Want to boost savings to pay down debt, build an emergency fund or invest?
Controlling your expenses is the first step. After that, you can look at ways to increase income. You can check out this article to balance your efforts between expense reduction and income growth.
Expenses are like weeds: they will naturally grow to match (or exceed) your income if you don’t keep them under control. That’s why income is irrelevant for those who cannot control spending.
After years of monitoring my expenses, I found it best to batch my payments into three categories:
- Spending Related to My Environment
- Habit Driven Expenses
- Status-Based Expenses
These categories help you focus on financial decisions, habits, and your own well-being.
- Environmental expenses include those tied to where you live, what you drive and your friend group. Single decisions to engineer your environment influence expenses for years to come without additional effort or self-discipline.
- Habits drive many small expenses. When you add up these small expenses, they have a huge impact. Habit replacement is the best approach. Focus on one habit at a time.
- Status-based items lose value, and we quickly adapt to luxury items. Identify the goods that add value to your life, find alternate ways to meet your “esteem needs”, and understand the sources of sustainable human well-being.
Table of Contents
Essential vs Non-Essential Goods
Goods can be classified as essential or non-essential. Essential material goods include shelter, clothing, transport, food, and your cell phone.
But even these essential goods can become non-essential, like when your house is larger than what is functionally required.
The Three Expense Categories
Most of your spending is habitual, environmental, or material. Both non-essential and essential goods can fall into these categories.
So how does this simplify things?
You can apply the same management approach to all expenses within a category. This is time efficient and energy efficient:
- Environmental expenses are managed by changing your environment through single decisions.
- Habitual expenses are reduced by building new habits, ideally via replacement habits.
- Status based expenses are managed by identifying the items that provide actual value to your life, reducing comparison to others and understanding human well-being.
Your environment drives your expenses.
The vehicle you own dictates your fuel, maintenance, and vehicle depreciation costs.
Friend groups who love NFL games and expensive vacations will be way more costly than friends who love to go for hikes.
Your home size and location drive commute costs, property tax and mortgage interest costs.
Environmental expenses are the most effective to get under control. Usually, you can alter your environment with a single hard decision. After that, limited self-discipline is required. This is working smart, not hard at its finest.
Environmental Expense Example: Your Home
Your home’s size and price dictates the following:
- Mortgage payments/interest
- Home Insurance
- Furniture to populate the house
- Property tax
- Hydro and gas costs
- Home maintenance costs
- Your valuable time spent cleaning the house
Finally, home location determines your time spent driving to and from work, fuel, and vehicle maintenance costs.
The singular decision to select a home drives many expenses for years to come.
Your home’s price, size, and location are environmental factors that direct a stream of future expenses (negative cash flows).
This decision should be made wisely, including understanding the rent vs buy assessment.
Environmental Expense Example: My Project Car
I once had a fast hobby car in addition to my primary vehicle.
I sold this car and my environment changed – all expenses associated with the car immediately disappeared: the 94 Octane gas, insurance, performance parts, synthetic oil, expensive tires, and annual registration fees.
Unlike changing a habit, all it took was one singular hard decision to sell the car. All associated future expenses related to the car went away automatically without any additional effort.
2. Habit Based Expenses
Habits are the repetitive actions that occur while your brain is on autopilot.
- Do you have a habit of eating out twice a week or eating at home?
- Do you buy lunches for $15/day or do you have a meal prep habit?
- Are mall visits every Saturday the norm?
- Or what about scrolling through Amazon when you’re bored?
These habits drive your expenses.
Many Small Habits, Big Opportunity Costs
Each habit may seem innocent on its own. But layer 20 of them, and the effect is massive. This is a critical concept from the book Atomic Habits.
A $12 lunch each workday seems minor, but this is $240 per month or $2,160 per year.
If you made lunches and invested 2,160/year in a global index fund over a 30-year career, you would have $260,000. The opportunity cost of spending is the lost opportunity of investing.
Now layer on top a $3 daily coffee, $20 of monthly subscriptions, $100/week at the bar. By investing this money instead over 30 years at an 8% annual return, you would have $1.17 Million.
This is how two people with the same income can end up in vastly different end-states. The Pareto Distribution is talks about how small changes in inputs can result in large changes in outputs.
How To Reduce Habit Based Expenses
Habits are hard to change. The difficulty depends on how long the habit has existed and how frequently the habitual action is conducted.
The best approach is to replace bad habits with good habits. This works better than attempts to eliminate a bad habit in a vacuum.
It takes discipline to change a habit consistently applied over two months or so.
But the discipline needed declines to near-zero after the habit is ingrained. I like to say that habits are discipline efficient.
