Maximizing Frugality Is More Important Than Maximizing Investing (Unless You’re Already Rich)

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With a title like that, I’m sure to grab some attention, but it’s true – unless you are already rolling in the cash, frugal choices and finding ways to save money is much, much more effective than maximizing your investments. That’s not to say maximizing your investments isn’t worthwhile, but that you can often find a lot more money at home than in the stock market.

Let’s look at Joe, a reader of mine who actually wrote to me a while back asking some financial questions. He and his wife bring home about $3,000 a month and they have a $900 mortgage payment. At the end of the month, Joe reports that they’re usually about $250 ahead, and that $250 goes into a savings account.

Joe’s initial question to me is how he could invest that money better so it would get a better return. I told him to just stick it in a low-cost index fund at Vanguard and instead spend his time worrying about cutting his spending so there’s more breathing room. Here’s why.

Let’s say Joe just sticks that $250 a month in an index fund that returns 10% a year. At the end of five years, Joe would have $19359.26 in that account. That’s a nice little amount to get started – you can buy an excellent car in cash with that kind of money.

Let’s say, instead, that Joe gets seriously into investing. He manages to spend three hours a day doing stock research and takes that $250 a month and actually gets a return of 18% a year. Tremendous! At the end of five years of focusing on investing, Joe has $24,053.66 in his account! The investing is paying off, right?

Let’s take another tack. Let’s say Joe just spends one hour a week looking for frugal things to do, like going for more energy efficient lighting, installing low-flow showerheads, making some homemade meals, and so on. Joe manages to save $75 more a month in the budget this way, giving him $325 a month ($75 isn’t hard to do at all from almost any monthly budget without much life change). If he puts that $325 into that index fund at 10%, he’ll have $25,167.05 in his account. Even a bit of frugality blows away an incredible investment.

Unless you have a tremendous amount of money to work with, you’re better off spending some time looking at frugal techniques than looking at investments. Naturally, there comes a point where the effort of squeezing out an extra percent on the return will be much more worthwhile than preparing meals at home, but most investors simply aren’t at that stage – and the ceiling is much higher than people think. If your investment isn’t well in the six figures yet and you don’t have an immediate clear way of adding more than a percent to your investment return, you’re better off looking at how to increase the amount you can add to the investment.

So, the next time you have an hour to burn and are looking for ways to improve your bottom line, spend the time figuring out ways to tighten your budget rather than looking for an extra percentage point on that investment. Frugality provides far better returns.

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28 thoughts on “Maximizing Frugality Is More Important Than Maximizing Investing (Unless You’re Already Rich)

  1. It has been awhile since posting here — so first — hello Trent.

    I agree to an extent about what you wrote. It behooves most to go through their expenses and try to remove as much as possible — to increase the available funds. Some people benefit from forced savings as well — having a set amount removed from their account on a regular basis to ensure that saving will take place (some people use their tax withholdings for this purpose — and due to the time value of money this is not preferred and should be changed itself).

    My point of contention is expectation of rate of return. Investment advisors, funds, and analysts will tell you that double digit returns should not be expected – or planned for. If they should occur — fabulous and more power to you — but one should be realistic. (I don’t have time now to cite the analysis here — but you can google returns on various indices for various periods of time to see what I mean.)

  2. don’t forget the $75 you found through frugality is after tax money…the extra income you earn investing is taxable….you would have to earn well more than $100 to end up with that same $75 in your pocket at the end of the day.

  3. If Joe could get 18% returns year in and year out, Joe would not have to worry about saving a few bucks on the cable bill. He would be filthy rich soon enough.

    You cherry picked your data to fit your conclusion. An 18% annual return is obviously better than a 10% return over the long term. Joe would have to save many thousands more per year to keep up at 10% after a few years.

