What is the classic archetypal personal finance blogger post?
You guessed it – it’s clearly the post that sets out why your daily Starbucks habit is killing your ability to retire. Am I right?
Have you read the important notes? It’s a precondition for reading this blog.
Financial Economics and Your Starbucks Habit is Killing Your Ability to Retire
It is a rite of passage among personal finance bloggers to write a post that decries a Starbucks Latte-a-day in favor of saving the money and putting it towards your retirement. The key point being that this abstemious behavior, when combined with the miracle of compounding over the long-term, provides a surprisingly large sum of money.
When you forgo a $3 a day latte for 25 years, and instead invest that amount in a low cost index fund returning 8% a year, this will yield a final sum of almost $90,000. Pretty impressive huh? That’s certainly enough to prompt me to make my own coffee in the morning.
Now don’t get me wrong here, I am not turning my nose up at this type of blog post – I am not sneering in any way.
On the contrary I applaud this illustration. There is a reason this type of post is popular; it illustrates many important and valuable behaviors, such as:
- Unthinking and automatic spending can have a measurable impact over the long term;
- The power of compound interest is large;
- Frugal habits can make a difference;
- Investing your money for the long term can provide significant growth;
- Never think that small actions won’t make a difference to your wealth.
These are all important points worth making. If you can parcel all that up with a neat post about buying a Starbucks-a-day then you are doing a great service to a great many people.
So what’s my beef?
Investment Returns
The above assumes that the money saved will grow at 8% a year.
And let me be clear, I don’t particularly object to fact that the assumption is 8%.
If the assumption had been 7% per year, or 8% or 9% or whatever I would still have reservations.
Equity Returns
What we’ve done in the above example is assume that the Starbucks consumer has invested in a portfolio heavily weighted to equities and then extrapolated past experience to invoke a future assumption of 8% (or whatever).
But you knew that – what’s my point?
We have assumed that equities are guaranteed to return this amount in the future.
Don’t get me wrong here – I am not one of those perma-bears. I have a well-thumbed copy of Jeremy Siegel’s “Stocks for the Long Run”, and I have bought into equities for the long term. My personal portfolio is around 80% stocks – so I’m on-board the equity train baby!
But stocks are not like a higher returning version of bonds. They are simply more risky and they are not guaranteed to outperform bonds or cash over the long term. If equities were certain to do that then equity managers would be offering you a premium to take your money instead of you having to pay a management fee – see my last post on this issue.
If equities were guaranteed to outperform bonds over the long term then you could borrow cash and invest in equities for a riskless profit (this is called ‘arbitrage’). You would simply take out your 30 year mortgage and pay just the mortgage interest payments. Then instead of paying the principal down each month, you would instead invest in stocks. At the end of the 30 year period you would have earned enough to meet your borrowing costs, pay off the house and leave you with a tidy profit as well.
Apart from a flurry of activity in this vein in the 80’s I don’t see a lot of this type of action among investors.
Why? Coz it’s risky. That’s why.
Zvi Bodie the Norman and Adele Barron Professor of Management at Boston University and co-author of the textbook Financial Economics with Nobel prize-winner Robert Merton, wrote that the higher expected return for stocks is a reward for taking the risk, but it is an expected return. It is not a “free lunch” or “a loyalty bonus” for long term stock holders.
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Starbucks and Public Pensions
So you cannot take your Starbucks savings, invest them in equities and be certain of earning 8%.
But… I probably wouldn’t bet against it; so why am I getting my shorts in a twist?
This issue has been a matter of huge controversy in the actuarial profession.
In the early 2000’s pension plans were funded on the basis that future stock returns could be “banked”. Just like our Starbucks saver, pension plans would take advance credit for future stock returns that have not been realized. There was then a huge argument in the actuarial profession about whether this practice was justified. It was a debate with sharply polarized sides. Think titanic Game Of Thrones battle with the two armies amassed on both sides and a gory showdown with blood-curdling screams combined with medieval weaponry.
Actually it wasn’t really like that; there was a considerable amount of earnest debate and polite, but somewhat strained, discussion of this issue by a load of old guys.
But what emerged was victory for the progressives. No longer would pension plans be able to take advance credit for an equity return that had not yet been earned, they would have to assume a lower return.
Except…
That only applied to corporate pension plans and not public pension plans.
