Saving for retirement is pretty straightforward. We try to max out 401k’s and IRA’s, hope the markets do their thing over the long haul, and then retire a millionaire. Simple enough.

Hopefully that’s not the full extent of ours savings though. We also need to consider things like…

-Vehicles
-A house down-payment
-Education (self or child)
-Wedding (again, self or child)
-Vacations
-Emergency expenses

I can think of three ways to pay for such big-ticket expenses:
1.) Rake in a monstrous income and pay for them as they come.
2.) Charge them to a credit card or dash to the bank for a loan.
3.) Steal from your future by raiding your retirement funds (and paying enormous amounts in taxes and fees to boot).
4.) Plan well in advance and save.

Unfortunately, option 1 isn’t realistic for most of us, and numbers 2 and 3 are definitely undesirable. It’s clear that we need to become proactive with our savings.

Now the issue at hand is how to save. For the most part, there is no right or wrong way to save. The only blatantly wrong decision is simply not saving at all. However, I’d like to make a case for having multiple savings accounts, each with a specifically designed purpose.

Even though you may not know exactly how much you’ll need (or when), there are still advantages to saving this way. I’ll use an example:

Let’s say that, outside of retirement savings, you have $17,000 in a single money market account. In addition, your old rust-bucket of a vehicle is on its last legs and will need replaced soon. How much of the $17k should you spend on a new ride? How much (if any) should you finance? It’s a tough call when your other big objectives of your savings are considered- a proposed trip to New Zealand, a MacBook, and a healthy cushion for emergencies.

Now with the same $17,000 split up among different accounts- one each for a car, a MacBook, New Zealand, and an emergency fund, the decision is easier. If the vehicle account balance is $9,267.45, you know exactly what you have to work with.

Even though the total sum of your savings is the same, it’s easier to prioritize as you go when you save this way. You can contribute more to accounts of higher importance while depositing smaller amounts to other goals.

A criticism I’ve heard of this method is that, if unavoidable expenses are bigger than the amount you’ve allocated to it, you’re going to have to pull money out of other areas anyway, so why bother to keep funds separate? This is true, but this system ensures that only on genuine emergencies would this be the case. In instances such as the car example, you can raid other accounts only by clearly acknowledging that you’re stealing from one of your other goals. As a result you’ll be much less likely to do so. Besides, by being more proactive, you reduce the likelihood that these situations will create such a dilemma.

To account for some of the uncertainties of life, I’ve opened a miscellaneous savings account in addition my defined ones. It will take some discipline not to tap into it for certain whims, but I think the added flexibility will be beneficial.

With their great subaccount feature, ING* is the perfect banking institution for this setup. I don’t know of any other bank that allows depositors to open and maintain multiple accounts so easily. It literally takes less than 30 seconds to open a new account when you’re an Orange Saver, and the ability to name them is beyond awesome.

Once again, there is no necessarily right or wrong way to save. I just wanted to share this method because it seems to work fairly well. As always, I’d love to hear your opinion on this.

*Note: If you’re interested in ING and decide to open an account(s) with them, let me know. New customers that deposit at least $250 and use a referral code get a free $25 and I get $10, so it’s a win-win for all.

What advice would give your younger self? What do you know now that you wish you knew much earlier? A little while back, J.D. over at Get Rich Slowly wrote what I found to be a really thought-provoking post, by asking his readers to recount their younger and less financially-wise selves. He then did the same thing himself.

He was likely referring to the late teens/early 20s time period, which means I’m not looking back at the time in my life- I’m still in it. J.D. is an extremely smart and successful guy, and when someone like that talks about what they wish they knew at an earlier age, I’d be a moron not to soak it up. For the same reason, I felt I should pass it on.

So without any further ado, here are the 5 financial truths that JD wishes he knew at an earlier age…

1.) Why it’s important to pay yourself first:

The government certainly does this; by the time you get your paycheck, Uncle Sam has already taken his share. It’s foolish for us not to do the same (especially with the respective tax advantages of 401k’s and Roth IRAs).

It’s almost a given that if you wait until the end of the month to save what’s left over, there isn’t going to be much there. By paying yourself first, you make it top priority to invest in your future and consistently inch closer to financial freedom.

