In my financial literacy class for teachers we spend a lot of time discussing the balance between spending money now and saving in order to spend money in the future. And I want to be perfectly clear, this is an important balance to achieve. Some folks (myself included) may delay gratification too much, always saving for the future instead of finding that balance between living the life you want to live now and living the life you want to live in the future. That balance is going to be different for each individual/family (obligatory “personal finance is personal” statement here).
But I’ve (slowly) come to realize that, despite spending a fair amount of time in the class discussing the wonders of compound interest, many (most?) participants still don’t understand the impact compound interest has on future spending. Their cognitive framing is something like this, “I can spend this $1,000 on myself now, or I can save it and spend this $1,000 on future me 30 years from now.” But that ignores the impact of compound interest. At the historical average of earning a real return (after inflation) of 7%, that $1,000 allows you to spend about $7,600 on future you in 30 years (again, that’s after adjusting for inflation). Even if you think future returns will be less stellar, say only a 5% real return, that $1,000 would allow you to spend about $4,300 on future you. So that $1,000 you are spending on yourself now could be used to spend anywhere between roughly 4 and 7 times as much 30 years in the future (again, after adjusting for inflation).
It’s important to not take this to the extreme and never spend money now because you will be able to buy more in the future. After all, in the end, we’re all dead. But I think it’s equally bad to think of it as “spend $1,000 now or spend $1,000 in the future,” because humans have a well-known preference for now over later (with various names given to that such as present bias, hyperbolic discounting, temporal discounting). Instead, the more rational way to frame it is “I can spend $1,000 now or $7,600 thirty years from now, which makes the most sense based on my values and goals.” (You can, of course, adjust that to $4,300 if you expect a lower real return, or you can adjust the 30 year time frame to something else and do the appropriate math.) I think this framing is necessary not only to overcome present bias, but to really think about this in a careful and thoughtful way.
I’m still struggling with the best way to communicate this to my participants (and to other folks I talk to), because it can be interpreted as shaming present spending (which I definitely do not want to do). But I’m hopeful that perhaps being able to refer to this post will provide enough context to forestall that interpretation. If you have any ideas of other ways to share this, please leave them in the comments.
Update 3-13-24: Just listened to this podcast episode with Anne Lester and she mentioned a nice shortcut way to think about this. “Add a zero.” For any given spending decision (and amount), add a zero to the end of it to help you visualize what it will be worth in 30-40 years if you save and invest it instead.
Fisch Financial 