Personal Finance Success Comes More From Smart Budgeting Than Smart Investing

One of my closest friends (let’s call him Kevin) is obsessed with individual stock picking. He bragged to me quite loudly recently that his portfolio was up 15% for the year so far, which is pretty good – and I told him so. I asked him how much his net worth increased, though, and I found out that he didn’t even bother to calculate it. In fact, I’m quite aware that Kevin is swimming in credit card debt and payments on a leased Lexus and a house that he probably shouldn’t be in because it’s out of his reasonable price range.

The truth is that personal finance success comes from smart budgeting and frugality, not from chasing a couple more percentage points on an investment. Let me show you what I mean.

Let’s say Kevin and I both make $50,000 a year. Kevin spends his spare time chasing individual stocks; I spend my spare time looking for frugal living ideas. Kevin spends $45,000 in a year and is thus able to invest $5,000 a year, while I, through budgeting and frugal living, only spend $40,000 in a year and am thus able to invest $10,000 a year.

Now, Kevin’s a smart investing cookie and is able to crank out a 16% return each year. I just take my money, dump it in a Vanguard 500, and move on with life, which means over the long haul I earn a 12% return. Who earns more in the long run?

After five years of this same investing, Kevin has $34,385.68 in his investment account, while I have $63,528.47 in mine, a difference of $29,142.79 in the frugal guy’s favor. Even at the twenty five year mark, if the investments have continued for that long, Kevin has $1,246,070.12 in his account, while I have $1,333,338.70 in mine, a difference of $87,268.58.

This is assuming no taxes, of course; since mine has just been sitting there in the Vanguard 500, I will have incurred no tax penalties and when I take it out, virtually all gains will be long-term capital gains (with a very low tax bill), while Kevin has had to actively manage his portfolio and will have taken some serious tax hits in there which aren’t included in these numbers. In reality, Kevin is even further behind because making tax guesses only reduces Kevin’s number and has almost no effect on my number.

If you move the threshold out to thirty five years or so, Kevin is ahead – the power of compound interest does eventually win out – but, again, this is assuming no tax hits along the way.

What can we conclude from this? Unless you’re very young and aiming solely for retirement, you’re better off spending your time budgeting and living frugal than digging for a better investment. As long as your return is solid, you’re better off just leaving an investment alone in an index fund somewhere and not worrying about it than battling for big returns. Instead, spend time doing what you enjoy or doing things that save you money in your budget so you can invest more in your fund.

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  1. Patty says:

    “Unless you’re very young and aiming solely for retirement, you’re better off spending your time budgeting and living frugal than digging for a better investment.”

    Now how young is young? 18, 20, 25, 30? I’m currently 23 about to be married and I can already see that the next couple of years we will be scraping along and trying to save money for paying down our debt (student loans, car, credit cards), our upcoming wedding and a downpayment for a house. My fiance is 31 and we both currently have nothing significant in savings. If we use those figures, I just wanted to know if we could end up in your route, since we may have to take the “Kevin” route for a few years until we can afford to save more after our big start up costs creating a home.

  2. Jonathan says:

    You are also neglecting to account for the risk that Kevin will be accepting during this period. While he may earn 16% or even 20% in any given year, other years may provide no gains at all or a loss. Over time I would be skeptical if he could maintain an average return of over 12% (especially if you count trading and management fees where applicable).

  3. Interesting article. I’m always tempted, when I read things about picking out stocks and the like, to go and learn everything I can and try to squeeze out the last of the blood from the oranges (if that metaphor works). But when it comes down to it, I just don’t care enough to. It’s good to see an argument can be made for just letting it sit.

  4. Sarah says:

    I agree with Jonathan–a 16% per year return in active trading *after accounting for all fees* is the impossible dream.

  5. I think you also neglect the quality of life of the two people. Kevin has had $5,000 more to spend each year on luxury items. That’s certainly worth quite a bit.

    Secondly… Perhaps because Kevin is an investment guru, he had the foresight to diversify outside of America while the Vanguard 500 crashed hugely in 2015 (or was it 2018) with increased globalization and didn’t recover to earn 12% over the whole time span.