  4. Though the brokers will swear up and down this is false, this blogger is absolutely right. I work for bupkis at a publisher & have a fair amount of debt. Until I got very frugal I couldn’t come up with anything but 3% per paycheck to put in a 401K, which is not enough for any age. So, you have to take it to the limit of frugality at which you can still enjoy life & then buy or check out from the library two books:
    1. Common Sense on Mutual Funds by John C. Bogle
    2. A Random Walk Down Wall Street by Burton Malkiel

    Take it from someone that has a relative that made let’s say ‘untold’ amounts from the stock market (as a social worker) & a relative that is a V.P. of a major fast food industry chain….. as a small-time investor you do not want to go much further than the advice of #1 & 2. But, of course, that is my & their opinion & life experience.
    I’m now finding over $750 a month in “extra” money I never knew I had due to “livable” frugality!

  5. I do have to agree with Matt — an 18% return year after year is absolutely not concurrent with any historical data on markets or the real-life experience of market cycles.

    Overall, a great article to prove a point.

  6. I’ve been noticing this with my own finances within the last week.

    For the last several months, I’ve been looking into strategies like credit card arbitrage and looking forward to the point where I have enough in emergency savings to invest in individual stocks.

    Its been dawning on me this week, that there are lots of little changes (eg. bringing a lunch to work – instead of fast food) that can make a much larger impact (risk free).

  7. Matt, I’m not sure what your point is; it seems to strengthen his conclusion. He’s saying even if you get super pie in the sky returns by actively managing investments, you spend a lot of time to not make as much money over the long term as you do by simply saving a few dollars more per day in your plain old index fund. Could you rephrase?

  8. Good post Trent. In my opinion, the fact of the matter is that you need cash to invest. One of the easiest way to obtain cash is to spend less than you earn.

    FT

  9. I’m not sure I agree with Matt as he seemed opposed to being frugal, but Matt is right to say if someone could get 18% a year vs. 10%, in the long run that guy or girl will be better off. Maybe not in 5 years, but certainly 10 years. The power of compounding. If you can get 18% returns consistently just open a fund, and make even more….

  10. My point is that saving $3,000 per year with an 18% annual return turns out to be much better than saving $3,900 per year with a 10% annual return. Trent picked a five-year timeline because it fit his conclusion, but if you run the numbers out to 10, 20, and 30 years 18%/$3,000 absolutely kills 10%/$3,900.

    I was working with the premise Trent set up. With a more realistic set of circumstances (say 10% vs. 12%) Trent’s point would have made more sense, but he chose to use 18% and then he selected a five-year window because after that his conclusion falls apart. He was making a point by picking a specific bit of data while ignoring the data that would counter the conclusion he was after.

  11. I saw a piece from an investment company a few years ago that looked at a related topic. They looked at the results of a once-a-year investment into an S&P index fund over a ten-year period for three different scenarios: You deposit the money on best day of the year (the day the S&P was lowest), on the worst day of the year (the day the S&P was highest), and on the first day of the year. The upshot was, it scarcely mattered. Even if you were incredibly unlucky, and managed to send your money so that it arrived at that year’s peak, after ten years your total was scarcely different that someone who just dollar-cost-averaged in on the first day of each year (and the guy who hit the low each year did hardly better).

    Getting the money in there where it can start earning a return matters more than minor (or even major) improvements in timing or return.

  12. That doesn’t make any sense, Matt. My point was that if you’re starting off with nothing, even a little increase in your investment blows away a huge difference in returns, meaning that at the start of your investing life, frugality is way better than the best investment.

    If you start looking beyond that, you’re no longer talking about that scenario (a beginning investor) at all – you’re starting to look at investing with a decent bankroll. At that point, investment choices do begin to make a difference, but that’s not who we’re talking about here.

  13. Good points Trent! I have been doing this since the start of the year, and while I am constantly badgered by my family for being “cheap”…I stay the course because I am enjoying the extra payments on my debt and to my savings acct!

  14. I like this post because I have spent quite a bit of time worrying about what I should be doing with our portfolios, and whether my low cost index funds are really better than low cost mutual funds, etc etc. However, IN MY SITUATION, scraping up an extra $100 a month and actually getting it into our portfolios is going to make a bigger difference than trying to pick the “perfect” investment, which I am unlikely to ever actually do. Being more frugal is easier for me to control than the markets. I also know a lot more about being more frugal than I do about investments. This makes me think about my financial priorities.

