In America, this task starts to become difficult at a very early age. We live in a culture saturated by carefully-choreographed advertising and marketing campaigns. These infer that unless you have the very latest and greatest of whatever product or service is being offered, your life is less than ideal. Particularly in the area of technology, which is changing at a breathtaking pace, can this be a challenge. It may be a simple as not appearing as "cool" as the kid next door who has the latest and greatest. For example, I happen to own the very first version of the iPod Nano from Apple. It's a great toy. As I write this, however, I am already two versions behind. My Nano cannot play video; the newest model can both play and record video. Apple would very much like to sell me on the idea of running to the nearest authorized retailer, or their online store, and upgrading as soon as possible and their advertising is very carefully produced, by wonderful people who are extremely talented and paid very well, in an effort to get me to do so.
"How Much do I Want It?"
I am going to propose here that each time you are considering the purchase of a product or service, the key or fundamental question you need to ask yourself is "how much do I want it?"That may not have been the first question that came to your mind. Your first thought, or what you may have been taught, may have been to ask either "can I afford it" or "do I really need it"? I am going to propose that the question "how much do I want it?" gets to the core of the situation far better than the other two questions.
The Problem with the Question "Can I Afford It?"
Consider the question "can I afford it?" This question does not really get to the heart of the issue. For example; if see an iPod you like priced at $149, and you happen to have this amount or more in your bank account, at some level the answer to this question is "yes." But that does not necessarily imply that you should immediately purchase the iPod. If the answer were that simple, many individuals who have followed the principles we will discuss in this series could easily put a new BMW or Mercedes in their driveway any time they so chose. And yet, at least at the present time, they may choose not to do so. That choice will likely be made based on the decision-making process that I will discuss here. Ironically, it is often because they have learned how to choose properly that they are in that position today.At this point, please take a minute to digest a very important concept: With the exception of those born with proverbial "silver spoon," for most of us life is about choices. While there are a few who truly are able to buy this and that, or do this and that, for most of us the choice becomes this or that.
The Problem with the Question "Do I Really Need It?"
At first glance, this seems like a very reasonable and logical question. However, while the question has some merit when posed in connection with a decision to make a purchase or undertake an expense, I propose that the answer will often prove very elusive, with a side effect of causing needless guilt.Take the iPod we've been considering. Does anyone actually need an iPod? After all, the fact that generations of humans lived full and satisfying lives prior to the invention of the iPod would seem to answer "no." The trouble, however, is that at some level this question is designed to induce guilt; as if the idea of owning or doing anything that adds enjoyment or richness to one's life is somehow an evidence of moral deficiency. If that logic were true, than no one should pay to see a performance of Shakespeare, an opera, and certainly not to pay to travel to Paris and visit the Louvre Museum to view the priceless artifacts displayed there. While technically one could live without any of these activities, they contribute enjoyment, meaning, and richness to life.
This or That - the Decision-Making Process
Perhaps now you are starting to grasp the beauty of the question I propose you ask: "How much do I want it"? You see, this question accurately conveys the point that there will be a price, some price, for making a purchase. By "price," I'm not referring to the actual monetary cost of the item, but rather a price that will be paid in terms of an effect on your life, something else that you will likely not be able to do or buy because of your decision to do this, or purchase this.Let me give you an example: I enjoy visiting Italy very much. I love the scenery, the food, and the people. My wife and I can take a two-week vacation to Italy, and treat ourselves quite nicely, for somewhere in the vicinity of $6,000. Let's say, though, that I am browsing craigslist one day and run across an ad for a classic used car, one that will let me relive the glory days of my youth. As it happens, the asking price just happens to be exactly $6,000, and the seller lists the price as "firm," in other words they believe the price is fair and are not willing to negotiate any lower. Assuming I am not so wealthy that I can afford both, I now face a choice. A decision to purchase this car would likely mean that there is no trip to Italy in my immediate future. If the item I am considering purchasing is even more expensive, the implication might be that I won't be able to enjoy another Italian vacation for years. Neither choice is right or wrong, but rather becomes a matter of deciding what is important to you, what your priorities are.
Therefore, the decision-making process becomes vital. For the remainder of this article, I am going to give you two different tools, or thought processes, that should get you well on your way to making sound decisions.