  6. Trent says:

    Lazy Man: being frugal doesn’t mean reducing quality of life. It means doing stuff like airing up your car tires, clipping coupons from the newspaper, installing CFLs and programmable thermostats, and getting books at the library instead of buying them. The point is you’re better off doing stuff like that, seeing how much it saves you, and investing that money instead of spending the time seeking out the hot new stock tip.

  7. shawn says:

    Lazy Man and Money your point is horrible. As most studies have shown once you make ~$50k/yr your income has no direct effect on your happiness. That $5k of “luxury” is not likely to increase the quality of Kevin’s life long-term or even short-term for that matter. Furthermore even if Kevin diversified, the drag on the US stock market would still likely affect his return as well. Futhermore it would be easy to invest your $10k/yr in different index funds that would likely provide you with a better diversity than Kevin could ever hope to attain.

  8. Eric says:

    Out family has a number of priorities

    1) Emergency Fund
    2) Proper Insurance
    3) Retirement
    4) Pay down debt
    5) Investing

    Somewhere near the bottom I spend a bit on little luxuries. I avoid like the plague anything that had a reoccurring monthly bill where it can be avoided. No cable for this household, but that does not mean we don’t have HDTV ( Antenna ) and a DVR ( Tweeters clearance rack ).

    I know some people think you should invest before paying off debt, but the physiological benefits and freedom to NOT having to pay a monthly bill can not be understated. Investing for me is picking good low fee mutual funds and ETF’s and then ignoring them.

  9. BigBuddha says:

    Hmm… I wonder how many people have actually been able to say “I don’t have to work any more right now” before say the age of 55 (the magical retirement age for many), by living “frugaly”.

    I dare say not many.

    Why not try and increase your earning’s capacity instead or find ways to increase your CASHFLOW so that you can steadily replace your “work or SALARIED” income with passive income from your investments. Wouldn’t this seem like a better course of action.

    Don’t get me wrong, spending more than you earn is definitely sending you in the wrong direction financially but I think alot of personal finance blogs don’t pay enough attention to increasing cashflows other than by decreasing your living expenses.

    You can only decrease living expenses so far. However your potential to increase cashflows via investments or UPGRADING your job is virtually limitless.

  10. Eric says:

    @BigBuddha

    Expenses, without fail, grow with income for most people. Between that and the fact that 90% or more of the population does NOT have their spending under control is why most PF blogs concentrate on that aspect.

    Investing, starting a business, “upgrading” your job, and other things that you are suggesting are all dangerous propositions each with their own risk/time/reward balance that must be struck. I would much rather lead a simple, but effective life so that I can spend time with my daughter during the important formative years. Upgrading my job would require working hours that would mean I may not see her all day!

  11. 60 in 3 says:

    “You can only decrease living expenses so far. However your potential to increase cashflows via investments or UPGRADING your job is virtually limitless.”

    That’s completely untrue. Sure, I can upgrade my job, and I am, but even that has limits. A very small percentage of people can become CEO’s of their own successful start ups. I wish them the very best and I aspire to be one of them, but it takes a lot of hard work and still, only 1 out of a 100 succeed.

    Same for investments. Find me a good investment with a high return and no risk. No such thing exists. Money isn’t free. The trick is to make a lot of it and save what you can. So yes, you should also aspire to improve your revenue, but cutting expenses is by no means negligible.

    Gal

  12. BigBuddha says:

    To Gal from 60in3

    I think you haven’t understood my arguement regarding increasing CASHFLOW’s.

    I’m not advocating going out and finding HIGH risk high return investments. I’m talking about investing to create cashflow’s that will supplant your SALARY income, this can be achieved any number of ways through a multitude of investment types, low risk and high risk.

    I probably phrased the last sentence of my first post incorrectly. I should have said, the opportunity to create cashflow’s from investments are virtually limitless. Yes of course there are limits to how far you can keep upgrading your job thats common sense, but then again that shouldn’t ever stop people from trying to continually advance themselves.

    you say the “trick is to make a lot of it (money) and save what you can.” hmm that’s pretty much what I am saying isn’t it?

  13. There is a possibility that Kevin learns more, as he is investing in stocks first hand, about analysis of investments and gets better at controling investment cost and taxes. Even headed first hand analysis of investments is a great skill.

