Consumption is a Poor Investment

On Monday, we talked about the importance of a low-cost lifestyle in Finding Financial Freedom by Living on the Cheap. If financial freedom is the goal, consumption is a practice that needs to be controlled. After all, consumption is a poor investment.

And that’s the point.

Each of us earn a certain amount of money; in the process we have a choice – to “invest” it in consumption, or to invest it in savings for true investing. Statistically, it appears that a lot of people are making the wrong choice. A 2011 study revealed that 64% of Americans have less than $1,000 in savings. That’s in a day and time when $1,000 doesn’t by a whole lot of margin of safety.

Consumption is a Poor Investment
Consumption is a Poor Investment
And the situation isn’t getting any better either. The current US personal savings rate is less than 5%. That doesn’t bode well for the future, especially considering that we’re supposedly in an economic recovery.

The lack of savings in the US is a national crisis – and more important, a personal one. And tragically, it’s increasingly coming to represent a national cultural norm.

I don’t mean to minimize the economic stresses that people are facing – they’re very real. Wages have been declining in real terms for a long time, and prices are rising. That can make traditional investing a tall order. But at the same time, investing should become even more important in a time of limited financial options. It’s a way of compensating for them.

Even if you don’t earn much money, you’re still making investment decisions every day. At every turn, you can choose to either spend money, or to save it for investing. But don’t jump to quick conclusions about the type of investing I’m talking about – there are different ways to invest, even beyond financial instruments.

Consumption posing as investment

One of the biggest illusions that we live with is the notion that certain purchases are actually investments, when in fact they just represent consumption. Examples include buying a house, a car, or even paying for college education.

In reality, a house is just a large consumer good. The notion that it is in any way primarily an investment is mostly incidental. Property values experienced a spectacular rise from the early 1970s until about 2006. The conclusion is that a house is an investment that you live in.

That can lead to a lot of distorted decisions. For example, if buying a house is a good investment, then buying a bigger one is an even better investment. We can use that thinking to justify buying a more expensive house, telling ourselves that we’re merely making a bigger investment – when what we’re really doing is feeding our egos.

The same is true of buying a car. There’s no doubt that a car has a strong financial component. After all, you use it to commute to work in order to make a living. But once again, it’s a matter of degree. A 1997 Toyota Corolla could get you to work and back every day – a 2013 Lexus will perform the same function but at a much higher cost.

The same has become true of a college education. Students – and their parents – often enter high cost college programs with little consideration of the real world employment prospects waiting at the other end. The excess money spent on an elite education (above a basic college education) ends up being a poor investment choice.

Make no mistake about it – each of these purchases represents an investment at some level. But you are making decisions about where to allocate your money, and often basing those decisions more on emotional factors and personal preferences than on financial realities. That’s when an investment becomes a form of consumption.

When consumption becomes the default option

Consumption can become the default option when true investing seems to be out of reach. You start telling yourself – if only subconsciously – I don’t have any money – I’ll never have any money – and eventually stop thinking about improving your lot. Consumption becomes both more convenient and more satisfying, because it creates a short-term high.

The culture plays a role in this as well. At every turn we are being solicited to buy something. Whether it’s TV, radio, the Internet, or the print media, the message is always the same – buy, buy, buy. Products and services are sold by pretty, happy people who got to where they are by buying Brand X – and you can be one of them. It’s hard to resist the trend.

Breaking out of the default pattern of consumption

The only way to break out of that pattern is to be very intentional about it. You have to tell yourself I have X amount of dollars to spend this month, but I want to save X % of it. That may mean pulling out the savings allocation as soon as you get paid.

You may say I can’t do that but you can! Anyone can live on less money than they earn. We might even ask ourselves what’s the alternative? We all want a better financial situation, and the only way to get it is through self-sacrifice. You have to create a lifestyle in which you:

  • Earn more money,
  • Spend less money,
  • Save more money, and
  • Invest the money you save.

