Imagine that Bill and Ted have gone trekking in a remote corner of the Death Valley National Park in the USA.
They’ve been backwoods camping and were carrying all their own food, tents and equipment.
Unfortunately some coyotes stole all their stuff a couple of days ago and its taken 2 days to walk back to the edge of the national park towards the car park. They have no water and they’re still a full days hike in the hot desert sun from where their car is parked. Without water they won’t been able to keep going much longer.
As luck would have it, they then turn a corner and see a lemonade stand that has been set up by some enterprising kid. What a relief!
Then they see the price: the mini-
entrepreneur is charging $5 per cup of lemonade when they know perfectly well that, at home in the suburbs, the normal going rate for a cup of lemonade is $0.50 a cup.
Bill pays the $5 with as much good grace as he can muster, acknowledging that the entrepreneur’s distribution cost is higher out here in the middle of nowhere. The kid is providing convenience and a life-saving product here so good for him. Plus Bill knows his chances of finding another lemonade stand around here are slim to zero. Bill buys the lemonade, walks on refreshed to his car and drives home.
Ted has the $5 but refuses to pay because, well $5 is daylight robbery. He grumbles that its a total con, never gonna pay that etc etc. The funny thing is that Ted feels like he’s standing up for what’s right…but really he’s just a penny-pincher. Ted refuses to buy the lemonade and a few hours later he collapses with dehydration and dies.
OK, so maybe that example is a little contrived but I’m trying to illustrate a real blindspot: the problem with penny-pinching. Ted’s mistake was to focus exclusively on the price without thinking about value.
Price is what you pay, value is what you get and the two can be very different. I’ve written before about the difference between frugal and cheap. It makes no sense to be penny-wise and pound foolish.
The next year or so is going to be tough economically so a lot of people are going to keep their spending down in Monk Mode. Lockdown showed what was possible in terms of living cheaper and cutting out unnecessary spending. The aggregate savings rate in the UK went from ~5% at the start of the year to ~30% during lockdown. Credit card debt got paid down at a record rate (every cloud has a silver lining).
But whilst Monk Mode is good, that doesn’t mean all spending is bad. Imagine you are the Chief Financial Officer of your own life. A Chief Financial Officer understands the difference between operating expenses (bad) and an investment (good).
Paying a utility bill (e.g. electricity) is an operating expense and those should be squeezed down as hard as possible. You should always shop around on price when buying a commodity. One company’s electricity is much the same as another company’s electricity.
But Chief Financial Officers also know that some things are investments and that quality matters. Good Chief Financial Officers invest in themselves and they invest in their people: in their wages, training and education. The most successful companies in an industry often pay staff the best wages and invest heavily in training. If you pay peanuts, you get monkeys.
So we should be willing to pay money to invest in something with a high return on investment. My favourite example of this is spending on great books. This week I’ve been re-reading the excellent Atomic Habits by James Clear which feels like the book I wanted to write. As you may have heard me say before, the best books have an almost infinite return on investment.
Think of the value that you get. The author typically spent decades working hard, gaining skills and experiences in a particular field. They then spend a couple of years painstakingly writing this down, capturing their hard-won accumulated wisdom. The book gets edited, re-drafted and lovingly polished. If you apply the wisdom of a book like Atomic Habits to your life and your actions, the value to you could be thousands and thousands of pounds over your lifetime.
That’s the value, what about the price? Well, you get to access that wisdom for free from a library or for less than £10 online. These days, books are so cheap that it’s almost unfair to the author. By all means get your book free from the local library but, if they don’t have it, not buying the book is penny wise, pound foolish.
Here are 2 ideas that I hold in my head at the same time:
- It’s all about The Aggregation of Marginal Gains. Plug the leaks in your spending bucket because the combined effect of lots of small wins adds up over time to create amazing results.
- Penny pinching is a a bit depressing and, for most people reading this blog, mostly unnecessary. Better to focus your scarce headspace on the Big Wins and Think 80:20.
The Pareto principle (also known as the 80/20 rule) is the idea that only ~20% of inputs control about ~80% of outputs. In personal finance the implication would be that you get most bang for your buck by focusing on the 20% of decisions that provide 80% of the financial results.
Take spending for example. You get most of the value from the Big Wins on spending such as:
- Don’t buy the biggest house you can (and just one)
- Small car (3-5 y/o) pay with cash 🚴>🚕>🚐
- # of children
- Find a good state school
- Offpeak holidays: Driving > flying, Renting > hotels
- No shopping for entertainment, online where poss
- Real food prepared from ingredients
- Eat what’s in the fridge first
- Home entertaining > pubs > restaurants
- Price compare utility bills on moneysavingexpert.com etc
If you get this stuff right (plus getting a decent job) then there’s probably no need for penny-pinching for most readers of this blog.
[Side note: I totally accept that people stuck on minimum wage or unemployed may be in really tough circumstances and need to watch every penny. I can’t emphasise strongly enough that nothing in this post is a criticism of those people.]
What is the difference between penny-pinching and Monk Mode? Both of them might look much them same. The difference is not in the number of £ spent. The difference comes from the internal motivation.
In Monk Mode, your motivation includes progress and productivity. In Monk Mode we are trying to get better, get richer and, yes, get more. More freedom, more time, more income. Just not more stuff.
In pennypinching mode, the motivation is more likely to come from fear. The sad thing is that penny-pinchers have often not rejected consumerism. The worst penny-pinching is stuff like clipping coupons so you can get 10% off at Carbz R Us. Cheap shit is still shit.
In personal finance you need to be able to balance offense (more income) with defence (less spending).
Penny-pinchers have rock solid defence but they don’t score. Personal finance is more like basketball (where every player needs to be able to play both defense AND offense) than rugby (where the backs and the forwards can just focus on their primary role).
It’s not enough to keep a clean sheet. To win the personal finance game you need to score.
The other problem with penny-pinching is that it, at best, it underweights quality and at worst, it completely overlooks it. Quality is as essential an element of value as price. Warren Buffet is a famous example of a value investor who learned to appreciate quality.
Warren Buffett was brought up frugal. He was raised during the Great Depresssion of the 1930s and had frugality inculcated in his Money Blueprint from that time. He famously still lives in the same house in Omaha that he bought in the 1960s before he became a billionaire.
But Buffett invested in his own financial education and went to study for a year in New York City with his mentor Ben Graham, the father of value investing. Graham was famous for finding very cheap “cigar butt” companies trading at less than breakup value. As stockmarkets got more efficient, those opportunities dried up.
Buffett’s investment holding company Berkshire Hathaway was originally a textile company that had no quality advantage in a fearsomely competitive industry. Buffett bought it cheap but after heavy operating losses and closing it down he realised this:
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”Warren Buffett
In the stockmarket a quality strategy can outperform the market over the long term. This is why I (partly) use a quality strategy in my own investing. Don’t get me wrong, I’m not encouraging people to stray from low-cost index tracking investing which is MUCH simpler and safer for ~99% of people.
A lot of investors go on a journey starting from hardcore value investor and ending up placing more emphasis on quality. At first it goes against the grain to pay a price:earnings multiple of over 20x or accept a free cashflow yield of less than 5% but once you’ve bought a few value traps e.g. banks or beaten up commodity stocks with a juicy dividend yield of >5%…only to see the dividend slashed, well then you learn to prioritise quality.
Remember the story of Ted. Sometimes you need to pay more to get more. Value is more important than price. The trick is to find the sweet spot; the intersection between need, quality and price.
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