Tool #1: How Long Do I Have to Work to Purchase This Item?
Earlier, I said that there would be a price associated with any purchase decision, in terms of an effect on your life. A key element of that price gets back to something very fundamental; namely that most of us have to work, and often work very hard, to earn the money we need to make our way through life. Your work represents your time, your effort, your physical and mental talents.Therefore, when considering a purchase, ask yourself "what is the price of this item in terms of my time and effort"?
To help you do this accurately, let's follow our hypothetical friend, whom we'll call Bob. Bob is single, lives in beautiful sunny Southern California, recently graduated from a technical program at the local trade school, and just got his first job, with a starting salary of $50,000. Bob has a great boss and works a 40-hour week, which translates to approximately 2,000 hours per year, or an average hourly salary of $25.
One morning, Bob is surfing the web and comes across an ad from his local electronics megastore. The ad announces that new inventory has just arrived, and all existing items must be cleared out this weekend, at rock-bottom prices! One of the sale items is a 50" HD flat-panel TV that would look great on his wall. None of Bob's friends has one of these. Bob immediately sees visions of hosting the next Super Bowl party, and being the envy of his friends! Not only that, the price for the TV has just been reduced to $2,499.95! It was $4,000 just six months earlier. Should Bob purchase the TV?
Take a look at the exhibit below. As you do, ponder the question I proposed earlier; "What is the price of this to Bob in terms of his time and effort"?
That would be true if it weren't for taxes. Taxes are the funds the government extracts from us for providing services; such as roads, schools, fire and police protection, and many other things. Whether or not the services are worth the money they extract is a hotly debated subject. But, it is somewhat irrelevant from our standpoint. They must be paid, unless you fancy the idea of the IRS or some other agency tracking you down and penalizing you.
The first tax in the above diagram is sales tax. Living in sunny Southern California, Bob is probably subject to an 8.75% sales tax in most jurisdictions as of the time of this writing. So, right off the bat, the TV is no longer $2,499.95, its actual cost is $2,718.70.
As with most Americans, though, the far more expensive tax for Bob is income tax. Bob's employer does indeed pay him $50,000 a year for his services. But that's not what he actually takes home in his paycheck. The federal government starts by taking their share (federal income tax). An additional amount goes to Social Security and Medicare. In addition, since Bob lives in California, they take their share as well (state income tax) as well as disability insurance, in case something happens to Bob such that he can't work for a while.
As you will see from the diagram, in Bob's case this comes to $8,525 per year, or an effective tax rate across his total income of 17.05% ($8,525 ÷ $50,000), leaving him with only $41,475 that he actually takes home.
Before I go any further discussing Bob's analysis, and the question "how much do I want it?" let me leave you with this key takeaway: taxes matter. Because the government takes the first 17.05% of every dollar Bob earns, in actuality Bob has to earn, not merely the actual $2,499.95 base price of the TV, nor even the $2,718.70 amount once sales tax is added, but $3,277.51! The item is actually 31.1% more expensive than it appeared at first glance. So, as opposed to 100 hours, it actually turns out that Bob has to work 131 hours to pay for that beautiful TV he want so badly. And that's if he can afford to pay for it in cash. If he has to go into debt to buy it, it gets much worse very quickly. But that's a subject for another section.
Here's the main point, though. Now, Bob has one tool to help him evaluate how much he wants that TV. Does he want it enough, is it important enough to him, that he is willing to give up approximately 16-1/2 working days to buy it? Put otherwise, that is almost 3-1/2 weeks of his time and effort that he will not be able to use to accomplish anything else, financially. He won't be able to use it to eat out with his friends, go skiing, much less save or invest it such that he actually might have more some day.
That leads very nicely into our second question, or tool.
Tool #2: What Am I Giving Up In the Future by Purchasing this Item?
Once again, do you remember a key concept I shared earlier? Namely, that there would be a price for each purchase in terms of an effect on your life? So far, I've encouraged you to consider this from two vantage points:- The concept that you will likely need to choose this or that; that if you purchase or do one thing, you will likely not be able to purchase or do something else.
- The related concept that there is a price in the form of the time and effort you must expend in working to acquire the needed money.
