How Much That Splurge REALLY Costs You...

Full disclosure time here at The Bill Stark Blog: I suck at staying in my budget for my weekly personal spending. Time and again when it comes to Budget Night at the Stark household my wife has chastised me for not being able to stay within the boundaries of my budget for eating out at work and buying the things I want. One solution to my over spending problem? Looking at the math behind what those added expenses truly cost. The results led me to change everything.

My spending problem

I’ve written before about the moment I decided I needed to start caring about my spending and personal finance habits. I was never the type of person who spent his money on lavish goods; I’ve never purchased a brand new car (I always pay in full for slightly used), I don’t buy lots of electronics (even though I work in the technology industry), in fact I rarely splurge on things at all (exception: buying gifts for others). Yet early on in my relationship with my eventual-to-be-wife she pointed out that despite earning half my salary she had as much in savings for the simple reason that I spent more than she did.

The question for me was: what in the hell did I spend my money on? It turned out the difference between my wife’s spending and mine was simple: I ate out way more than she did. To fix that we utilized the most powerful financial tool in our arsenal and created a budget to set a reasonable limit on how much we wanted to spend eating out each week. In fact, we decided to simply allow ourselves a small amount of money we could allot to spending on whatever we wanted, guilt free, every week. For those wondering at home, the total we settled on was $25 each plus a separate $25 for the two of us when we went out with friends or family.

Even with the budget, however, I struggled to keep my spending in check. As a natural-born extrovert I get energized by being around the people I like so it was really difficult for me to say “No,” when someone at work asked if I wanted to grab lunch. Plus there were tangible benefits to my career in learning to get to know my coworkers better and interacting with people outside of the office. After all, I wouldn’t want to find myself in a position where I was paying my boss just so I could do my job. But I was consistently spending two or three times what we had budgeted on these excursions each week, and that was a problem. Or was it? I started to wonder if maybe our budget should just increase so I could enjoy eating out; after all, $50 each week wasn’t a crazy amount of money, and most of my coworkers spent more. Plus, it was less than I had been spending, so what was the big deal?

That’s when we decided to do the math.

The most powerful force in the universe

I’ve written about magic dollars and the most powerful force in the universe and if you haven’t read about it yet you should (follow that handy link!). It turns out compound interest is a helluva drug and can really turbo-charge the strength of your savings. So how do you compound and what is the impact?

You already know what to buy when buying stocks: index funds. These low-fee investment vehicles let you reduce risk by investing in small slivers of lots of stocks instead of betting all of your money on just one thing and exposing yourself to a lot of risk (what happens if the thing you invest in goes out of business?). They follow an index that tries to match the performance of a specific grouping of stocks.

One of the most famous indexes is the Standard & Poor 500, or S&P 500. The index is comprised of 500 of the largest companies on the New York Stock Exchange or the NASDAQ. The specific companies in the index change a bit over time as companies grow in size and contract, but it’s a very popular index and well known within the investment world.

So what does the S&P 500 have to do with the fact I overspend on my personal spending budget each week? Because when I’m not spending money on eating out with coworkers I could be spending that money on investing in the S&P 500, which is what I do with some of my retirement accounts.

S&P 500 and returns

Before we talk about stock market returns it’s important to note this fact: past behavior does not guarantee future success. So we’re going to talk about historical rates of return to help frame today’s conversation, but remember this: just because a stock index has generated a rate of return in the past, that doesn’t guarantee it will perform the same in any given year.

So how has the S&P 500 performed historically? Calculating the number is a bit tricky, but estimates range from 7-12% over a period of slightly more than 100 years of existence. We’re going to work with the conservative number of 7% (if you’d like to try your own calculations you can use the MoneyChimp calculator here). That means if you put $1,000 into an index tracking the S&P 500 when it first started in the late 19^th century, at 7% growth each year today you’d have well over $1,000,000!

That’s how powerful compound interest is, and we’ve talked about that in length here on the Bill Stark Blog (it really is the most powerful force in the universe). The S&P 500 is so highly regarded as an index fund that legendary billionaire investor Warren Buffett even backed it famously in a bet he made against hedge fund investors that their actively managed funds would perform worse than just betting on the S&P 500 without ever picking stocks. Spoiler warning: he’s crushing them.