    It also can’t be ruled out that he may not start live frugaly later, life changing events can force him to do that. He could very quickly embrace frugality if he decides to and views it as just another investment.

    Let me not speculate any further.

  14. Lisa says:

    I agree with Eric, the only thing I would add is that as I am choosing my low cost mutual fund I not only evaluate increases(gains) but also decreases(losses). How does the mutual fund do in an up/down market? So my fund needs to beat the S&P and it also needs to lose less in a down market. I now stick with these mutual funds and let them ride while I do other things. This is why I use managed funds over index. Kevin obviously enjoys watching/investing in stocks. It sounds like a hobby or obsession(?). You choose to value family and quality family time over individual stock picking. Since you don’t mention a wife and/or children for Kevin perhaps his motivations are different.

  15. Sylvain says:

    Being frugal and picking individual stock are not incompatible. I have a brother who des just that. You might even argue that following the stock market very closely is a frugal hobby.

  16. ck_dex says:

    Stockpicking as a path to wealth is just not going to work for most people because you have to go beyond the reading of financial statements to be really knowledgeable about the company’s products and r&d. My people, self included, are not able to do this well outside of their industry.

    But frugal living on its own wouldn’t have made it possible for me to be able to retire, as I could now in my late 30s. Rather, it’s been the choice of a high paying career, and choosing to work for early stage companies that offer lots of stock options that has made the difference to me.

  17. ck_dex says:

    Stockpicking as a path to wealth is just not going to work for most people because you have to go beyond the reading of financial statements to be really knowledgeable about the company’s products and r&d. Most people, self included, are not able to do this well outside of their industry.

    But frugal living on its own wouldn’t have made it possible for me to be able to retire, as I could now in my late 30s. Rather, it’s been the choice of a high paying career, and choosing to work for early stage companies that offer lots of stock options that has made the difference to me.

  18. freespine says:

    I really don’t think Kevin is interested as much in the money as he is in the challenge and “chase” of investments and appearing rich.

    Living frugally and budgeting is not nearly as exciting, but in my experience, it provides more peace of mind at the end of the day.

  19. Ranjan says:

    I really liked the posts here. Even though I’m from India and the financial products are different here, I could make sense out of your posts. In fact I too have a blog on personal finance and business management.

    The bible says, “Whatever we do in life requires effort” so if we wish to ask for tips and then act, it is a sure way to disaster. Either we must take effort to do all the hardwork ourselves or take the effort to search for a trusted advisor and outsource our efforts. Finding a trusted, knowledgeable and skilled advisor is not a very easy task to do, I beleive.

    And yes, I’ve subscribed to your posts.

  20. Dodgerman says:

    The truth is over a period of 25 to 30 years the stock picker is just not going to beat the index investor. The are professional fund managers that have a team of M.B.A.’s at their beck and call and can spend 20 hours a day studying this information and STILL lag the market over time.
    I also bet that Kevin will lose 16% in years where the market only loses 2%. While I believe you should also index in the international areas the Index 500 gives you a great deal of global exposure also. Think Coca Cola and General Electric.

  21. steve says:

    I appreciate this article and all of the comments readers have posted as well.

    I think that it is not an “either your are frugal” , OR “you earn more money” dichotomy.

    To me, the frugal and in control part of the personal finance equation is definitely the most necessary foundation stone of personal finance. And it is just that–it’s the foundation stone, and it’s one that a lot of people are missing without realizing it.

    Fiscal discipline (one aspect of frugality) is like the drain stopper that sits at the bottom of the tub, helping the the water level increase by keeping cash from draining out the bottom. Then when you pour more water in, you get a bountiful tub, not a leaking, unsatisfying mess that you can’t even enjoy.

    If you have an ironclad budget and spending discipline, it will definitely show you how to make do with what you have. But it will also help you fix your income or top line, because that discipline is always causing you to look squarely at reality, see your options, and make choices. I think that’s the most important part, and it can enable you to either choose a lifestyle and future with your current income, or decide to change it. Whichever your choice, I think most of us can agree that the feeling of control is satisfying in itself, regardless of your level of income.

    And,having a fiscal discipline/habit and a plan in place, if you do decide to increase your income, you will very likely make much more effective and satisfying use of the extra $$ than if you didn’t engage in fiscal discipline in the first place.

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