When first attempting to gain some control over your finances, it’s particularly helpful to micromanage. If your money is in a state of disarray due to spending more than you’re earning, then it’s helpful to look at every little expense, at least for a time. This will help give you a more accurate picture of your overall “outgo.” You may decide that those expensive coffee-related drinks you buy every day add up over time, and you can use that money for more important things, like investing for the future. (This idea is known popularly as the “Latte Factor®.”)

Paying close attention to the minutiae of spending is certainly helpful to many people as they learn to gain control of their financial lives and maintain that control. It’s easy, however, to get into the habit of looking through a microscope so often that you fail to see the bigger picture. This is a classic case of being penny wise, pound foolish.

Put another way, buying the wrong car can in an instant undo years of your hard work and financial gains sustained by eliminating your daily latte or replacing it with a $0.99 coffee. Following a tip on a hot stock has the possibility of decimating your investment in a short period of time. In fact, although I wouldn’t consider Vanguard’s Total Stock Market Index (VTSMX) a “hot stock tip,” I invested $5,000 in this fund for charitable causes at the end of of 2008, and the value has already dropped by 10%.

An article at the Motley Fool presents an interesting idea to illustrate just how much one big mistake, though seemingly innocuous, can undo years of scrimping and saving pennies here and there. The article presents a better example for housing than they do for stocks:

Conventional wisdom says that buying a house beats renting because you build equity and get tax benefits on your mortgage interest. But as with any investment, price matters.

And prices got detached from underlying value in a major way during the run-up. Those who took on conventional mortgages with monthly payments they could afford can wait out the storm. Unfortunately, those faced with refinancing teaser rates they could barely afford don’t have that luxury.

To calculate the cost of a housing mistake, let’s assume someone bought a $400,000 house and the house’s value dropped 10% (the latest numbers show average housing prices have fallen 14.4% year over year). That’s negative equity of $40,000, or 10,000 days of lattes. You’d have to skip that pick-me-up for 27 years to make up for this one. Yikes!

While most people decide when to buy a house out of necessity, perceived or actual, many people try to time the housing market, no matter how intelligent they may seem otherwise and how well they’ve convinced themselves of their infallibility. You can pinch all the pennies you want, but if you still make poor choices when faced with major purchasing decisions, you’re no better off.

The best solution is to find a balance between micromanagement and focusing on the entire financial picture.

Don’t Blow Your Retirement With One Mistake, Anand Chokkavelu, Motley Fool, June 19, 2008.

I’m on a quest to determine a number of financial moves that will accelerate savings beyond the typical snail’s pace. I’ve written so far about opening a high-yield account, keeping your change creatively, and automatic your savings. These are all basic concepts that can be applied in interesting ways with a little bit of attention.

Many people disagreed with me when I railed against The Latte® Factor, David Bach’s trademark catchphrase and program which prescribes dropping your expensive morning coffee drink and depositing the value of each day’s savings into some sort of magical account that will return 10% annually after taxes and fees for forty years and end up with close to $1,000,000 more than you would have otherwise.

I’ll address my issues with David Bach’s program below. Nevertheless, a system similar to David Bach’s suggestion has merits for some people, thus I have a fourth tip for putting your savings in hyperdrive.

4. The Expensive Coffee-Related Drink Factor.

Obviously, I don’t want to call it The Latte® Factor, which is a registered trademark and a signature selling point that drives millions of dollars in books in seminars. Since I don’t drink coffee, I’ll use the therm ECRD to refer to any habit that requires a frequent expense but is easily controlled or replaced by another, less expensive habit. The savings from the elimination or switch can be accumulated and deposited into a high-yield savings account.

Problems With The ECRD Factor

It is important to remember that all of this is pointless if one doesn’t make smart decisions about the larger issues in life. You can forgo the daily coffee from Dunkin Donuts, but if you still eat two doughnuts every day, you’re spending money on something that you may pay for in health care costs later on. You can switch from premium gasoline to regular gasoline, but if you buy new cars every three years, the savings from the gasoline are ten or a hundred times lost by the unnecessary expense of buying new cars so frequently.

