“Money begets money.” - Benjamin Franklin, 1748
Wealth is power. Wealth enables happiness. Squandering wealth diminishes power and happiness by reducing the ability to navigate future necessities and contingencies. Indulging current wants at the expense of our future selves deprives us of the power to live comfortably or with less pain and suffering. Wealth is a moral value and a moral outcome: It helps us endure personal and economic setbacks and empowers us to thrive. We all know that we should spend less and save more, but we just don’t. If you realize the magnitude of the loss to your future self and livelihood whenever you spend money rather than save it, then you are psychologically able to feel its loss more. Feeling loss more is sometimes good for us because it makes us avoid it. I want to use this to motivate spending less and investing more for the sake of our future prospects.
Money is a means to wealth. In every decision involving what to do with our money we should consider what we risk losing when we use it, not just what we can gain by it. Spending money or saving money is a hard choice; we want to use our money and have it too. Why save for a nebulous future good what I can spend on tangible present good? Answer: You really have more to lose than you have to gain if you do not invest more of your money, much more, than most people already do.
In “The Framing of Decisions and the Psychology of Choice” (1981) Tversky and Kahneman found that people experience the pain of a loss with much greater intensity than the pleasure from a gain and that this disproportionally affects decision-making. When choosing actions leading to comparable outcomes where there is the risk of loss and an opportunity for gain, people prefer avoiding losses to acquiring gains even when the likelihood of gain outweighs the likelihood of loss. Loss aversion corrupts the perceived value of our assets and our estimates of potential gains from holding such assets. However, since we care more about losses than gains, maybe we can use our loss aversion when framing decisions about how to use our wealth, i.e., money, when we consider prospects for short-term vs. long-term gain and loss. Let’s exploit loss aversion to our advantage. Instead of asking, “Would you rather spend $5000 this year or spend $10,000 ten years from now?” ask “Would you rather lose $5000 now or $10,000 ten years from now?”
Consuming less, expending less of your resources enables your money to earn money. Money grows when you invest it. Compounding interest and re-investing dividends on investments, e.g., shares of an S&P 500 index fundwork like magic but it is just math. Returns on investments are risky, where risk is the probability that an investment's actual return will be different than expected. Statistical data on U.S. stock market activity provide us information we can use to our benefit when deciding how much to spend or invest given past market returns. Here is a rough inductive argument framing the choice of comparable outcomes we face that should trigger our aversion to loss.
- The average annual return for the U.S. stock market since 1928 is 7%.
- Assume I can invest X dollars at 7% interest compounded annually in the U.S. stock market.
- At this interest rate, whatever I invest this year probably doubles in value ten years from now.
- For example, either I spend $5000 this year on things I don’t need, or I invest $5000 in a market that on average yields a 7% annual return.
- If I spend rather than invest $5000 this year, then I lose $10,000 ten years from now.
- If I invest rather than spend $5000 this year, then I gain $10,000 ten years from now.
- So, I either lose $10,000 ten years from now or I gain $10,000 ten years from now.
Don’t confuse wants with needs. We lose too much by overpaying for our present self-indulgences. Routine expenses such as bottled water, boutique coffee, fancy new smartphones with unlimited data plans, useless vitamins and herbal supplements, credit card debt, crippling auto or home payments, $25,000 weddings and private colleges are money-sucks. Instead of buying lunch at the food court, pack a PBJ.
Investing only $5000 per year as I suggest in the example above is not going to yield enough for those of us who are neither earning six-figures nor inheriting a small fortune. If you want to fund your kid's college education or live well in retirement on, say the median average income, then you must invest at least two to three times that amount annually. Most Americans are not saving enough. Further, recessions, job loss, divorce, medical emergencies happen, each erodes our future ability to meet our obligations. You need to become a millionaire, so you will have to invest 15 to 20% of your income. I'll produce an argument for that proposition later.
Scott Merlino, PhD
Department of Philosophy