Lattes, Space, Burgers, and the Physics of Finance
He always said, “Take it down to the Physics”
Above is one of the phrases that Elon Musk always used to preach to his engineers when they ran into an unsolvable problem. He believes that virtually all problems have a solution, and that the solution can usually be discovered if you remove your pre-dispositions and analyze the problem in its rawest form.
Elon Musk is trying to solve electric cars, take human beings to Mars, and solve global warming. The physics of his problems are as follows:
Solar Energy: solar energy was too expensive per unit of electricity generated and customers could not access it easily for their home use.
Space Travel: Rockets were 100x too expensive to produce and use. They were also unreliable and could only be fired once per rocket. Space was inaccessible economically but not technologically.
Electric Cars: The batteries on the cars were garbage. They were unable to sustain long distance travel and electric cars drove like toys instead of luxury vehicles.
While Elon feels that those are the main problems worth solving, my priorities are less extraterrestrial. What I see is one of the most heavily levered nations in the world with a population that has a national savings rate of under 5%. We are becoming increasingly more levered for personal consumption and we have the least amount of savings to pay for it if we lose our jobs — which over the long run tend to become obsolete as is if Google has its way. It’s pitiful and it needs to change.
At the same time I see a country in which we’re getting older and heavier. Almost paradoxically, we are also starting to live longer. This leaves us with two problems. (1) We are getting older but we will not have enough cash to cover our expenses upon retirement. (2) Someone is going to have to pick up that bill, and it’s going to be the generation after us.
For more information on the second point listen to this Radical Personal Finance Episode.
But let’s take this back to the physics. Why is the national savings rate at a 3.8%? What should the savings rate be given that know that we will retire one day and that the government does not have enough cash to cover this liability? On top of that, what are the components of American spending that result in our daily spending habits? The short answer to each of them in order: we have lots of debt and loads of bad habits; retirement is really far off and seems irrelevant to a 25 year old professional; and the third I’ll explain with an example.
Now the numbers. If the median American takes home $50,000 dollars a year and saves an average of 3.8% then the average American spends $127.61 dollars on their daily consumption.
If you make $50,000 dollars a year after taxes and you purchase a latte and lunch everyday then you are sacrificing 10.5% of your daily budget — $14.00 a day @ $4.00 per latte and $10.00 for lunch (a burger, if you want to get your money’s worth). Extend that out to 260 work days a year (the number of average American working days) you end up with a total bill of 7.28% of your total income — 7.28% of your total time at work to support yourself while you work. That’s a different conversation for another time.
Many would argue it’s a bad habit. Personally, I think these types of decisions are the under-discussed and the continuously bleeding wound in American personal finance. While there are a select few that realize their own consumption is the solution to their financial issues, most of us don’t realize that our latte is costing us our financial independence thirty-five years down the line. Put another way, capitalism is not designed to support sound financial decision making.
There is no incentive for a company to teach you to spend responsibly. Starbucks does not want you to take the money you spend on their latte and re-purpose it for your own investments.
If an individual desires a latte and is willing to pay it, then the business should charge where marginal cost is equal to marginal revenue. Service desired, service provided, service rendered.
Although, purchasing a latte everyday is the second worst financial decision that an individual can make. The first — taking on a car or home loan at an early age when you cannot afford it. That is because the opposite of wealth isn’t poverty, it’s debt. Unfortunately for us the American dream is drilled into our skulls to the point of irrationality. We have to own a car. We have to own a home. It’s ingrained in our culture. It follows then that:
The individual American is not likely to change their daily habits for the vague concept of retirement thirty-plus years from now.
It’s too far off, so it doesn’t feel real. Who wants to plan for sixty-five when you can be twenty-five and full of caffeine? If I hadn’t seen the consequences of debt and financial strain as a child I wouldn’t be thinking of retirement at twenty-two.
But acknowledging its importance is not something that many dispute. Eventually the office worker will want to shoot their boss. Eventually you might get tired of going to work forty-hours a week, every week. Eventually you might decide that you want to take a trip to the Caribbean for longer than a week sucking down cruise ship booze.
