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.
Published or updated June 23, 2008.
{ 3 comments… read them below or add one }
Good point to the post. Some people worry about spending on small things when if they saved on the big things, they could buy lots more of the small things, still save money, and not feel pinched. Homes are one example, but cars, when leased or traded in often can lead to a large loss in money. Also, if you drive a car for 30 years that averages 25 mpg versus an SUV or pick-up that averages 15 mpg at a moderated 12,000 miles per year and earn only 3% interest on the money for gas at an average of only $2.25 a gallon, (considering past price history), you would have an extra $37,000 in your bank account at the end. If you go to 15,000 miles per year, $2.75 per gallon average and earned 4%, the savings would be $64,000!
UH2L: Quite right! You’d have to cut back on 16,000 $4 lattes, or one a day for almost 44 years, to achieve $64,000 in savings (not taking interest into account).
I am observing this same thing happening with a person close to me, and am having to bite my tongue. This person is buying a house in a town they don’t like, that is 25 minutes farther away from where they and their partner work, and which they’re planning on living in for less than five years. They believe that “you have to get on the real estate merry-go-round some time” and that “now’s the time to buy”.
I’ve given my advice, and now it’s time for me to stand aside and be happy for them.