2.) How to harness the power of compounding:

Compound interest has often been called the 8th wonder of the world. It’s a double-edged sword though. Depending on which side of the equation you are on (saver or debtor), compound interest can create wealth or destroy you financially.

It’s extremely simple, but once you truly realize this concept, you never look at financial decisions the same way again.

3.) How to avoid the seductive trap of lifestyle inflation:

I haven’t mentioned it on this site, but the “lifestyle inflation” term has become fairly popular in the PF blogosphere. I first learned the concept under another name- “Parkinson’s Law of Finance”, which states that expenses generally expand to fill the available budget. In other words, as you make more money, you tend to spend more money in proportion, and you still don’t get ahead.

This is precisely why people claim that things would be better if only they made more money, even after numerous promotions and raises.

We could go into a lengthy discussion about anti-consumerism and learning to be happy with less, but not today. This problem has a simple, practical solution- always, always save a percentage of what you earn, not a specific dollar figure.

This way you get the best of both worlds. As our income increases, our savings rise as well, but we also get the opportunity to enjoy the fruits of our labor and spend more liberally if we please.

4.) How to avoid the chains of debt:

It seems incredibly obvious, yet many people (and governments) seem to completely ignore the implications of recklessly living on borrowed money.

Clearly, not all debt is equally bad. A low, fixed-rate mortgage with an easy manageable monthly payment is a good example of a more “healthy” debt. But if you’re like the many who use plastic to spend like a drunken sailor, know that you’re borrowing against your future well-being, and it will come back to haunt you.

We in the United States already stand to sacrifice much because of the financial recklessness of our elected leaders. Don’t make it even harder by abusing debt yourself.

5.) How to save on things both big and small:

And then of course actually doing it… Most people probably know how to save on the things we buy, but actually doing it is another matter (just as almost everyone knows that we should eat healthier and exercise).

But there is some technique involved in getting the best value for our money.  Just as we should be aware of small, consistent money drains (the Latte Effect), we also want to avoid making a big blunder on a big-ticket item. A car salesman feasting on an uninformed buyer can effectively erase many small gains made by conscious spending.

~

I’m glad I came across this post of JD’s. It’s solid advice that is all-but guaranteed to help anyone get rich slowly if they apply it faithfully.

Any other pieces of financial advice you wish you knew at an earlier age? Feel free to share them below.

In my last post, I wrote about the potential benefits of tracking income and expenditures all the way down to the penny. While this habit is certainly helpful in itself, we might as well fully utilize our thorough recordkeeping. I’d like to explain how I do just that.

At the end of every month, I tally up three totals:

1.) Total Expenses
2.) Total Income
3.) Alternative Income (Total Income – Work Income)

Alternative income includes all incoming cash flows outside of a traditional job; dividends, home business, Forex trading, web-income, embezzlement (just kidding!), etc.

This figure shows how dependent you are upon paid employment. If your work income ended without warning, what portion of your expenses could you cover with other income sources? Clearly, the higher percentage, the better. In this event, most of us would likely still be tapping into savings (hopefully a healthy emergency fund!) to temporarily get by, but alternative income sources would help mitigate the damage.

And of course, if this figure were to surpass your expenses consistently, you could potentially be in a position to leave your job if you wanted. Even if you would have no desire to, it would still be a good feeling to know that you are there solely on your own terms.

I’ve seen enough graphs and charts in my econ classes to last a lifetime, but I still like to make data visual when I can. Using my incredible Microsoft Excel skills, I did the following:

Note- I just made these numbers up. My real spreadsheet only has one entry so far, so it doesn’t look like much yet. Besides, I’d feel like a show-off posting my real income from my student work-study job!

Then I inserted a simple line chart:

The authors of Your Money or Your Life recommend doing this on a physical piece of graph paper and hanging it on your wall. That’d work great too, and it would be motivating to actually see progress on a consistent basis.  But I’ll opt to use my 21st century technology and save some trees.  The Excel file is saved on my desktop, where I can easily refer to it anytime.

The time investment is minimal, and I think it’s well worth it. I don’t know of a much simpler way to observe financial progress over time. Just remember, that which is measured generally improves.

I’ve written before about managing our money with a higher level of consciousness. But I have yet to discuss any concrete ways to work on developing more financial mindfulness…

In Your Money or Your Life, Joe Dominguez and Vicki Robin draw an interesting parallel between finance and meditation. In most forms of breathing meditations, we strive to become more aware, more present, by watching our breath. To accomplish a similar outcome with our finances, we watch our money- every penny of it, by keeping detailed records.