The younger you are, the more seriously you should consider this perspective. For the younger you are, the more time you have ahead of you, at least from the standpoint of average life expectancy. Given that time, many options will open to you. The number and variety of those options, however, will at least in some part depend on the amount of money you have to take advantage of them. If you want to buy a house someday (and genuinely be able to afford it), you are going to need money. If you want to be able to drive a decent car, you will need money. If you wish to travel to distant and different places, you will need money. If you get married and have kids, you will need money to house, feed, clothe, and educate them.
The good news is that any money you decide to save and invest now will grow to a much larger amount if you give it a little time. Back to our friend Bob. Let's say that Bob decides that the 27-inch TV set Dad and Mom gave him when he left home is all he needs for now, and that he would actually rather save and invest the $2,718.70 instead. Take a look at the table below:
To see the power of this at work, let's follow your original $2,718.70 down the 3% column in the table above. Did you note that at the end of the first year, it has grown to $2,800.26? That implies that you received $81.56 in interest that first year. Now, look at the value at the end of the second year. It is now $2,884.26, which means you received $84.00 in interest during the second year. Why did you not simply receive the same $81.56 that you received in year one? After all, you did not make any additional deposits to increase the original amount you started with. The reason is that you were paid interest not only on the original amount (the "principal") but also on the interest you earlier received. Now, it doesn't look too impressive at first; 5 years out you still only have $3,151.71. But take a look 40 years out; your original $2,718.70 has grown to $8,868.49, more than triple your initial amount saved! The best part is that you did not have to work a single additional hour for that to happen, your money did the work for you! Pretty good deal, huh?
Finally, take a look at the difference in the second column. The second column tracks the growth of your money if you are able to earn a 7% rate of return, on average, each year. Over the first few years, it doesn't appear that earning 7% vs. 3% really makes that much of a difference. At the end of 5 years, you're only about $660 ahead. But by year 20, you have more than twice the money, and 40 years out you have almost five times as much money as you do at the 3% rate.
I picked the rates of 3% and 7% for a reason. I wanted to take a fairly conservative approach while still making the point that, given time, money you save and invest will grow very handsomely. Over time, it should be relatively easy to average a 3% return simply by putting your money in savings accounts or CDs. Your principal would never decrease, but rather would grow over time, albeit slowly. In contrast, if you invested in a nice balance of stocks and bonds, it is not at all an unrealistic expectation that your money could grow at an average of 7% over time. The road would be a little bumpier, as you would have more direct exposure to the ups and downs of the economy, but the extra return is the market's way of paying you to take that risk.
We'll delve deeper into all these options in later chapters; for now I simply want to reiterate the point that saving and investing can be very good for you over the long term. However, the harsh reality is that you probably won't ever have anything to save unless you do what I proposed in the very first paragraph of this chapter; namely control your spending.
Summary and Conclusion
In this chapter, I started by highlighting the simple truth that in order to make financial progress, we first need to learn to control our spending. For most of us,the choice as to what we purchase or do comes down, not to this and that, but this or that. Additionally, no matter what you have, there will always be something newer or "cooler" out there, with some added feature. The question you have to ask yourself is whether you want it enough to keep giving your money away in a never-ending cycle?I proposed that a key question to ask yourself when considering any purchase is "How much do I want it"? I then gave you two very practical and helpful tools to do so. In the course of the discussion, we discussed the price you will have to pay, in terms of your time and effort spent working, the fact that you will likely have to give up something else, and finally that the money you spend has the potential to grow significantly over time if you choose to save and invest it as opposed to spending it. In the course of the discussion, we also talked a little about the effect that taxes have on your power to spend.
Before we leave this chapter, please allow me to share one final thought. While I suggested above that, in my opinion, the question "Can I Afford It?" was not the very best way to think about making spending decisions, it does have some merit. All of us must prioritize for fundamental human needs, such as food, clothing, shelter, and medical care. This takes on even greater meaning in later life if one must also provide for a family, including children. If a purchase compromises your ability to be self-sustaining in these areas, the answer to the question "can I afford it" when considering any discretionary purchase should be "no."
In our next two chapters, we will address two areas related to this; beneficial versus harmful and even dangerous use of debt, and setting up a personal budget.
© 2010 Karl D. Pratt - All Rights Reserved
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