I think of habit replacement as an investment in my human capital. Once the habit is replaced, the new habit offers a free Return on Investment for life. It takes roughly 60 days to change a habit.
Be patient and Focus on one habit at a time. You may give up if you set expectations that are too high. Remember giving up is the only absolute failure.
For more, check out James Clear’s free resource on habit replacement. He is the habit Guru. Or, just buy his book Atomic Habits.
Habit Based Expense Example
Kara seeks to increase savings by $200/month. After an expense audit, she sees that lunch at the local bakery every day costs her $240/month.
She decided to alter the habit by preparing meals at home every Sunday night and Wednesday night.
Instead of going to the bakery, Kara eats her full meal at the park to replace the daily habit of eating lunch at the bakery.
The new price per meal is $3. Kara saves $180 per month. After two months of making meals from home, Kara has established two new habits:
- Meal preparation.
- Visiting the park at lunch.
Top 8 Books To Build Wealth
3. Status Based Expenses
The desire to signal status is a typical genetic desire baked into all animals, including humans. It helps you measure your location in the hierarchy.
A lovely BMW feels good because it improves your status relative to others. But it doesn’t provide much functional value over a Honda.
Material goods are poor metrics for comparison for the following reasons:
- Most material items are fuelled by debt. You are comparing yourself to broke people.
- You quickly adapt to nicer things, returning to a baseline level of well-being.
Four Ways To Reduce Status Based Expenses
- Understanding that most people are broke
- Asking yourself a few questions
- Understanding the hedonic treadmill
- Finding other ways to meet your esteem needs
1. Understand Reality: Broke People Impressing Other Broke People
The goal is to be wealthy, not to look rich.
The reality is that over 60% of people are living paycheck-paycheck, consumer debt levels are through the roof, and over 80% of Americans can’t afford a $500 emergency expense. This data is from this post on Personal Finance Statistics.
The lovely toys you see are often purchased with debt.
Perhaps your skills, self-discipline, and wealth-building habits are more practical measures for comparison to others.
The wealthy spend LESS than they earn and put it into assets you cannot see, such as stocks, bonds, and cash-flowing real estate.
2. Material Expenses: Do They Add Value?
It can be hard to determine if an expense brings you true value.
Goods tend to bring value to your life if they enable good experiences or save time.
Here are some questions you can ask yourself to determine if the item brings adds value to life:
- Does it save me time and energy?
- Would I buy this if no one else knew I had it? This filters out status reasons.
- Does it enhance my experiences?
Answering yes to these questions means the item is purchased for reasons that will add value to your life.
For example, I love cycling and spend 100+ hours on my bike every year.
Therefore, I’m okay with sacrificing some future wealth for the present joy I receive from my bikes.
3. Understand The Hedonic Treadmill
Beyond strict functional needs, the new car, bigger house, or fancy watch add zero value to your life. You can thank hedonic adaptation.
The short-term dopamine spike when purchasing status-enhancing “stuff” makes us feel fleeting “happiness”.
But this spike fades quickly, our threshold for luxury rises, and we are left in the same psychological place we were before the purchase.
This is “lifestyle creep”, and it has phycological characteristics that parallel addiction. Attempts to revert backward in lifestyle are painful due to loss aversion.
You will adapt to your new lifestyle and have the urge to buy something better. This cycle can carry on infinitely, leaving you broke and unhappy.
4. Find Low Cost Ways To Meet Your Esteem Needs
Status goods help to meet esteem needs. I don’t believe it’s reasonable to rid yourself of all esteem needs.
It seems reasonable to seek ways to meet your esteem needs that are low cost. Ideally, you earn income while meeting your esteem needs, as I do with this blog.
When I look at these models, I see the following ways to meet esteem needs and improve well-being:
- Perform well at work
- Build a business
- Compete in sports
- Lift weights and ride your bike
Material Expense Reduction Example
George leases a new BMW 3 Series for $530 per month ($6,360/yr).
George decides to target these expenses to meet his monthly savings goals. Upon expiration of the current lease, George buys a one-year-old Honda Civic for $14,000 and drives it for nine more years.
He saved $43,340 over nine years.
George invests his savings and receives annual dividend income for the rest of his life. The dividends are taxed far less than his employment income.
George can buy luxury items later in life with his dividend income.
Many of your expenses are based on your environment, your habits, and how you meet your esteem needs.
You can make considerable changes to your expenses by engineering your environment, changing habits (one at a time), and finding free or paid sources of well-being.
With expense reduction, you set yourself up to grow wealth with simplicity.
No matter what option you select, it will be hard. It will require self-discipline.
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