Time Value of Money

From Investopedia:  "The time value of money draws from the idea that rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time. For example, money deposited into a savings account earns a certain interest rate and is therefore said to be compounding in value."

This is a fancy way of saying that spending money today that we could have saved adds up--especially over time. As we spend, the "adding up" is obvious, as in "I overspent on groceries, eating out and movies, that that adds up to $150 over what I planned to spend this week." Do that every week for a year, and that adds up to $7,800 overspent during that year. That is becoming real money, but we haven't yet factored in the "compounding in value" multiplier that results in that adding up to larger numbers over time. 

Time Value of Overspending

Here is how that would look over 20 years:

Spending $7,800 more than I want for the next 20 years totals $156,000--a meaningful amount of money.  If I would have invested that money in something earning 5 percent return yearly (which is the lower end of what the stock market has returned over the decades), this is really costing me another $102,000 in money I could have had at the end of those 20 years. Ouch!

Hopefully this is eye-opening for you, but I can imagine some people saying "That's just a few thousand per year; it's not that big a deal."

I can relate to that, but here's what that thinking can miss:

  • $125/week in overspending adds up to at least $500 per month in real money I don't have (lost "cash flow") to pay for other things. Most people would struggle to avoid racking up credit card debt and/or avoid checking account overdraft fees when they overspend by $500 every month. This cash flow hit can be a killer.
  • If I'm making $100,000 per year, my available cash after taxes is roughly $70,000 per year. Overspending by $7,800 is about 11 percent of my available cash. The counterintuitive aspect of this is that if I had pre-planned to invest that money instead of letting it slip through my fingers, it wouldn't be that hard to control that spending (by, for example, having that money automatically deducted from my paychecks and sent to that investment account), and I would not only avoid the cash flow stress of unplanned spending, but I would also end up with that $258,000. 

Factoring in modest inflation over the next few decades, that $258,000 is about an extra year's worth of living expenses in retirement.

  • Yeah. That's real money.

The Overspending Double-whammy

By not paying attention to this kind of spending, we get ourselves into cash flow trouble, and we end up with way less money later. Ouch!

Astute readers will be thinking that these numbers become even more dramatic at higher levels of unplanned spending and at higher incomes. Here are some examples: 

This adds up to half a million to a million in lost value at these higher numbers, and it is really easy to let this happen as income (and life's complexities) grow.

The Magic of Paying Attention

Like many "simple" behavior habits (including healthy eating and regular exercise), our spending habits have a way of sneaking past our best intentions. One solution would be to think carefully about how much we should spend every time we make a spending decision.

In the absence of that magic wand, we do have some human nature "magic" at our disposal: Recency bias.

  • Recency bias is a cognitive bias (a subconscious error in thinking) that causes us to assign more importance to recent events than to older events. 

We can use this part of our human nature to our advantage here. By simply paying attention to our spending--as soon as practical after we make spending decisions--recency bias will help nudge our brain toward being more consciously aware of our spending when we make the next spending decision. This tiny nudge adds up into a greater awareness of our own behavior.

Do Try This at Home

Try this yourself. The next time you make a spending decision, think about how that decision makes you feel:

  • In that moment
  • The next day
  • The next week

No judging; just feel. Try it.