  15. No, I see what Matt was getting at now. He says that, all else being equal, the $250/mo plus 18% on the accumulated $25K will start dominating the $325/mo plus 10% per annum at some point not long after the five years.

    I also see what Trent is getting at: that all else is unlikely to be equal five years down the road. For example, if you instead spend some of that three hours a day for five years on self development, you may have a whole other story.

    This is why it’s good to review your choices every year. If your situation changes, you can adjust your strategy.

  16. It’s quite simple, really.
    If you have $10,000 in the bank, an extra 1% return is just $100.
    When you have $1 mil in the bank, the extra 1% is $10,000.

    So, when you aren’t quite rich yet, the quickest way to increase your total is to increase your contributions, not trying to squeeze an extra percent or two.

  17. I knew a guy that was real serious about his stamp collection. What a bean counter!

    Trent’s thought may not logically project out into infinity, but I think his point is clear. If we get stuck in the minutia, then, as so often is the case — we miss the point.

    Breathe.

  18. I really don’t care what rate of return Trent used, the point is that savings derived from spending less are tax free whereas any returns you make(outside of a Roth IRA) will always be taxed. Besides….adding an additional $75.00 a month to the $250.00 is an additonal 30%(instantly)…..try finding those kinds of returns in a safe investment.

    Great point Trent!!!

  19. Another point is that you can control you expenses. You are at the mercy of the markets in regard to returns. An 18% return would usually involve a riskier investment. CFL have a definable, reliable return/savings. Frugality is under your personal control, while investing is not under your personal control. The markets do as they will.

  20. Just for the sake of argument:

    Why would you treat time expenditure on frugality and investment as an either/or situation? Why not do both?

    What if Joe spends 10 hours a week (as opposed to 15 hours a week in your example, excluding weekends) on groundwork for his investments, and an hour a week on frugality exercises. How would you compute the returns on such an investment?

  21. I guess the message here is to be frugal..but it is also a good idea to be smart in investing that money which saved being “frugal” !!

    I have seen many people in their early 20s earning good amount of money ..but are not frugal & not investing either.

    another important point : Its important to Invest regularly instead of just Saving

  22. I think it’s important to consider a 5-year window because (1) we’re talking about a specific timeframe early in someone’s ‘financial life’, and more importantly (2) there’s no way the market is going to return 18% consistently for the next 30 years or something like that.

    I mean, maybe an individual super-talented stock picker might, but it’s hard to imagine. Even mutual fund managers don’t get those kind of results.

  23. The point is that frugality lays the foundation for investing. The stronger and bigger the foundation, the investing edifice to be built can be that much bigger and stronger. So figure it out, do you want to build a financial fortress or a tract home? Sure at the beginning frugality has an immediate and tangible reward, much less so when it becomes just a part of how you live your life. Then the rewards start to come from those investments made. While the frugal lifestyle is being established it is a wise idea to learn as much as possible about investing.

  24. Frugality extends to investing, i.e., not handing over 2.5% of investable assets to a financial advisor and fund/transaction fees.

    Trent’s and Gayle’s point about educating oneself (for at least several months) before launching into stockpicking is absolutely key.

    But with regard to frugality, I think people focus too much on the latte factor (consumables) and not enough on curbing spending on the big ticket items like cars, insurance, vacations, “it” bags, electronics.

  25. Frugal techniques will also help you get out of debt faster which is where a lot of people find themselves. Once you’ve got a fair amount of money you can concentrate on investing.

    Controlling spending until you have a considerable excess of income is probably the most important lesson anyone can learn about finances. Live within or below your means.

  26. Living frugally offers another benefit that hasn’t been discussed up to this point. That is regardless of how good or bad your investments do at some point your going to have to live off the money you’ve saved. The less you can live on the less you need to worry about that extra percentage point return.

    That is the very situation that my wife and I are facing. She wants to quit the corporate world at some point but we were never if we could give up her wage. Having made the transition to frugal living has shown us that not only could we live on my wage (free lance English teacher) but if she worked partime we could save a good chunk of that as well. It’s given her a new sense of enthusiasm for work knowing that in a few years she’ll be able to chuck the corporate world for a part time job, something we could have never of conceived before. Thank you Trent (and all you other bloggers)

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