originally on your shopping list, but hey, they’re 33% off. Wrong! In this situation, your absolute savings are actually negative again since you didn’t plan to purchase the item in the first place. These advertisements and discounts can be highly attractive at times, but stick to your list and be deliberate in your purchases.
Not all discounts, deals and coupons are bad. In the previous examples, the purchases were not made deliberately, but instead on a whim due to a “good deal”. However, if you plan to purchase an item or service and then actively look for a deal or coupon, that is smart bargain-hunting!
Let’s imagine I’ve been planning to visit my family in Florida for the past few months and all of a sudden a cheap flight is available. I would be silly not to buy it. This is because I deliberately planned to take this trip. This is vastly different than seeing a cheap flight and buying it on a whim. The former exemplifies positive absolute savings, while the latter is negative. Use discounts to your advantage and don’t be persuaded by flashy ads and marketing schemes.
Value vs. Savings
The cheapest option is not always the best one. Harcore frugalists and optimizers might cringe at that sentence, but it is true. What I am referring to is the sacrifice of value or utility in exchange for a low price. A $25 bicycle might work okay, but its $100 counterpart lacks the faulty gears, squeaky brakes, and rusty frame. Maybe the $75 savings is worth the hardship, but you might reconsider after months or years of cycling despair.
I reference this example because I made this exact mistake. If only I suppressed my frugality and spent the $100 to purchase a decent bike. Instead, I spent $25 on a rusty bike that squeaked incessantly and lacked the ability to shift into 4th gear. Several months after the purchase, I deeply regretted my decision.
What I lacked during my decision-making process was the ability to acknowledge value over savings. This dilemma can occur with any purchase depending on your values and level of frugality. The $1.50 eggs in the grocery store are probably laden with chemicals and hatched from grain-fed chickens pumped with antibiotics and arsenic.
Although these eggs are clearly the cheapest option, they are much less nutritional than their organic, pasture-raised, $3.00 counterparts. Is the additional $1.50 worth it to avoid the consumption of harmful and unnatural chemicals? Maybe. But that’s not for me to decide for you. As long as you understand the difference between value and savings, you can make purchases with a clear mind.
A New Outlook
Hopefully, some of these ideas and concepts have opened your mind as to what savings actually means. Let’s summarize everything we’ve talked about in a few concise bullet points.
- Using relative savings as a means of measure can often be misleading. Expressing savings in absolute, real-dollar terms is preferable to ratios and percentages.
- Understand how much your certain lifestyle actually costs using the various segments designated by the BLS. Focus on reducing the powerhouse categories like housing and transportation costs, which make up 50% of average American household spending.
- Think twice about criticizing someone else’s discretionary spending decision, as this only makes up 5% of average household expenditure. In addition, a purchase that may seem silly and frivolous to you might bring someone else tremendous value and utility.
- Do not get tricked into “saving” by spending. Be deliberate in your purchases and take advantage of good deals.
- Recognize the difference between savings and value. The cheapest option might not always be the best option.
Share your savings successes and failures in the comments below. The Fly to FI community and I would love to hear them. Thanks for reading!
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