It’s pretty simple:

Every penny that leaves your life is recorded as an expense.
Every penny that enters your life is recorded as income.

At the end of the month, it’s helpful to tally up the totals. Then you can figure out the net difference (which is hopefully a positive figure!) between money-in and money out.

With this one little number you get a reliable indicator of your financial health. You probably worked hard over the past month, but what do you actually have to show for it financially? Do you have more savings now than 31 days ago, or did you bleed more cash than came in? Either way, the documentation you kept along the way provides a means to scrutinize what happened.

There’s really no specific goal or end in mind, other than increasing awareness. It becomes nearly impossible, however, to spend money without giving it at least some conscious thought. For that reason, it’s likely any costly spending habits that have long gone unacknowledged (insert crack about $5 Starbucks lattes) will be exposed.

I’ve done this off and on several times in the past, but I never considered implementing it as a ongoing habit (read: I got lazy). I started again last month with that intention though.

Here’s a couple of guidelines that I’ve identified for myself:

1.) Use specific descriptions. For example, an entry labeled ‘food’ doesn’t mean much. This could be anything from staples at the grocery store to an expensive dinner out on the town. Big difference.

2.) Don’t go too overboard. Speaking of groceries, it almost certainly wouldn’t be worth the time to list out every single item. I would just list the total. Just look at the receipt if you want to see it in more detail.

Then again, don’t cheat. Don’t buy magazines at the grocery store and sneak them in under ‘groceries’. Make a separate entry. Same goes for alcohol, and probably should as well for any empty-calorie food or beverage. Honesty is key here.

3.) Voluntary contributions to 401k’s and similar tax-advantaged accounts should probably be counted as income. Even though they are pretax dollars, and you never actually see them in your paycheck, it’s still money you earned and are voluntarily saving. This will also give you a more accurate end-of-month figure how much you are actually saving. Of course, hopefully this won’t be your only savings though.

4.) Big, lump-sum payments can be broken down into monthly expenses. For example, if you pay for 6 months worth of car insurance at once, it only makes sense to divide the payment by 6 and apply it over the next half-year instead of all at once.

5.) You’ll also need to decide how you treat interest and dividends. I consider all interest and dividends received in taxable accounts as income. The fact that I don’t use it like normal income doesn’t matter much to me; it’s still money coming into my life. Plus, I’ll record any taxes I pay next April as an expense, so it’ll be accurate. As for dividends received in my Roth, I don’t record these. Outside of actual portfolio maintenance, I basically just pretend like that account doesn’t exist.

There may be some other quirks that you may need to consider, but it’s not meant to be complicated. Once you take the time to get organized and make it a habit, the ongoing time investment is minimal. I just use a simple spreadsheet, which works great, but paper would work just fine as well.

So this is my challenge; if you don’t already do so, try tracking your expenses and income, down to the penny, for 30 days at the bare minimum, then reevaluate. A longer trial (90 days maybe) may be preferable, but my guess is that even one month is sufficient to make it a habit you won’t want to give up.

Part 2: An overview of how I plan to use Excel to visually observe my savings progress over time.

Note: A big thank you to J. Money over at the awesome blog Budgets are Sexy, who agreed to publish a guest post of mine why he is on vacation. Thanks J!

In recent years, expensive gas changed a lot Americans’ driving habits, and even spawned a new term- hypermiling. By making adjustments to one’s driving techniques and car maintenance, it’s possible to achieve significant savings in fuel consumption (check here for specifics from the guy who coined the term).

Not too long ago, the EPA updated their testing to reflect more typical driving conditions. The effect was that mileage estimates dropped quite a bit- the window sticker on my ‘04 Civic says 29/38, but with the new testing methods the revised estimate is 25/34.

^That’s her and I during our spring break trip.

By driving sensibly and taking care of your vehicle, you can easily get far better mileage than what the sticker says. My car has 112,000 miles, but I still routinely get between 33-38 overall. The majority of that is highway miles, but it’s still better than estimates.

Basically, I do the following:
-Drive the speed limit.
-Limit hard accelerations and braking.
-Keep up on maintenance.
-Keep tires well-inflated.
-Limit idling time.
-Try to cut back on A/C use when possible.

