Danger of excessive spending

BUSINESS/YAP MING HUI: Danger of excessive spending
By Yap Ming Hui

2008/03/16

THE founder of one of the largest investment fund in the world, Sir John M. Templeton, once said: “Those who are thrifty will grow wealthy, and those who are spendthrifts will become poor. During my first 15 years after college, I made a game of adhering to a budget that included saving 50 cents out of every earnings.” In fact, the discipline of being able to control our spending and save consistently would make or break our wealth maximisation success.


Case study


Many years ago, I met Joshua in a business seminar. He was then the managing director of a multinational corporation. He was in his late 40s. Over a conversation, he shared with me that he was earning RM600,000 per year. I must admit that I was impressed. I was still new to the industry then.


RM600,000 annual income was really big.


I expected him to have accumulated a substantial amount of wealth over the years. However, when I added up all his assets, I found that his total asset was less than RM2 million. His net worth was less than RM1 million. More than 70 per cent of his net worth was from his EPF saving.


Iwas really shocked.I asked him where all his income has gone to.


He told me that he didn’t know.


Every month, his family and he spent the income to maintain their life style. At the end of the month, there was nothing much left to accumulate and invest. Every time there was an income increment, he just increased his spending accordingly. This is a classic example of excessive spending.


The problem Joshua is definitely the classic victim of Parkinson’s Law. The law states that your expenditures rise to meet your income.


Remember the time when we started working, we earned about RM1,500 per month. Then, we barely had enough money to sustain our monthly expenses.


However, we were not worried.


We knew that when our income increased later, we would have some saving. After a few years, our income rose to RM3,000 per month. Did you really end up having a lot of saving? The answer, of course, is no. You discovered that your expenditures actually went up to meet your income. As a result, you didn’t have much to save. To most people, the same thing happens when their income increases to RM5,000, RM10,000 or RM15,000. In the case of my friend, Joshua, his expenditures rose to meet his income of RM50,000 per month.


When you suffer from excessive spending disease, it will cause the following problems to your wealth maximisation:


•The more we spend, the less we save
The first problem is simple and obvious. The more we spend, the less we can save. As a result, we would have less resource to invest.


•The more we spend, the more we need to sustain during retirement
When you spend the majority of your income to maintain your current life style, you create a huge challenge to maintain your life style in the event that your active income stops.


We can see the picture better by using Joshua as an example. He spent almost all of his income almost every month to maintain his RM30,000 life style. Should he retire, he would have to maintain a retirement life style of RM30,000 per month without his active income.


This would present a very huge challenge. However, if he were to control his living expenses to RM20,000 per month, not only would he have extra RM10,000 to save, also he would need only maintain a life style of RM20,000 per month during his retirement.


•The more we spend, the higher rate of investment return we need The more we spend and the less we save, the more risk we will need to take in wealth accumulation planning.


Lets take an example of RM5 million accumulation goal in Table 1. Assume that your are 45 and plan to retire at 60. If you can save RM180,000 per annum, you need to achieve only 8.3 per cent of return on investment (ROI). If you can save less at RM120,000 per annum, you need to achieve a higher ROI at 13.4 per cent. If you can only save RM50,000 per annum, you need to achieve 23.9 per cent of ROI for RM5 million goal.


Therefore, the lesser you save, the higher ROI is required to achieve your accumulation target.


As a result, you will need to take higher investment risk to achieve the same goal. When we do not need to achieve a high ROI, we do not need to take too much risk and volatility. The less risk we take, the more peaceful our life will be.


Alternative solutions


•Acknowledge the danger of Parkinson ’s Law
To avoid the problem of excessive spending, you must be aware of the impact of Parkinson’s Law. You need to know that saving would not come naturally unless you make it an effort to control your spending. Unless you acknowledge the danger of Parkinson ’s Law, it is very difficult for you to tackle excessive spending

•Spend after you save
The most effective practice to avoid excessive spending is to spend after you have provided for saving (Income –Savings = Expenses. NOT Income –Expenses = Savings). By forcing yourself to save more, you would definitely have less to spend. As a result, you are able to control your living expenses and live within your means.


• Conduct a life-long cash-flow plan
In order for you to know your optimum life style (living expenses) and savings required to support that life style without active income, it is important that you conduct a life-long cash-flow plan.


This cash-flow plan will project your annual income and expenses until the last day of your life.


By doing this exercise, you can find out what living standards yo u can afford and determine the savings needed during your active income years.


As a result, you can appreciate how challenging it is to sustain high living expenses without active income.


Hopefully, you can also recognise the urgency and importance to start saving now.


Yap Ming Hui is the managing director of Whitman Independent Advisors Sdn Bhd, the first multi-family office in Malaysia


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