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.
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.
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?