1€ in the hand is worth how much in the future?

Something that is very important about any kind of investing mindset is the understanding of perspective. Essentially this means understanding the time value of money – money that you spend or choose to not spend at this moment – what could potentially happen to it in the future?

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The time value of money

The time value of money is an essential concept that gets drilled into the head of pretty much every financial manager out there. I had a 5EAP subject at TTU this semester which basically boiled down to this same idea as well. To save you the trouble of having to spend time with my mildly sexist professor – in the event of other things being equal it’s always better to have the money now.

Money loses value as time goes on. This was painfully obvious during the financial crisis – inflation ate away at the value of money so if you had 1000€ at the beginning of the year, then by the end of the year it was more likely to be worth closer to 900€ than the original 1000€ in terms of purchasing power.

This very idea is the basis for pretty much all investment advice which tells you that the best time to invest was 20 years ago and the second best time is now. The younger you invest, and the more, the more likely you are to end up making huge returns. The stock market’s historical returns are around 8%, which means that every year that you delay your investing you have to invest roughly 8% more to get to the same results. As time goes on, that 8% keeps increasing as compounding interest starts working against you.

So much is your 1€ worth?

Quite often people spend money on tiny purchases without thinking much – it’s just 1€. The problem is that if you add up an euro here and there, then it ends up in hundreds and as years go by that compounds into thousands.

Just to give you a visual of what this works out to. I’m currently 25 so I’m likely to retire at about an age of 75 looking at the current trends in retirement ages – this means that I have 50 years to gather up money. (Or less if I want to retire early.)

This is what is likely to happen to any single euro that I invest at this point with a pessimistic return of 5% and a more likely historical 8% of the stock market. Looks impressive, doesn’t it? At a 5% return it climbs to 11€ in value, at an 8% return it climbs to 43,5€ in value. (Leaving out inflation and changes in money value, let’s think in today’s money.)

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How much should you worry about that 1€?

MrMoneyMustache I think was the one who has a great philosophy about the impact of saving on your future. Essentially, it isn’t so much about short term savings and keeping yourself from spending that x amount (though that is important too). It’s about adjusting your standard of living to spend less recklessly – every euro that you save WHILE keeping that euro off your everyday life expenses actually ends up saving you the original 1€ that you’ve not spent and also saves you from having to save so much for retirement – because you don’t need that much money.

Seeing as the logic of most retirement portfolios is that if you want to spend x amount of money per year, then you have to save 25 times that. For example, a 1000€ per month vs 950€ per month in planned expenses means that you have to save 15 000€ euros less for your portfolio.

This doesn’t mean that you have to go mad with saving money (some do) and sacrifice your free time, health or enjoyment of life to save that money. There are however several very reasonable things that you should be doing that will help you free up those very important euros for investments. Like a lot of other financial tips, these things compound on each other as time passes.

Important steps to keep expenses down

1. Spend reasonably on the big things. (It’s silly to fuss about the lattes if you’re overpaying on your car or rent)

2. Buy high quality items. (This might mean higher initial costs – but you can afford that – it will mean lower overall expenses)

3. Spend on things that matter. (I’m sure just looking around your room you can find things that you wish you hadn’t bought – I can!)

4. Put in some effort to find good deals. (This means rewards programs, sales etc. A bit of effort can have high returns)

5. Take good care of your things. (Things like your home, your car, all sorts of tech lasts a lot longer with proper maintenance)

What’s your great habit to keep expenses down?

Building good financial habits: budgeting

Making drastic changes in your life is hard. This is very easily evidenced by how terribly most people manage to fill their New Year’s resolutions. Most promises are just too far optimistic and require changes that aren’t sustainable. One of the key pieces of advice in the land of personal finance is emphasizing the need for having a budget. However, it’s not just all that simple to start keeping a budget and even worse, following a budget! What will get you there in the long run is building sustainable habits step by step so that you don’t feel as if you’re being deprived of anything.

1. Keeping track of where your money goes

There are multiple ways of doing this. There are whole programs for it (Quicken and YNAB come to mind). There are also apps that you can use such as Mint, or you can just make a spreadsheet using Excel or Google Docs. Alternatively you can just also write everything down into a notebook manually to keep track of it. The problem with all these is the amount of time/dedication required to keep track of things. Forget just a few things and you’ll be quite hopelessly lost. It is important to know where your money is going, so there are a few habits to build that help you keep track of it without going insane with bookkeeping.

– Pay for everything by card. A lot of banks run an analysis on your expenses, which means you can get an overview without spending time on the tracking yourself. Some people also use an envelope system (set cash aside for certain categories).

– Set an amount of money as a daily/weekly budget. If you know that your weak spot is spending money on food then just plan to use x amount per week. If you find yourself running short then you’ll know that you’re having issues.

– Automate as much as possible. Rent, cable, internet, phone bill, insurance etc. Most of these can be set as automatic payments meaning that you know when they’re planned (1x month, 1x year) and know how much money they take.

– Plan for bigger purchases in advance so you won’t be surprised by them in a way that destroys your budget. (For example save x amount per month for replacing any appliances that may break.)

– Keep track of any expenses that might bring about fines, extra payments or other extra expenses. (Take your car into maintenance before something really breaks and you start bleeding money.)

2. Staying within your budget’s limits

– Pay yourself first. Transfer money into investments the day you get your pay. If the money isn’t just sitting in your account then you won’t be able to spend it!

– For bigger purchases force yourself into a time-out. There are a lot of suggestions about this – one example being taking an extra day to think for every 100€ that something costs.

– Do research before buying things! Often things are cheaper online, or in some obscure shop you wouldn’t think to check. Waiting for summer/winter/other sales might also save you a lot of money. (Clothes are a great example here.)

– Limit your discretionary spending. It’s completely fine to buy things you enjoy – coffee, candy, etc. However, unless you limit yourself even a bit then you’ll likely end up spending way more than you realize.

Building habits

My financial habits are a general mix of these suggestions. I transfer a part of my planned investments the day I get paid (it’s taken me a while to get to the point where I can do this every month though). I mostly pay for everything by card and let my bank run the expense analysis for that, but I do have a spreadsheet for my home expenses.

I tend to spend a bit of time to find good deals on things, I quite often end up ordering things online since things in Estonia are unreasonably expensive at times. One of my big weaknesses is spending money on food, so I’ll write about that later. I’ve gotten better with impulse purchases, but I sometimes splurge on books but I’ve gotten a bit better at choosing ones I really want to have for a long time. In the end, small steps lead to great habits and after a while you don’t really need to think about them.

What’s your greatest habit that helps your budget?