Public Pension Plans
For some reasons that I don’t really know, and I’m sure you could not care about, public pensions preserved a much more lenient regime. Public pensions are allowed to fund on the basis that their assets magically return their expected assumption.
Who do we blame for this?
For the purpose of this article I’m going to assume it’s the politicians. However, I would forgive you for putting the blame squarely at the feet of the actuarial profession.
Public pension plans are highly under-funded and a Milliman report from 2017 estimated a total deficit of around $1.5 Trillion! This issue discussed above is still a live, and highly contentious issue. In 2016 a task force of actuaries who was investigating this issue was disbanded under mysterious circumstances.
“This paper (is) being censored by the American Academy of Actuaries” and Society of Actuaries, said Edward Bartholomew, who was a member of the former task force, in an interview. “They didn’t want it to get out.”
Firstly can you think of a more actuarial name than “Bartholomew”, but secondly don’t you think this is the actuarial equivalent of a John le Carre novel!
Back To Personal Finance Bloggers
The issue of whether you can bank your Starbucks savings and assume a future equity return is therefore an ongoing debate. It goes to the very heart of the intersection of modern financial economics and actuarial practice. Personal finance bloggers have unwittingly stumbled into a warzone.
By assuming a future equity return, personal finance bloggers are complicit with the sort of financial smoke and mirrors that politicians are pursuing with the current public pension funding catastrophe.
So What Do I Do?
Given I’ve now blown up your assumption for future portfolio return, then what should you assume?
That, dear readers will have to wait for another post.
What about you? Do you eschew your daily Starbucks in favor of saving the amount? Do you thumb your nose at so-called financial economics and assume a healthy future equity outperformance? Were you disappointed that there weren’t any groovy charts in this post? I know, I was!
Comment below and thanks so much for visiting!
Want to read something else? I suggest How Should You Invest for the Short Term?
Great post, incorporating ”abstemious” and a Game of Thrones reference in the same piece. Bold and brilliant!
What do I do? Well, I generally make my own coffee, which is better than most and has made be virtually indispensable at home. As such, I have been able to call my own shots, including going part time, offering my opinion on the color of the cushions of the patio furniture and making the wine selection for dinner.
In addition, I have played a clever mind game on myself. On the rare occasion that I buy coffee at Starbucks or other local coffee shop, I immediately transfer $25 to my Betterment account. If I can afford $5 for coffee, I can pay myself 5x toward saving. (I know, it’s just taking money from my left pants pocket and moving it to the right…j
In general, I assume a lower rate of return for my investments. I have much greater fear of not meeting my needs or goals for retirement than I have the optimism (or greed) of future higher returns. If things work out as most expect, I will have oversaved and my hypothetical children of children will be happy that I have.
Now, I need to return to the GOT episode in which the Actuaries are storming Kingslanding…with dragon FIRE.
Ha ha, I see what you did there with ‘dragon FIRE’. But just remember… I make the jokes around here… 😉
You have a sweet deal going there with the home coffee making. I too hold the keys to at-home coffee making, but it has bought me nowhere near the privileges that you have. I obviously need to up my coffee game.
Cheers!
There are only two things for sure in life, death and taxes. I get my coffee mostly from home but occasionally splurge on WAWA. No assumptions about return here.
ok I had to google WAWA! I thought that was an acronym. I don’t think they exist in New England.
Thanks, as always, for dropping by FTF.
David Bach built up a huge career off that one simple idea and while it’s “true,” it’s a huge turn-off. The people are frugal don’t buy Starbucks everyday. The people who aren’t, they don’t care. There are just a few people on the margins and the challenge isn’t in proving it’s worth it (or disproving the extent that it’s worth it, given promised returns), it’s that habits are hard to change.
Personally, we have a drip coffee maker for 99% of my coffee consumption and Nespresso for when I want a quick pick me up (or forget to set up the drip). I consider the Nespresso as my “upgrade and save” strategy, which is to say you don’t have to rely on the “best” and cheapest option (drip coffee). You can spend money (upgrade) and still save over Starbucks.
I had not of David Bach, and now I’ve looked at his website I find it really weird that he refers to himself in the third person. I think I might try that!
We also got a Nespresso. I think it’s a big indulgence, but it does make really good coffee. When coupled with a milk heater and frother, you can make some pretty fancy drinks. I like the phrase ‘upgrade and save’.