Most of these things should be common sense, but it blows my mind how many people still waste way more fuel than necessary by driving like maniacs. Ironically, it’s very likely that many of these lead-foot drivers are the ones who complain the most about high gas prices. That’s like complaining that you’re overweight as you down a Big Mac meal.

Why hypermile? There are several good reasons too.

1.) You help the environment. Less fossil fuel burned, less emissions, less carbon in the air.

2.) You save money at the pump. Even global warming conspiracy-theorists can’t argue against this one.

3.) Your car will likely require fewer repairs and last longer. My grandpa’s old Ford Escort is still running at 230,000+ miles. His secret? Regular maintenance and driving sensibly. Imagine that.

4.) You help reduce our dependence on foreign oil. President Obama acknowledged this one. Remember the off-shore drilling debate during the presidential race? Obama stated that if Americans would simply keep their tires inflated to the recommend levels, we would save as much oil as what would be produced by proposed off-shore drilling plans. The “drill-baby-drill” Republicans criticized him heavily for this remark, not surprising given their coziness with big oil. Obama was absolutely right though, and I hope at least some people took note.

Maybe I’m just nerdy, but I enjoy trying to get the best gas mileage possible. It’s like a game; I just tap into my competitive side and try to beat my mileage on the last tank. I keep a log in my car, then enter the numbers into an Excel Spreadsheet (screen shot below), where I can easily see my MPG’s over time while keeping a running average (35.567 since buying the car).

I’m also beginning a new experiment (which is noted in the last entry). Here in Iowa the 10% ethanol blend usually sells for 8-12 cents cheaper than the regular unleaded, so I always used to fill up with it without even thinking. However, it’s a well-known fact that ethanol burns less efficiently than gasoline, but enough to make up for the price difference? I figured that warranted a test. So for the next 10 fill-ups, I’m putting in the regular unleaded blend. Then I’ll calculate whether or not the (likely) increase in mileage is enough to make up for the higher price. It’ll probably be a matter of nickels and dimes either way, but it will interesting nonetheless.

Our individual financial decisions, as personal as they may seem, have global implications.

To operate efficiently and grow, an economy needs consistent sources of capital. Unless we don’t mind hyperinflation, this capital can’t come out of thin air. It must come from savings (primarily from bank deposits, the stock market, and bonds).

Economic growth is achieved when those with growth opportunities who need more capital successfully acquire it from savers. Normally, an economy will rely heavily upon domestic savings for this process. The United States is a glaring exception.

For many, many years now, investment in this country has far exceed our domestic savings. Foreign nations, who have been attracted to the investment opportunities within our borders, have provided us with the means to grow our businesses, consume more goods, and generally improve our economic well-being with a cheap supply of money. This works fine…indefinitely.

We are essentially living on borrowed time; outsiders have been providing us with the ability to live the materially-crazed lives that we have, but that doesn’t mean they will forever. Our party will quickly come to a halt when the bill arrives, and by this time it will be too late to avoid deep economic hardship.

Let’s say that foreign nations decided to stop buying (or even begin to sell off) the massive amount of Treasury debt they hold.  Interest rates would rise as the value of the dollar falls, and our government will be essentially broke with few takers willing to finace more deficit spending. The Fed would probably buy Treasuries to prevent the government from bankrupting, effectively flooding the money supply and wreaking even more havoc on the dollar. It’s not a pretty scenario, but what other result can be expected when you actually consider the madness of our unsustainable ways? We’ve been leading ourselves to the economic grim reaper.

Unless we Americans drastically change our heavily consuming, instant-gratification ways, we are in for a serious wake-up call (even bigger than the financial mess that began to unfold last year). The current state of affairs has many Americans changing their habits, but this needs to be a part of a bigger shift, not just a temporary response to the economic downturn. By living beyond our means, we’re jeopardizing not only our own futures, but the future of our country as a whole, of both current and future generations.

Every dollar that we save in domestic banks, stocks, or bonds is a dollar invested in the future of our nation. Collective change begins with individual change, so we all need to examine our ways as part of a bigger picture. When you forgo some needless little gizmo and save the money instead, you’re making a positive investment in the future.