The scenario David Bach paints—an after-interest, after-fee, after-tax increase of almost $1,000,000 in 40 years from dropping your daily latte is an extremely unlikely scenario, both mathematically and behaviorally. Bach makes some serious assumptions that don’t have much validity in the “real world.”

• You probably won’t earn 10% in an account for forty years after taxes and fees.
• To invest in an account that earns even 8% over forty years, you will lose a lot of your money due to transaction fees. A $4 transaction fee, like the one charged by ShareBuilder, on a $150/month investment is a 2.7% fee right off the top. That’s not a wise investment.
• Without your daily dose of caffeine, you may miss out on career opportunities while asleep at your desk. This sounds like a stretch, but if you quit cold turkey, you could see adverse effects in your productivity and you may miss an opportunity without knowing it.
• It’s also quite possible that you enjoy your latte, understand the consequences and future savings you are giving up, and have decided your enjoyment is worth the potential loss.

So The ECRD Factor can have mixed results when you deal with variables in the real world. Don’t expect the kind of wonderful returns David Bach promises, but the frequent expense reduction or elimination that forms the basis of this tip can be a significant part of your saving strategy if the rest of your financial decisions are sound.

Making The ECRD Factor Work

What’s your ECRD? It’s probably best to pick something to which you do not have a physical addiction without appropriate support. While I would always suggest eliminating an addiction to heroin or alcohol, there are more immediate concerns in these cases than saving money, namely staying alive and healthy. It’s best to choose a daily expense that can be eliminated or replaced immediately without any significant withdrawal symptoms. The daily coffee-related drink might be a good candidate, particularly if you buy such drink from an expensive store like Starbucks. The good news is you won’t go through withdrawal if you simply replace the expensive drink with your own freshly brewed concoction.

And if you eliminate the drink entirely over the span of a few weeks, or replace it with water, you will get used to the change in chemicals in your brain within a few weeks.

Caffeine isn’t the only option. A coworker of mine has stopped buying lunch every day, opting to bring in a homemade sandwich instead. If not lunch, I know someone who used to eat out at an expensive steak restaurant every week. If you work in New York City, there’s the temptation to go out to the bar for happy hour with your coworkers. Do you smoke? Slowly cutting back will improve your health and save you thousands of dollars even before interest.

How about the news stand in the morning? If you pick up a newspaper on the way to the office to read on the train, consider this your ECRD. Replace the newspaper with a free news podcast if you already own an mp3 player. If you really like the newspaper, consider subscribing. You’ll save quite a bit off the newsstand price. The difference in price is your ECRD.

Apply Your Savings and Earn Positive Returns

If these are habits, cutting back (without affecting your networking experiences) and intentionally depositing the money you save will add up over the long term. It doesn’t have to be perfect. The three previous hyperdrive tips come in handy here. If you’re used to spending $4.50 in cash every morning for your latte and are ready to eliminate the drink entirely, put that $4.50 in your coin jar before you leave for work for later deposit into a high-yield savings account. Not a cash user? If you spend about $100 for your chosen ECRD a month, set up an automatic transfer from your checking to savings account for that amount. If your bank allows you to create separate goal-related accounts, like ING Direct’s subaccounts, create one specifically for your ECRD savings and transfer your monthly savings there.

Your high-yield savings account is not earning the 10% promised by David Bach. Forget about that rate and use the money saved for short-term goals. The more you save, the more you’ll also have available for long-term goals like retirement and legacy. So keep making good decisions all around—especially on the bigger expenses like real estate, vehicles, and education—and these seemingly small savings will add up over time. It starts off slowly, but compounding interest is the key to putting you savings in hyperdrive.

Image credit: Drab Makyo