Jim – thanks for dropping by. I thought your appearance on the DYEB Podcast was great. Very humble and sincere given all you have achieved.
Hahaha don’t be a weirdo and talk about yourself in the third person 🙂
It’s big compared to a drip coffee maker, it’s crazy cheap compared to Starbucks. 🙂 Upgrade and save what I call the “strategy” of buying a Nespresso so you’re more likely to break an even more expensive habit.
Thanks for the compliments about the DYEB podcast, Pete is a great and it was a great conversation!
As a statistician and math major, I’m always a little bit more conservative with my assumptions for growth on my investments (or anything I’m projecting in general)
There are so many variables which you can’t control (and if you try to fit data to something like this, you certainly will get an overfit model.)
Great post
I’m a math major too, so we need to stick together! I need to do the follow up post to this one that will discuss assumption setting.
I make my coffee at home. Haven’t been to a Starbucks in a while.
I think you do need to make some assumptions when performing financial calculations based on future investment returns. But like Erik said in his comment, it might be best to use a more conservative number. I cringe whenever Dave Ramsey uses 12% annual returns in his calculations.
OMG don’t get me started on the Dave Ramsey thing. I really need to write something down on assumptions, as I’ve been opinionated here, but offered no real opinion of my own. *shrug*
I use 7% in all my assumptions but I’m nearing the point where I’ll soon begin to drown down on my portfolio. That means 7% is even more of an uncertainty since I might not have time to recover. Or I’ll need to recover an even greater amount if I draw down during a dip. Hmmm.
By the way, coffee and transportation is covered by my employer and I do invest my savings; I call it the Lexus/Latte Factor. Mr. Bach so far hasn’t reciprocated my eagerness to pursue the idea. Any interest from you AoF?
I’m always up for a challenge! Give me some data and I’ll crunch it.
Thanks for visiting Ty.
I drink Starbuck’s Double Shots. I wait till they go on sale, and buy them out as many as the store will allow. Typically therefore I get my double shot Latte for about $1.66 per beverage. I don’t drink much coffee anymore, but using the 25 year rule I guess I’m out $49,800 vs $90,000 but no one has revealed how much it costs me to brew 25 years of coffee at home including water cost, coffee cost, brewing device cost, disposal cost and electricity compounded. I’ll throw in my labor for free. I bet the DIY is still cash flow positive but BARELY.
I’m thinking about stashing some retirement money for my daughter who is graduating next month. I’ve been looking at investments. I’ve paired it down to IWY, VTI, BND, BRK,B.
BND costs .05% VTI costs .04%, BRK.B costs nothing, IWY costs .2% I ran the choices through the efficient frontier calculator and the calculator chose:
74.7% BND, 8.8% BRK.B, 16.5% IWY for a reward of 6.17% and a risk of 3.32% for the tangent portfolio. VTI was not chosen as part of the portfolio because the calculator considered it an inferior choice.
If I forced VTI and BND, the tangent portfolio was VTI 20.2% BND 79.8% with an expected return of 5.32% and 3.02% risk. The VTI portfolio returned .85% less. The IWY portfolio costs .069% and the VTI portfolio costs .048%
What’s the better deal? Have you ever heard “widely diversified low cost funds” pushed ad naseum?
personally I’ll take the extra .85% return over 25 years over the saved .021% cost. It works out to about 20% more money after 25 years.
Sometimes we spend too much time worrying about the price of coffee. Very thought provoking AoF. I’ll be interested in part 2
The difference in cost is only 2bps between the portfolios. Personally that seems like pennies to me and I wouldn’t even worry about that. (Although I have lost pitches on the basis that my price was 2bps higher than a competitor!) And given the expected return is a massive 85bps higher, then I think you have to go with the BND/BRK.B/IWY portfolio.
But 80% Bonds seems like a very bond-heavy portfolio, any particular reason for that?
Also why the growth bias in US large cap with IWY? Personally I don’t have much of a style bias between growth and value and just go for a generic large cap.
And… why no overseas stocks? I bet you can juice up the optimizer with some international stocks and say 5% EM exposure… More expensive funds, but I bet it will push the efficient frontier out.
Personally I don’t love single stocks – even BRK. But I do get the tax efficiency of that choice.