I know that there is a darn good reason for objecting to my reasoning- what’s the use? Those who do save will only have it robbed by our government to give to the foolish ones who didn’t (including our government itself). We’re seeing this already, and it figures to happen even more in the future. It’s simply an unfortunate fact though. We must lead by example and help convince others to join the fight to create a far more rewarding, sustainable economy that doesn’t borrow (or should I say steal?) against the future.

Image Source

ETFs have been around for quite some time now, and index funds for even longer. It is now possible for even the smallest investors to own a thoroughly diversified portfolio that tracks the market indices. So why hasn’t the mainstream public swarmed to these investment vehicles?

Sure index investing keeps growing in popularity, but much of this growth is probably accounted for by institutional buyers like life insurance and pension companies. There aren’t many individual investors out there deliberately seeking out these funds and investing their money. Millions even have access to these funds through their employer-sponsored plans, but still don’t make use of them. It’s ridiculously easy to set up a dummy-proof investment strategy all but certain to deliver long-term growth, so it’s unfortunate that so many neglect to do so.

I don’t believe the financial sector in general wants people to realize how simple investing can be, for an obvious reason; their profits largely depend upon making people believe that investing has to be difficult. Several examples:

1.) Financial advisors need people to feel ill-equipped to manage their own investments. The less confident their clients are about their own abilities, the better chance a financial advisor has to profit off of them.

2.) CNBC and all other investing networks and programs need investors to overcomplicate things. Passive index investors don’t waste time watching the garbage on CNBC, waiting to hear about their investments. They’re out doing something more enjoyable.

3.) Online brokerage firms’ profits depend upon getting people to sign up for accounts and squander half their investment capital on transaction costs They love to perpetuate the message that you can only win by ‘taking control of your investments’ by becoming an active trader (I’m thinking about those E-Trade commercials with the day-trading baby).

Td Ameritrade probably hates buy-and-hold customers like myself who only have a handful of transactions a year (I used to do otherwise, but I’m beginning to wise up now). They honestly don’t care too much if their customers succeed; what they want is to rack up as many $10 commissions as they can.

4.) Mutual fund companies need us to believe that their so-called professional management is the ticket to investing success. They love to hype the extraordinary market vision they have as financial gurus. What they don’t tell you is this; almost no mutual funds manage to beat the market consistently for a considerable length of time, especially when expense ratios are figured in.

Don’t get me wrong- mutual funds were without a doubt one of the most incredible financial innovations of the 20th century. They can be a highly useful tool for long-term wealth creation. However, with very few exceptions, they have proved mathematically inferior to passively managed funds.

Scare tactics:

The extremely broad investing field thrives by making it all seem threatening and complicated. The industry spends billions upon billions of dollars each year propagating this message, so of course it’s going to make regular John and Jane investors feel overwhelmed and intimidated.

John and Jane could set up a incredibly easy plan that invests passively in the indices and basically runs on autopilot, saving them money, time, and stress. Instead, it’s more likely that they opt to turn their investment decisions over to a financial advisor who charges $75 commissions or buy a mutual fund with a 2.5% expense ratio (or heaven-forbid trying to become a day-trader in their free time). The sharks in the investment field claim yet another victim…

Image Source

With diligent research, rational and emotionless decision-making, and unwavering persistence, it’s possible to manage a portfolio that regularly ‘beats the market’, whatever market you may be referring too. Beating the market is the name of the game in the investing world. If you can do it on a consistent basis, you’re winning…right?

Not necessarily.

There are several important, but often overlooked, factors to ponder.

1.) Time-

If you aren’t actually passionate about deeply researching investments, then the use of that time must be justified by other reasons. I myself am not particularly fanatical about poring over financial statements and slogging through annual reports. Therefore, I’m not going to spend 5-10 hours a week doing just that unless I reap significant rewards because of it.

Let’s assume the benefit of foresight. Over the next 10 years, the S&P 500 will return an average of 8%. With my 5-10 hours of weekly research and active investing techniques, I average 10%. Was that worth it? For me, the answer is probably no; I’ve sacrificed far too much time for a result that isn’t all that much better than I could have gotten by simply buying the indexes. However, if I were to average 20%, easily trouncing the market return, the decision is a bit more interesting.

Time is the most precious, finite resource we have. It needs to be accounted for. Passive investing is attractive because you can match the market with a very, very small time investment.

