The Multiplier Effect
I often tell people how I think about money not in terms of days, weeks, months, or even years – but decades. I’ve found that training myself to think in this way helps better align my financial decisions with the things in life I truly value. It is so easy to go through life and not give a second thought to the long term impact of our day-to day decisions! In this post, I’ll provide an easy framework to help evaluate spending decisions in light of their true long term effect.
Did you know the largest living organism in the world is the aspen tree? One of my favorite times of the year is Fall, and one of my favorite places to be in that time is Colorado to witness the aspen trees changing the color of their leaves from green to beautiful and bright shades of red, orange, and yellow. When I’m going through those beautiful groves, I’m always intrigued when I realize that what appears to be a grove of many aspen trees is often just one entity with a shared root system which has grown exponentially.
Of course, this grove started as a single tree – much like the penny in last weeks’ post. It takes time for that single aspen to develop into an entire grove, but it definitely started with a single lonely tree. In the same way, what often seem like small and isolated financial decisions actually have the potential to produce entire financial groves. I call this the Multiplier Effect.
The Multiplier Effect
The Multiplier Effect (which we’ll abbreviate as “ME”) refers to a certain way of viewing expenses in terms of their broader impact on our financial independence goals. As with many things in life, there is often more than meets the eye when it comes to the things we spend money on!
We can look at ME for two different types of expenses – 1) one-time expenses (like buying a new television), or 2) perpetual expenses (like leasing a car).
The ME For One-time Expenses
As an example, let’s say I wanted to buy a new TV which cost $1,500. Just as we’ve discussed with respect to mortgages, its all-too-common and easy to look only at the total amount (or total payment) and ignore the greater impact. In this case, we’ll ignore financing and consider the TV as a one-time cash purchase of $1,500. So, if I pay $1,500 for this TV, what is the financial impact to me?
It’s easy to say, “Well Jake, obviously a $1,500 TV costs you $1,500 – what are you trying to get at?” To which I would reply yes, of course the immediate cost is $1,500. But… the reality is there is a MUCH larger financial impact.
What if I had taken the $1,500 and invested it instead? Let’s set the timeline to 40 years and assume a reasonable inflation-adjusted rate of return of 6%. $1 at a 6% annual return after 40 years could grow into about $10 – therefore, the ME (Multiplier Effect) is 10x and the real cost of this $1,500 TV is now $15,000.
I find it really easy to think in terms of a 10x ME – simply take any one-time expense, multiply its cost by 10, and see if I still want it. Often times the answer is yes, which is great. But sometimes the answer is ‘heck no!’. This provides a fantastic gut check on whether an expense is aligned with my values.
Here’s a calculator for you so you can play around with the concept. Just enter the amount, your rate of return assumption, and how many years you want to conceptualize. Bonus points for those who enter ’42’. If you have no idea what I’m referencing, don’t worry about it (but here’s an article for you)!
The ME For Recurring Expenses
The Multiplier Effect is even more impactful when it comes to recurring expenses. What may seem like a small recurring expense is often creating a much larger drag on our financial independence goals than we might think.
This post is not about leasing or renting vs buying, but let’s look at this in terms of a car lease at $200/month. Again, it’s very easy to view this only in terms of its monthly cost – which is $200. But what is the true impact of a $200/month recurring expense?
For something like this, I like to think in terms of how much more I would need to save/invest in order to generate $200/month of income to cover this new expense. And to get that answer, I created another simple calculator (see below!) – just enter the amount and your safe withdrawal rate assumption (this post has more detail on withdrawal rates, but 3.5 to 4.0% is a commonly used figure for this). What we are trying to determine is how much larger my nest egg needs to be in order to sustain each extra dollar of regular expenditure (assuming I am living off my portfolio by withdrawing a certain percentage of it and the goal is to not run out of money before I die).
For me, the rule of thumb here is an ME of 25 – 30x for recurring expenses. Which means I can view this lease of $200/month as having a true cost of $60,000 to $72,000.
Here’s how the math works (don’t care – no worries, skip to the next paragraph!). $200/month x 12 months x an ME of 25x = $60,000 (or a 30x ME = $72,000). And to get the ME, we simply take the inverse of the withdrawal rate (i.e. the multiplicative inverse of 4% is 25).
Certainly, some regular expenses can be viewed more in terms of value delivered and not simply money down the drain – that’s not what this concept is for. I’m talking about purely discretionary / consumer spending. Here’s the calculator and then we’ll dive a bit deeper into its applications.
Though less dramatic, this idea is quite relevant for smaller expenses, as well! Let’s take a $10/month example. According to the calculator (assuming a withdrawal rate of 3.75%), incurring a recurring expense of just $10/month may result in needing to accumulate an additional $3,240 in my nest egg in order to support that expense. Now, think about how long it takes to save $3,240? A month? Several months? Longer? Is it still worth it?
For those who are hoping to attain financial independence sooner than later, we must ask ourselves – “is this expense worth the time it will take to accumulate the amount required to sustain it?”
We can also think about habitual expenses in this light. What is the true cost of going out for lunch instead of packing lunch? What is the true cost of getting that Latte a few times a week? I’ve found that these sorts of small things have a tendency to creep into my life and its valuable to periodically trim the excess ‘fat’. As shown in this calculator, a lot of small things can really add up!
Often times, even small habit changes make a big difference – driving for better fuel mileage, being mindful of where the thermostat is set, turning the computer off instead of just putting to sleep (phantom power drain makes up about 10% of a home’s energy use), etc. These are things which really make no meaningful difference in my life, but can easily add up to many thousands of dollars or more when viewed in terms of their ME.
Now, I’m not saying to not ever spend money or take on recurring expenses! If you’ve read my introductory post, you’ll know that extreme asceticism isn’t my style – but I do think it wise to periodically re-evaluate our expenses in light of the Multiplier Effect to make sure that what we are spending (and the true cost of those expenses!) still aligns with our goals and values in life.
Using the Multiplier Effect to think in terms of 10x the amount for a single expense and 25 to 30x for recurring expenses, I find it often changes how I feel about the need for a particular item! In a way, I suppose I could say that we should think of our expenses like aspen trees. Always remember that what may appear to be just one lonely aspen tree could actually be (or become!) an entire beautiful forest!
It’s important to remember these are merely heuristics. A heuristic is a quick approach to solving a problem which uses an imperfect method that is usually sufficient for the immediate task at hand, but may not apply to every situation.
So, does the Multiplier Effect change the way you think about your expenses?