The S&P and me

So here I am over spending my personal budget by $25 each week instead of putting that money into my savings and investing it in the S&P 500 instead. What is that costing me in terms of lost interest? I decided to do that math to figure things out. Here are the numbers we’re working with before we break them into the equation we’ll use to calculate our answer.

• Amount Bill over spends each week: $25
• When Bill first started over spending: January 2010
• How long Bill could invest that money: we’ll look at 5, 10, and 25 year increments
• Average rate of return: 7% based on the history of the S&P 500 (though we remember that’s not a guarantee, we’re using it as a guide to calculate things for today)

Okay, so let’s say instead of buying sandwiches with friends each week I put that money aside into my investment accounts. I invest it in an S&P 500 index to the tune of $25 each week (the amount I’m over spending right now) and let it run with our 7% guide as a potential rate of return. What is the impact of my investment?

Just setting the $25 aside each week would net me $1,300 each year. Over five years of just setting things aside I’d have $6,500 ($1,300 X 5 years). The investment in the S&P 500 with a 7% rate of return yields $7,836.58. Eating all of those sandwiches is costing me about $8,000; $6,500 in sandwich costs and $1,500 in lost returns over five years that I would have had investing! When I saw that overspending on eating out cost me $8,000 I had to see more.

I needed to know how much I was losing by over spending on a longer term basis. What if instead of 5 years I kept over spending for a full decade? My rate of return would yield about $18,910.48. That’s compared to $13,000 I would have spent on just the sandwiches. Eating out was going to cost me as much in lost interest as all the sandwiches I purchased in five years of dining out with coworkers!

The result of the math if I continued over spending throughout the rest of my professional career? At the 25 year mark my sandwich money would yield me $88,412.82 if I invested it in the S&P 500. It felt like my jaw literally hit the floor. Eating out to the tune of just that $25 extra each week meant that I was passing on the opportunity to save an amount of money equivalent to almost two full-time salaries for the median American worker.

After doing the math I was convinced: it was time to buckle down on my spending.

Getting back on track

There was no way I was going to pass on $90,000 in earnings for retirement simply because I didn’t want to eat left overs for lunch a few times each week. My strategy for adjusting the behavior? I switched to a simple method of paying for my eating out expenses each week: cash only. Instead of relying on my credit card I started carrying $25 in cash and only spending that on going out. When the cash was gone from my wallet? I started saying no to opportunities to spend more money; after all, I couldn’t! I didn’t have any more cash! When I was relying on my credit card it was pretty simple to say “yes” when someone asked if I wanted to grab food. Visa, MasterCard, and American Express essentially guarantee you’ll always have cash on hand, so by switching to cash I solved that problem.

Of course I still get to eat and enjoy the presence of my coworkers a great deal. That was important to me so I found ways to make sure I got to keep that element of the socialization of eating out. I created a few groups that meet over lunch to talk about subjects of mutual interest in an environment that allows us to eat the food we bring with us (naturally one of them is about personal finance!). When I do go out, I suggest eating at the places we like that aren’t quite as expensive; you can stretch $25 pretty far when you’re not spending $15/plate.

The end result? I managed to get my lunch spending back to the $25/week I was supposed to be spending freeing up my other $25 to go towards the savings that would yield thousands in long-term returns through investing.

Keeping it real

For many of my colleagues the notion of only spending $25 each week to eat out with friends is insanely low, and that’s okay. You should set your budget for your weekly allowance to be what you’re comfortable with, and honestly I truly believe you should try to have some amount of money that allows you to splurge on whatever you want within reason. From a psychological perspective this allows us to keep some of our worse spending habits in check (it’s why diets have a “cheat” day).

But it’s also important to own the financial impact of spending $50/week on eating out instead of spending $25. Or spending $100 instead of spending $50. When you splurge on that spending your money isn’t going towards saving and enjoying that sweet, sweet force multiplier that is compound interest. That doesn’t mean you have to cut your spending to $0; remember, all work and no play makes Jack a dull boy. But by being realistic about the impact of our spending habits we can better decide for ourselves what the goal of our finances are and spend accordingly.

As for me? I’m happy to have found a solution to my over-spending (as is Mrs. Stark) and doing the compound interest math has helped motivate me to make sure I hit all my savings targets laid out in the 10 Step Plan to your Financial Future.

(If you’d like to have some fun doing your own calculations for compounding what you over spend on each month head on over to MoneyChimp and try their compound interest calculator here).