If you outsource your investing to a financial advisor, you save time for yourself, but your advisor will make sure his or her time is adequately compensated for through substantial commission costs, far higher than what you will pay through a quality online discount broker.

2.) Stress-

A buy-and-hold index fund strategy is about as stress-free as investing can be. The global economy as a whole, as well as any sectors you may be playing with ETFs, are your sole concern (admittedly, worrying about the global economy can become stressful).

If you hold individual companies though, you clearly have an interest in the general health of the economy as well, but there are also many smaller variables at play; management decisions, lawsuits, recalls, patents, competitors, acquisitions, mergers…the list goes on and on. It’s a tedious (and pretty much impossible) process to stay informed of all the important developments related to your investments, and all these extra variables are a potential source of stress.

If Merck is a cornerstone in my portfolio, I’m naturally going to be alarmed when a newly released drug leads to a recall and widespread lawsuits. I might even lose some sleep when my shares plummet 10-15% in a single day. On the other hand, if I own every single publicly traded stock in the United States, these micro-variables aren’t worthy of my concern.

Needless to say, many investors thrive on the thrill that active investing can be. I’ll be the first to admit, putting money down on stocks is far more exciting than dollar-cost-averaging in index funds, and for many the higher risk is part of the fun. For others though, working to beat the market isn’t worth the added stress; they have no desire to burden themselves with unnecessary worries.

3.) Taxes- (for taxable brokerage accounts)

An actively managed portfolio will include more transactions than a passive one, as the investor takes profit on winners, cuts losses on losers, and rebalances from time to time. This means a more time-consuming and pricey experience come tax season. Uncle Sam gets to enjoy your success as well.

With a strict index buy-and-hold strategy, the only taxes you have to pay on a yearly basis are on any dividends received or the occasional capital gain distributions. If you do sell some shares at some point, it’ll probably be a long-term capital gain (> 1 year), meaning a much lower rate. In contrast, a heavily managed portfolio is bound to incur much higher short-term capital gain taxes.

Then there’s the time and money spent on actually having the taxes prepared, which isn’t insignificant either.

Unless your returns beat the market by a fairly sizable margin, the government’s cut can ensure that you do no better than the indexes. Never forget to leave taxes out of the equation; the IRS sure doesn’t.

Also keep commissions in mind. For both taxable and tax-advantaged accounts, those commissions will add up over time depending upon how much trading you do. Between taxes and commissions, a big chunk of profits from active investing can be quickly eaten up.

~

All in all, I think there is more than enough reason to question the standard of investing, especially when so few people have a proven track-record of beating the market. This is a bit troublesome for someone who not all that long ago could see myself working one on one with clients in a fairly typical financial advisor position. How many financial advisors do you expect are out there advocating strictly passive investing? Probably none that are still in business- it’s hard to earn much in the way of commissions doing that!

Personally, I don’t have any desire to pore over financial statements and annual reports for hours on end, looking for often deeply hidden clues that could indicate the difference between a successful and a poor investment. There’s a reason why I quickly dumped accounting after briefly considering it as a second major; I find it boring. I love studying fundamental economic variables, but I lose interest quickly in a sea of data.

At this point, unless I knew I had a high probability of significantly trouncing the market on a consistent basis, I’m not going to consider active investing to be worth my time. I’m not suggesting that everyone automatically do the same. What I am recommending is a thorough consideration of this issue.

In my previous post, I explained how every single expense can be considered an investment. As Financial Newb pointed out, however, I did not really explain how such an abstract concept can be calculated, nor how we can work to maximize it.

Without the benefit of hindsight, it’s often impossible to know with certainty all the costs and benefits of taking a given action. If we can make better predictions, though, we can improve our decision-making immensely and bolster the returns we achieve.

I’ve been brainstorming some ways to look beyond the actual monetary cost and direct benefits to more deeply analyze a potential investment.

1. Long term vs. short term benefits:

Say you won a mini-lottery, and there are two options for receiving your payout.
1. $100 right now.
2. $500 in 10 years.

Which do you elect to take? There’s no right or wrong answer; it’s a matter of personal preferences (time-value of money).

Some benefits are realized immediately (a new LCD TV), but there won’t be anything to show for it in 15 years. Other benefits don’t materialize for quite some time (Roth IRA contributions), but will pay off handsomely when the time does come.