Everyone is looking for the magic formula that will enable them to make and have more money. The reality is that there is no magic formula, and the financial way forward is completely basic. It’s the age-old concept of delayed gratification. You can sit around for a lifetime waiting for a magical solution – or you can put the old wisdom to work right away.

True investments

I described consumption as a poor investment – but what are good investments? As we saw above, not all investments are good – or are even true investments. Rather than get into recommendations of specific investments, let’s break it down in general categories.

Income generating assets. This is probably the broadest definition of what true investment is. It’s an asset that produces income streams. This can include interest or dividend bearing financial assets and rent generating real estate. The secondary advantage – in addition to the income stream – is the fact that most income generating assets tend to rise in value over time, or at least not to lose any.

At the opposite extreme, you can identify consumer goods by the fact that they have a specific physical purpose, generate no income, and often depreciate in value. These are the kind of “investments” that are best avoided, and purchased at minimal cost when absolutely necessary.

Business assets. Business assets are also a form of investment. They’re the kind of assets that enable you to produce an income from your occupation, rather than generating it passively as more traditional investments do. Business assets can be the purchase of a computer software program that will enable you to run your business more efficiently or increase profits, a lawnmower or leaf blower for a landscaping business, or purchasing a database for marketing purposes.

Investing in yourself. Any expenditure of money that is done in order to enable you to acquire new income generating skills – or to improve an old one – is a form of investment. It could be a course that you take at a community college, a seminar that you attend, or buying a new software program that enables you to learn an entirely new skill. If it raises your income level, it’s an investment – and one of the very best kinds at that.

Investment hybrids. There are assets that can be either a consumer good, and investment, or both. That’s where it gets tricky. For example, a car, computer or a cell phone that are used both for business and pleasure. If you are a salesman, and use your car 90% for business, then the car is an investment. If your computer is used primarily to run your business, that’s an investment. Ditto for a cell phone. But sometimes these assets are purchased with the intention of business use that never happens, and other times they have only very minor business applications. The amount that you spend on any of them should be dictated by how important the asset is in the production of income.

Why go through an exercise defining something so basic as an investment asset? Because some purchases have the potential to improve your finances, while others are mostly draining them. When you come to know and appreciate the difference between the two, you’re on a path toward financial freedom. When you can’t – you are running with the herd, hoping against hope for a better life that will never come.

Where are you investing your money – in consumption, or in real investment assets?

( Photo by Marcin Wichary )

2 Responses to Consumption is a Poor Investment

  1. In Canada, especially a city like Toronto where I live, the housing market is so inflated that real estate is not an investment. There are people who put down 10% down payment for a $600K house with the notion that it is a sound investment and that housing prices will continue to be on the rise. I personally don’t understand how that is an asset when the liability is so huge! And if interest rates are to rise, many people won’t be able to afford their houses (I guess that’s what happened in the US).

    In the case of purchasing a new car, even if it’s not a very fancy one, the new starts to depreciate as you drive it out the dealership parking lot!

    Ho hum. I am not an expert (or anything close to it!) on how to spend money and where to invest, but sometimes I am bewildered at what people find value in.

    I agree with your list of true investments, but I would also add Investing in People. I went to the dollar store and bought my toddler a broom and am teaching him to sweep. Currently all he does is spread the dust I collect, but one day, he will do the sweeping which will free up time for me to invest in myself 🙂

  2. Hi Emily – Teaching your son to sweep early will pay off later. We bought our son a toy vaccumm cleaner when he was just a year old, and now that he’s a teenager, he vaccuums for real, and cleans the bathroom too! Both our kids also cook, a skill we introduced them to early. Our daughter just made lasagna for a class project, and the tray came back empty!

    But back to the housing market, when prices are rising common sense leaves the equation. People assume prices will always rise. And they will – until they don’t anymore, and that’s when things get ugly. Unlike a stock market crash, a real estate price collapse affects people on a very real level. When that happens, everyone will look back and say “what were we thinking”. Until it does, nothing anyone says will change their thinking.

    As much as we like to think of ourselves as sophisticated, the most intelligent of Gods creatures, and “the best educated generation ever”, we are in fact quite the lemmings.

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