I just let the calculator optimize the portfolio. Just for completeness I added VEU and it wasn’t chosen either. If I wanted more return I would just run out farther on the frontier optimizing with less bonds. I chose IWY because it is the best performing fund/etf in the large blend category at almost the same cost as VTI. BRK.B has a chart that is virtually identical in terms of performance but the correlation between IWY and BRK.B is only 0.37. BND correlation is -0.17
This post was to buttress your contention bloggers are like politicians. They just echo each other’s opinions. When have you seen a FI blogger (except maybe big ERN) ever recommend anything but VTI or an equivalent total stock market “cheap” choice? How often do you hear about the Bogelhead 3 when that portfolio is also inferior on a risk adjusted basis? Saving 10 bucks a week on coffee means nothing compared to making an extra point of risk adjusted return, but all you hear about is “we made our own soap and saved 6 bux!”. You often say how the efficient frontier just chooses the 60/40 portfolio well here is an example of where it chose a well diversified superior portfolio and totally ignored the 60/40 choice.
It’s surprising the optimizer did not choose non-US equities, but given the low correlation of BRK then I can see why BRK would trump non-US equities in an optimizer. They love uncorrelated asset classes. Yeah I guess I did say that the modeling always chooses 60/40!
I still don’t know how I feel about investment complexity versus simplicity. On the one hand my job depends on complexity – if it were simple then anyone could do it – but I personally like things that are simple and transparent. But what you suggest is not a radical increase in complexity by any means. And your argument that a more efficient portfolio undergoes lower drawdowns in market stress is a good one. Since digging yourself out from a large loss can be a huge drag on your long-term returns, and so avoiding those large losses in the first place is really desirable.
I spent some time on the Personal Capital site looking over my portfolio. I generally don’t use PC because I have other software I use, but PC sends me emails all the time about my portfolio’s performance so I decided to take a look. PC has an efficient frontier analyzer built in as well as Monte Carlo projection to look at failure risk. It also automatically analyzes portfolio cost and makes suggestions on how to balance sectors and classes for a better risk adjusted return. My portfolio is fairly complex but it understood my portfolio perfectly and drew the correct expected return lines and efficient frontier plane. It was amazing! The point is we are probably now 2 generations into rules based advice and quadrature optimization and it already overtaking this PC product so choosing a guesstimated simple portfolio when you can have an optimized slightly more complex kind of misses the power we now have. Yes you can calculate the area under a curve using Riemann sums but you get a far more accurate and elegant result using an integral. It’s a really exciting development for the DIY investor
I’ll have a look at that tool from Personal Capital. I did not realize they had those kind of sophisticated tools available for the public.
BTW I can’t believe you are invoking integral calculus – I’m trying to dumb this stuff down you know!
Cute post. Everyone is revealing their coffee drinking secrets. I must have it daily. I rarely go to Starbucks. I sometimes buy Starbucks pods for my Keurig. I love dark roasted and am usually agnostic to the brand.
This wasn’t even supposed to be a post about coffee! Ha ha
But clearly people don’t want to wrestle with me on the issues of financial economics and public pensions. Which, quite honestly is fine by me!
One of the things that’s great about blogging is that you get to see your own ideas through the eyes of others.
Okay, I did not get to post the secrets to great coffee. You want to quit your job, be a lazy slob and stay married? Yeah, me, too. Follow these instructions:
1) Buy beans that are relatively dry (not “wet”). Wet beans make a sticky mess, which is annoying, and kills the mojo.
2) Grind your beans. (Burr grinder, not blade.) Use about twice what the package recommends. Don’t measure it out, just do it.
3) Prewarm the coffee pot with hot water (then dump out water and reuse warm water for dog’s dry food to moisten it)
4) While the coffee is brewing, put cream/sugar/whatever in the mug of your choosing and heat in microwave 10-15 sec.
5) Poor coffee over cream/sugar/whatever into your mug.
6) Enjoy.
Ive has the opportunity to meet David Bach a few times and I’ve read his book. His latte factor is a powerful teaching example because it forces people to focus on the small daily things. Done over a long period of time, will have a significant impact on someone’s financial future. I love learning both sides of the story though! Great post!
I agree. I’m guessing this is in response to Retireby40’s recent starbucks post…
Ha ha made me laugh! But Retireby40 gets a special pass on Starbucks posts coz he’s a legend.