It’s entirely up to you to decide how you value benefits received in different time frames.

2. Opportunity cost:

In a world of limited resources, by investing in A, we forgo the possibility of B, C, or D.

-By attending college, I turned down 4 years worth of earnings as a full-time worker.
-By investing so much time in personal endeavors (such as this site), I sacrifice a lot of leisure time.
-By purchasing healthier foods, I have less money with which to pay off debt, invest in ETFs, or save in ING.

There really is no such thing as a free lunch.

With every second or every penny that you invest in something, there were a million possibilities that you declined. Would any of those other options have been more desirable? It’s common to take a default, well-worn path without really consciously deciding to do so, which is a surefire way to miss potentially more rewarding alternate routes.

Many expenditures of money, energy, and time suddenly seem unjustified when examined in this light. Is playing video games for 3+ hours a day really superior to all the other ways you could invest that time? Is spending 40-50% of your paycheck on designer clothes really the best investment of your money? Since there is no universal standard, I can only answer for myself. All I can do is iterate the importance of understanding the opportunity costs of your actions.

Keeping this concept in mind will undoubtedly help in maximizing returns on investment, as you’ll be more deliberate in how you deploy your resources.

3. Hidden and Additional Costs

The actual cost of something is not always an accurate indication of how many resources it will consume. It’s important to consider the consequences that figure to show up in the future.

In an era of instant gratification, our society likes to act on impulse without much concern for the future results of that action. Unless you enjoy delegating stress to your future self, it’s imperative to act otherwise. Consider the following situations-

Eating fast food on a daily basis might be a major convenience now, but is it worth the likely higher health-care expenses and decreased quality (and maybe quantity) of life later on?

Older, higher mileage vehicles can be bought for cheap, but will the likelihood of higher repair bills and headaches involved with dragging it to the shop render it a poor investment compared to a newer car?

They may be difficult to predict with precision, but the possibility of incurring such costs can be incorporated into the decision-making process.

4. Hidden and Additional Benefits:

Same principle as above. There are often indirect benefits that arise from a certain investment which are difficult to gauge in advance, but add a tremendous amount of value.

For example, some of the direct benefits of striving to maintain a high level of fitness include more energy and increased self-confidence. What if, as a result of your boosted self-image, you land a lucrative contract for your business or receive a huge promotion at work? If it can at least partially be attributed to your investment of time and money into pushing yourself physically, then that investment returned more value than you probably ever imagined it would.

Conclusion:

I still actually provided an explicit way to increase your ROI, but frankly I think that would be impossible. As can be readily seen, it’s an extremely abstract and highly subjective concept. I’ve instead attempted to illustrate some important notions that, if applied, can definitely help.

Image Source

If you think about it, every expenditure is an investment…

-Food is an investment in subsisting.
-Gasoline is an investment in mobility.
-A DVD is an investment in leisure.
-A bicycle is an investment in health and recreation.
-A Big Mac meal is an investment in instant gratification and lots of greasy fat.
-A Toastmasters membership is an investment in skill- and confidence-building.

Easy enough to see.  Now, consider one of fundamental notions of economics; that resources are always finite. Therefore, it’s pivotal to employ our limited resources in a way where they can achieve the highest possible return on investment (ROI).

Carefully examine your current spending habits, especially discretionary spending.  What kind of ROI are you achieving?  It’s likely there are some expenditures with relatively low returns compared to others.  Can you redirect the investment into a higher-return area? 

Here’s a quick thought-experiment.  Roughly estimate the relative ROI of investing hard-earned income in each of the following.

-Fast food.
-Shares of stock or funds.
-The newest, hippest cell phone.
-Savings account for a trip to New Zealand.
-Video games.
-Gym membership.
-Launching a business.
-Cigarettes.
-Martial arts classes.

Isn’t it ironic, and perhaps even a bit sad, that the items on the list above with generally lower returns receive hundreds of billions of consumer dollars every year?  Many millions of people have the resources at hand to do absolutely amazing things, but they consistently squander their opportunities. 

Of course, this is all subjective to each individual person.  However, the following is a universal truth; if you aren’t fully maximizing your ROI, you are essentially wasting money.

You surely wouldn’t knowingly invest in something that is certain to deliver lousy returns, right?

Image Source