But then again saving is a huge pain. You have to open an investing account, invest into an IRA of some sort, or pick stocks on your own — depending on what strategy you use — but the point remains. It sucks. And nobody wants to delay their latte, do some boring finance stuff, and then not realize the results for another 35 years.
On top of that investing time to pick stocks in the stock market is a complete waste of time for most of us. Only 9% of active managers — some of the most sophisticated investors on the planet- are actually beating their passive indexes (Source). This means that we can get comparable returns to active managers net of fees simply by gaining exposure to the markets. The real problem is that our savings rate just isn’t high enough. What, though, is a high enough savings rate for retirement and how far off is that retirement?
Here are the numbers. This figure showing savings rate against years to retirement for a range of investment return rates, presuming that the total number of years worked and years retired equals 80 — for example, a person starts working at 20 and dies at 100.
Your number of working years is inversely related to your savings rate — which is just the percentage of total income that you put in some kind of investment portfolio. If you save 3.8% then you are going to be working somewhere between 33 years and 75 years. The spread can be accounted for by the possible combination of your investing returns. The beauty of this graph is that it shows the higher your savings rate is, the more robust you become to possible number of possible years in which you have to work.
Let’s make this even easier. You take your money, and consistently invest it in the S&P 500 index. The long term S&P 500 ten-year annualized average rolling return is 10.28% assuming dividend reinvestment.
If you saved 10% of your total income and you earned roughly 10% on your investments, you could retire in about 24 years after you start working.
For most of us that start around 25 with at least a $50,000 dollars salary that is retirement at age 49. Doesn’t sound too bad does it?
This is just the physics of money. Our savings rate is not high enough and it is the consequence of our debt choices and own bad habits. We spend 7.28% of our daily income on things that we don’t necessarily need at the expense of a time we’ll all have to address one day.
But what if we could manage to turn bad habits into good habits? What if we could use our spending habits to up our savings rate? That is precisely the premise behind Acorns. This business takes your credit card purchase, rounds it up to the nearest dollar, and then invests it for you in a tailored portfolio.
This premise is fantastic, but the math suggests that we need to go further and invest more. If you spend $4.00 on a latte and $10.00 on a sandwich that is $2 dollars of invested money at the end of every day. While it is a start, that two dollars is equivalent to an extra 1.5% of additional savings assuming you make 50k a year. If we turn this around and plug it in to Fisker’s formula, that only reduces our working years to between 30 and somewhere around 70 years. This still leaves us exposed to a 40 year range of possible outcomes. Realistically it only shaves off five years of your number of working years (a notable achievement, but not our end objective). I’d like to directly tie our savings rate to our discretionary spending rate using our purchasing decisions as the input variable.
If a latte and a burger account for 7.28% of our daily income then I believe it should be equal to or some divisible percentage of our investments.
If we make it easy to invest the 7.28% of our discretionary spending it will allow us to do three things:
(1) Make discretionary spending somewhat more painful because a latte will cost you $8.00 of immediate purchasing power rather than $4.00; this provides an incentive to drink less lattes. (2) Help us achieve a savings rate of greater than 10%, which is a reasonable expectation for most of us and essential for retirement. (3) Take the pain out of managing an investing account.
So for every discretionary purchase (or selected discretionary purchase type of your choice- beer, coffee, etc), the equal dollar value of that purchase will automatically be invested in a portfolio. The key is in the automation. The failure is in the amount.
I’d like to see a future where Social Security is not needed. We can’t afford it. Nor should we burden the next generation to afford it for us. Instead, I imagine a future where consumers can use their bad habits to reinforce their good ones; a future where lattes do as much good for our mood as they do for our finances. It’s good for business. It’s good for the taxpayers. And it’ll be good for my children when they realize that their father used to drink a ton of lattes in his day.
If we boil this idea down even further we are really only manipulating these three variables: (1) income, (2) expenses, and (3) invest the difference between one and two.
The third is where we are lacking. The second is where we are excelling. Let’s design the second to increase the third.
