Six Sigma Techniques for Your Budget
“Cure for an obsession: get another one.”
There are few things about which I am obsessive. One of them is toothpaste on the rim of the tube. For whatever reason, if the top doesn’t smoothly twist onto the tube, it drives me nuts. Yes, I know…squeeze toothpaste. Even though I am a generally Type B personality – which caused no end of consternation to my bosses in the Army – I do occasionally get my knickers in a twist over a few things.
One of them was looking at my net worth after I graduated from business school. Probably because it was quite a significant negative number.
So, seemingly every day, I’d fire up Microsoft Money, download statements, and see if we were making any progress. I did the happy dance when we finally got to a net worth of zero.
Then, slowly, over time, we got above zero.
Eventually, though, I started wondering what the world would look like when I retired. I harbor ambitious plans of early retirement, so I started trying to determine what I would need to retire.
That’s when I had the “a-ha” moment about what I really needed.
What I needed was the ability to pay for expenses. I wanted to be able to cover a certain amount every month through a variety of sources – to pay for food, electricity, etc.
It wasn’t my asset base that I was necessarily concerned about; it was the income and purchasing power that the asset base could create that I needed to focus on.
In 1920, a couple of Yale professors, Irving Fisher and Harry Brown, came to a similar conclusion in their book The Purchasing Power of Money. People who save, invest, and borrow money are concerned with its actual purchasing power. Inflation and prices rise and fall; yet, we generally consider money as something stable. Furthermore, we don’t really consider what a certain amount of money can yield in future income. Instead, we think in terms of either present income or present purchases.
Now, before you dismiss everything I have to say out of hand, I’m not saying that net worth isn’t important. Yes, you need to get your personal balance sheet positive, where assets are more than liabilities, and, better yet, get liabilities to zero. It’s much more fun to live life without debt! But, the focus on a “Number” – the magic point where once you reach it, you’re done – is probably overstated.
Here’s what you should be looking at:
- You can’t really change your net worth on a day to day basis. When I was in my obsession period (right after my Blue period and before my Orange period…thanks Picasso!), my wife and I were getting paid twice a month. So, for two days a month, our net worth went up. Whee! Yet, we spent money the other days of the month too. So, for 28 or 29 days a month, our net worth went down. Boo! Instead of seeing and appreciating the overall progress that we were making, my Monkey Brain was focused on 2 wins and 28 losses each month.
- It’s what you get in return for the assets that matters. As Ludwig von Mises postulated, money is simply a proxy for exchanging goods and services because there is no more efficient mechanism for doing so. If you were a shoemaker and needed bread, but the breadmaker didn’t need shoes, you’d have to find a third party to intermediate. That’s what money does. It’s why inflation is important. The purchasing power of a million dollars is less today than it was fifty years ago and will be less still in fifty more years. Over time, money sitting in cash loses its ability to buy things for you.
- Income provides you with security. This study shows that people who have sources of income feel more security. I believe that this is because people are more concerned with their purchasing power, and they’re more concerned about today than they are about the future.
Once you understand that it’s not net worth, but, rather, your potential purchasing power with future income that is important in retirement planning, you can take an additional step. Research from Boston College’s Center for Retirement Research shows that people who factor in how retirement investments can translate into future income save more than people who simply think about an amount to save. When presented with information about how much income they could get if they made additional contributions to a retirement plan, people saved 29% more than those who were not presented with that information.
If you’re sitting in your next HR presentation about 401k plans, or you’re deciding how much to contribute to your IRA, you might not have a calculator handy to tell you how much your contributions could actually affect your retirement income. What do you do then? An imperfect but effective way to estimate retirement income is to multiply your contribution by 0.03. The result you get is roughly how much annual income the contribution you make in one year would get you thirty years later. It’s an imperfect heuristic, admittedly, combining SAFEMIN and recent research challenging the 4% safe withdrawal rate for retirement, but it’s the process of thinking about future income which is important.
So, while net worth is important, it’s really just a proxy measurement for the things which matter – what can you purchase now and in the future, and how much security can that bring you. Furthermore, if you obsess over your net worth on a regular basis, you’re going to remember the losing days more than the winning days, which will cause you to take unnecessary risks to try to have more winning days – counter to the strategy that you really need to be following.
If you’re going to obsess about something, make sure it’s insignificant, such as how many times Snooki will say “um” in the next Jersey Shore episode.