Friday, January 30, 2015

Fundamental Strategies for Saving Money



I recently watched a movie titled Living on One, a documentary about four college students’ efforts to spend a summer in Guatemala living on a dollar a day. (The movie is available on Netflix and is worth an hour to view.) As 50% of the citizens of Guatemala live on less than a dollar a day, the film explored the personal finance habits of people who have a hard time earning enough money to live on, much less save.

My favorite segment of the film discussed the concept of savings clubs, a popular strategy in less developed areas of the world. To illustrate how a savings club might work, consider a group of 12 individuals who each agree to save $12 every month. However, each member contributes their $12 of savings to the group every month, and one of the twelve members keeps the full sum of $144. The member taking the lump sum alternates each month, so that consequently, every member of the club receives $144 once per year.

As you likely already see, the purpose of the savings club is not to achieve investment growth. Each member contributes a total of $144 to the club each year (12 contributions of $12), and every member receives $144 once per year in return. So what’s the point?

The point is that in the arena of personal finance, it is often more beneficial to receive a large lump sum occasionally than to receive a smaller amount more consistently. In Guatemala, a large lump sum can be used to purchase a stove to cook food, while in more developed parts of the world a lump sum might be used to purchase a car or as a down payment on a home. The $144 lump sum is more valuable than simply saving $12 for 12 months because humans find it difficult to save money they have access to. Having smaller amounts of money available that can spontaneously be spent on nice dinners, vacations, or other small ticket items can ultimately be a drag on a person’s savings efforts.

Another benefit of the savings club is that they force individuals to prioritize savings.  If a member of the club can’t contribute their $12 during any given month, they are kicked out of the group and will not collect the $144 lump sum they have been counting on. A factor that motivates savings is indescribably beneficial. Most people earn a salary, pay bills and have fun with that salary, and intend to save any funds that are leftover. Unfortunately, for most people very little is left after maintaining their standard of living, so very little gets saved. When we prioritize saving, we earn our salary, achieve our savings goal as soon as income is received, and find a way to live off what is left. This tactic ensures we are saving the amount required to meet our financial goals.

So a savings club both enables individuals to save while removing access to the funds that are put away, and forces members to prioritize saving by imposing negative consequences if savings goals aren’t met. Sound like any savings vehicles that you might use?

Employer-sponsored retirement plans like 401ks, 403bs, and 457s create the same driving factors as savings clubs. For example, 401k plans enable us to contribute relatively small sums of money to our savings consistently while removing our access to those saved funds by charging us a 10% penalty if we withdraw the money early. Further, a 401k forces us to prioritize saving by contributing to the savings before we even receive our paycheck. By taking the 401k contribution out of our salary before we even receive it, we are certain to save the percentage of our salary that we choose as our goal. Of course, employer-sponsored retirement plans are superior to the primitive savings clubs in that they allow us to invest in stocks and bonds, so their goal is not only savings but growth on those savings.

Still, I find these savings clubs fascinating because they highlight the most important and basic strategies to successful saving.  If you’re looking to ramp up your savings, the best things you can do is eliminate your access to the funds you set aside and create a motivation to place savings ahead of spending.

3 comments:

Pavlos Lombardi said...

I've been trying to make a financial plan over the past few days, but for some reason I just can't figure out anything that works. I always end up spending either way too much money, or just not enough. Do you know if there's anyone that I can hire to help me set everything up?
http://www.skdocpa.com/Financial-Planning.htm

Pavlos Lombardi said...

I've been trying to make a financial plan over the past few days, but for some reason I just can't figure out anything that works. I always end up spending either way too much money, or just not enough. Do you know if there's anyone that I can hire to help me set everything up?
http://www.skdocpa.com/Financial-Planning.htm

researching investing said...

Thank you so much for these fundamentals. I'm finally in a place in life where I can really start saving and investing but didn't really know where to start!