Why Saving Money Can Cost You Money
I had an interesting discussion yesterday with a good friend. He stated, that he had saved a lot of money by buying items at a sale, and although he spent around 150 Euros on them, he had probably saved as much as 300 Euros while making the purchase. I was shocked, how he could regard this as ‘saving money’, as my definition of saving has nothing to do with spending, but with putting money side.
It appeared that our definition of ‘saving money’ was far apart as our discussion progressed; I was unable to convince him of my standpoint as much as he was able to convince me of his standpoint. Whereas he defined saving money from an expense point of view, I was defining money from a wealth, or net worth, point of view.
But what are the differences exactly, and what are the benefits and risks of each viewpoint?
Net worth based saving
I will start with my own viewpoint, net worth based saving. One thing, that I am very conscious of, is to continually increase my net worth where possible, and to run my household like business. I maintain a very accurate balance sheet, with all income, investments, expenses, loans, and loan repayments documented; it is my goal to end each year with a profit, meaning that my income exceeds my expenses.
With this in mind, saving money has the main purpose of setting some of my income aside. I am literally ‘saving’ it from being spent. This means, I could set it aside on a savings account for the purpose of an emergency fund, I could save it for a purchase which is upcoming later this year, or I could even invest it in some way.
Each month, I set myself a target, or a proportion of my income which I would like to dedicate to saving. This target forces me to rethink my spending strategy, and to focus more on buying things I need, and generally limiting my spending freedom for that month. As time goes by, the savings accumulate, and I can either add it up to my yearly profit, or I can actually spend it on a more expensive item I need at the moment.
Expense based saving
My friend’s definition of saving money is rather expense based, and it refers to buying an item at a discount, which usually would have cost more. From what I understood, is that his main motivation is risk mitigation; saving money is purchasing an item cheap now, and therewith mitigating the risk that he has to buy the item at a later point when he truly needs it, but when the price is high.
This means, that in stead of setting that money aside and letting it add to his net worth, he would buy items which he would need at some point anyhow. According to him, even with net worth based saving, the money will need to be spent at some point, and potentially at an even much higher price.
Benefits and risks
Both definitions of saving money have their benefits and risks. I see one of the main benefits of net worth saving as being able to have cash available for any possible item when it is needed. This could be a suit when another one wears down, an unexpected bill from the dentist, a holiday. In addition to that, I could let the money work for me, in the form of receiving interest and dividend payments. Investing that money could also work, but the risk is that stocks might be priced low when I need it, so I would only invest money which I will not need in either the short-term or mid-term.
Naturally, the main risk of net worth investing is, that when I do need an item, I might have to buy it at an expensive price. This is the main benefit of expense based saving, as it focuses on low price purchases. However, while my friend is focusing on purchasing such items, he might not be able to set money aside, and work on his net worth. As an example, he might have 4 additional pairs of shoes to wear, which will not help much if his car suddenly breaks down.
The term ‘saving money’ can be interpreted in different ways. On the net worth side, savings focus on setting cash aside, and potentially let it work for you in order to increase your income. On the expense side, savings focus on purchasing items, you might need in future anyhow, for a low price, and mitigating the risk of purchasing that item when you really need it at a much higher price.
As with many things, the ideal solution might lie somewhere in between.