I discuss dividends and investing a lot here at Dividend Mantra, but I've also been very open about my belief that one's ability to achieve a high savings rate will have far more relevance on their ability to build wealth over the long haul. Being an all-star investor is important, of course, but being an all-star saver is even more important. Put the two together and you'll be unstoppable.
I tend to look at my expenses through a different set of lenses compared to most people. Most compare their work income to expenses, and if the expenses are covered by income then that's considered a pretty good situation. Even better if there is a gap between that job income and expenses, and better yet if that gap is large. However, I don't look at my work income and compare it to how well covered my expenses are.
I instead look at expenses in two different ways, and how I look at them depends on if they are recurring in nature or only one-time expenditures.
I look at recurring expenses as a noose around my neck, quite simply. The more of them I have the tighter the noose becomes. Every recurring expense I have means I am obligated to earn some type of regular income constantly to cover that liability. If I lack an ability to earn a regular income for whatever reason, then I am no longer able to pay whatever recurring bill is in question.
Examples of these types of expenses include a mortgage, car payment, cable bill, phone bill, utilities, etc. These expenses demand a constant stream of income because they are also constant in nature; they never really go away, for the most part.
Building a passive source of income is designed to cover these expenses, because most popular sources of passive income (dividend income, rental homes, fixed income) is designed to fluctuate as little as possible so as to cover likewise consistent bills. The quicker you can reduce recurring expenses while also simultaneously increase passive income, the quicker you can declare yourself financially independent.
I don't tally up recurring expenses and compare them to my ability to go out and earn a wage. Instead, I determine exactly how much I'll need invested at a realistic yield to pay for my regular bills. My entire portfolio has a yield of somewhere right around 3.5%, so that's typically what I use for these calculations.
So, if my recurring/fixed expenses are $1,400 per month, that means I need $480,000 ((1400*12)/0.035) invested and earning a 3.5% yield in order to generate enough passive income to meet my obligations without having to sell off any assets. That's no small sum of money. So, as I pointed out above it's in your best interest to minimize your recurring expenses down to a level that is sufficient, realistic and maintainable.
I'll use myself as an example. As many of you already know, I don't have a cable television subscription. I instead use a digital OTA antenna and get 5-7 channels (depending on weather), which are HD and free. But, this isn't always fun or easy. This past Sunday my girlfriend and I had to play digital antenna tetris where we stacked the antenna on top of a box fan, which was then placed atop a dog stroller. This was so we could get football, because for some reason we could only get a signal in that one particular spot. We all do what we have to to save money (and watch football). It's not always easy, but it sure is fun!
I look at recurring bills as a noose around my neck because as I'm suffocating myself through my own actions - mounting up bills that require me to go out and work to pay for - my cash flow is also suffocating, as I'm unable to divert cash to investments because it's being used to pay bills. Reversing that trend and increasing your free cash flow is paramount to your long-term success and ability to build wealth.
I look at one-time expenses a bit differently. Although they aren't a noose that starts to tighten its grip right from the first day of the month, they do choke off cash flow when they occur. I try to limit these as much as possible, but sometimes this is difficult.
One-time expenses are expenditures or obligations that aren't recurring in nature. Examples include the occasional replacing of long-lasting, durable goods like furniture, appliances, clothing or even the result or rare events like medical care, gifts or vacations. These expenses can't always be as easily controlled as recurring expenses, nor can they be as easily forecasted.
Because of their irregular nature, I don't calculate how much capital I'll need invested in order to yield an appropriate amount to pay for them. Instead, I do two things. First, I automatically build in a margin of safety to the calculated passive income I need to cover recurring expenses and the capital necessary to yield the appropriate amount of income, thereby having a little capital left over every month to cover unforeseen expenses. Second, I justify each expense on an individual basis and compare the cost of the action to how much invested capital (and hence, passive income) I'd have at a later date if the expense didn't occur.
For example, I recently discovered that I'm still dressing in clothes that I purchased just out of college. Although I can still physically fit in these clothes, psychologically it feels very strange indeed to wear ripped jeans and graphic t-shirts every day. What was appropriate for a 22 year-old might not best befit someone soon turning 32. I actually realized this a while ago, but my inner frugality convinced me to continue dressing age-inappropriately. So, I've mostly stuck to the same set of t-shirts, jeans and extremely casual clothing I've had for about a decade now.
I decided I have two options. Option 1 is to live with what I have. The clothes still shelter me from the elements and allow me to walk into establishments without fear of being arrested for indecent exposure. Even though I might look funny dressing like a college kid, life could be worse. This option costs $0. Option 2 is to finally update my wardrobe to levels more appropriate for my age and purchase a pair of chinos, maybe a nice pair of dress pants, a blazer or two, some dress shirts and maybe a pair of dress shoes. I figure Option 2 will likely cost me $1,000 if I buy quality clothing that should last a while.
After some deliberation and discussion with people close to me, I decided on Option 2 (this option was heavily favored by everyone). So, I have a one-off expense of $1,000. What I do when I'm faced with a one-time expense like this is I compare this expense to how much future capital I'd have had the expense not occurred. Let's say I can earn 8% on my money for the long haul. And let's say I can get by for another ten years with the clothes I have (the only holes in them were there were when I bought them). That means I'd have $2,219.64 ten years from now (ignoring taxes and inflation for simplicity and brevity sake), and figuring that capital stayed invested earning a respectable 3.5% yield I'd have $77.67 per year in passive income coming my way. Doesn't sounds like much; but it's more than nothing. And that will only continue to grow for decades on end from there.
After doing the math, I concluded that I'm actually okay giving up my right to that future capital and the passive income stream it would build. Obviously, I usually don't take the path to spend money but instead quite often choose the future capital. However, the point of the exercise is to add up the numbers and seriously contemplate whether the action is worth the ultimate cost. That $1,000 TV isn't just $1,000; it's giving up the right to a lot more future capital and an income stream for the rest of your life. That $3,000 vacation isn't just three grand. It's a whole lot more than that. If you're okay with the ultimate cost after running the numbers, then that's your decision. But if you just look at one-time expenses for the money that leaves your pocket today and act like it won't impact you ever again - well, I believe you'd be making a mistake.
The key to looking at recurring expenses and one-time expenses is looking at them differently. Recurring expenses require a source of constant income to pay for. If you plan on ever becoming financially independent, you'll have to replace your job income with a passive source of income that hits your bank account whether you work or not. And the bigger your monthly nut is, the more your passive income must be in order to meet your liabilities. Conversely, one-time expenses don't require a constant source of passive income. However, the money must come from somewhere so you'll want to build in a margin of safety when you figure out how much passive income you'll need to cover your recurring expenditures. Furthermore, you'll want to calculate exactly how much one-time expenses are truly costing you. That $3,000 vacation to Europe ends up being a lot more expensive when you compound $3,000 over 30 years at 8%!
How about you? Look at recurring expenses and one-time expenses similarly?
Thanks for reading.
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