Reverse Compounding

Background
A client called the other day – worried about the economy and the future. She got us thinking, because she really didn’t have to worry. Her economic future is secure, due to previous sound savings habits, frugal spending, and a willingness to be a bit conservative on her investing. The trouble is, she is precisely the type of person who does worry – the type that has done everything right and continues to do so. This article isn’t for her.

Heads up: the new normal is coming, only it really isn’t new - just a new version of an “old normal” - a time most of us have conveniently forgotten. This new, old normal is going to require changes to our spending habits.

Think back to the mid 1980s – a time before debt fueled our lives and our homes became castles. Our needs were simpler then. Cell phones and the internet weren’t staples carved into our budgets right next to the mortgage and the heating bill. Most people ate at home on Formica counters. Cruises and exotic trips to Africa were infrequent, special events. And keeping up with the Joneses meant comparing lawn mowers, not complete kitchen renovations. Most of us grew up in those days and never felt that we lacked for comfort.

OK, perhaps going back to the 1980s is too much to ask. But making some adjustments to one’s lifestyle is a reasonable request for most people, now that two steep, bear markets - in one decade - have challenged many long term retirement plans. But why change now, when there is still plenty of time – decades for most people - before the threat of running out money surfaces? Because of the Magic of Reverse Compounding.

Compounding
Everyone knows the savings story…a person begins tucking away a small amount each month at an early age and, by retirement, becomes a millionaire, having set aside only a tiny fraction of income. In order to create that same million, a middle aged person has to allocate a much greater proportion of income each year simply to get to the same account value.

It is all due to the Miracle of Compounding – a mathematical concept that allows you to turn a small amount of money into a lot of money over time, assuming you invest your savings wisely. If you save money the first year, that money earns interest. The next year if you add the same amount of money to your accounts, you are now earning interest on last year’s savings, last year’s interest on savings, and this year’s savings. As the years go by, interest keeps earning interest on interest, allowing dollars to add up at an ever increasing rate.

The Magic of Reverse Compounding works the same way – only instead of putting more money into your accounts, you are taking less money out. The dollars you don’t spend are now allowed to grow and compound over time, leaving you with more money – and potentially a lot more money - to spend later.

All of this sounds basic and simple, but getting people to change spending habits is not that easy. We know what we should do, just like we know we need to exercise more, but making a commitment to change is much harder, especially when we don’t feel any immediate urgency. So here are a few tips to get you started:

¨ Small Things Matter: Most budgets are sabotaged not by the big items, but by the incessant accumulation of little items. (Starbucks coffee, lunches ordered out, frequent trips to CVS, etc.)

¨ Stay Local: Save plane fare by keeping trips within driving distance. New Hampshire and Anguilla will not cost you the same, but both are lovely.

¨ Change rationales: Just because you have done something before doesn’t mean you have to do it again. There is no requirement that your car needs to be replaced every four or five years.

¨ Save Up for the Special Pleasures: Need new furniture? Check the savings account for available cash first.

¨ Less Frequently is not the Same as Doing Without: Cut back – but don’t cut out. Think brunch date, not dinner date.

¨ Set Priorities – Sit down with your spouse or partner and decide what spending is negotiable and what is not. Put the non-negotiable items at the top and cut off the bottom third of spending items.

The new, old normal is going to be far more challenging than most of us expect. Getting to retirement and living in retirement could require us to stretch our savings over 40 or even 50 years. We need to start changing habits now. Not only will we benefit from reverse compounding, but we just might spare ourselves a few worries later. Unless, of course, you are the client who called and got us thinking in the first place. Worrying, like spending, is a hard habit to break.

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