Saving and Spending

Savings rate. This is the amount you save each year divided by your income. The savings rates advocated by financial experts are usually couched in terms of pretax income, but the official savings rate from the Bureau of Economic Analysis is expressed as a percentage of after-tax income.

Net worth. This is the value of your assets minus your liabilities. Assets could potentially include cars and collectibles. But it’s more typical to limit the definition of assets to your investment portfolio and the homes you own. Liabilities include all your debts, including mortgages, car loans, student loans and credit card balances.

Fixed vs. discretionary spending. Fixed spending includes recurring costs such as mortgage or rent, property taxes, utilities, insurance premiums and groceries. Discretionary spending, by contrast, is easier to cut, and includes items like vacations, eating out and going to concerts. The lower your fixed costs relative to your income, the easier it will be to save and the more money you’ll have for discretionary “fun” spending.

Hedonic adaptation. This is the surprisingly fast process by which we adapt to new developments in our life, both good and bad. For instance, we might quickly get used to a higher income or a larger home. This helps explain why money buys limited happiness.

Experiences vs. possessions. Academic studies suggest we get more happiness from experiences than from things. Experiences—such as going on vacation—are not only enjoyable by themselves, but also offer months of anticipation beforehand and fond memories afterwards. By contrast, the pleasure from buying possessions can pass quickly, thanks to hedonic adaptation.

Flow. Our happiest times can include moments when we’re engaged in activities that we’re passionate about and find challenging. At such moments, we can be so engrossed that we lose all track of time. This notion of flow—as in “being in the flow”—was developed by psychology professor Mihaly Csikszentmihalyi.

Focusing illusion. When asked, those with higher incomes are more likely to describe themselves as happy, even though other studies have found that high-income earners are no happier on a day-to-day basis. This has been attributed to a focusing illusion: Questions about their level of happiness prompt those with higher incomes to consider their fortunate position in the world. That, in turn, leads them to say they are happy.

Delaying gratification. This involves putting off immediate pleasure and instead focusing on longer-term goals. Good savers are able to delay gratification. This is also a hallmark of those who perform well in school, train to run marathons and successfully complete long-term work projects.

Compounding. In any given year, you can potentially earn investment returns not only on your original investment, but also on returns collected in prior years. For instance, if you earn 10% a year for 10 years, your cumulative gain wouldn’t be 100%, but rather 159%.

Employer matching contribution. In an employer-sponsored 401(k) or 403(b) workplace retirement plan, the employee’s contributions to the plan are often partially or fully matched by the employer. In a common arrangement, an employer will contribute 50 cents for every $1 that the employee contributes, up to 6% of pay. If employees contribute the full 6%, they receive 3% from the employer, bringing the total sum contributed to 9%.

Time-weighted vs. dollar-weighted returns. A time-weighted return reflects the gain you would have earned over, say, 10 years, assuming you bought at the beginning of the 10 years and never again bought or sold. By contrast, a dollar-weighted return takes into account when you bought and sold. If, say, the market fell sharply at some point during the 10 years and you invested more during the decline, these purchases would boost your dollar-weighted return.

Dollar-cost averaging. This is the strategy of investing the same sum on a regular basis, no matter what is happening in the financial markets. If you regularly contribute $300 a month to your 401(k) through payroll deduction, you’re effectively engaging in dollar-cost averaging.

Value averaging. This is a variation on dollar-cost averaging that involves adjusting the amount you invest each month, depending on how the markets are performing. You start by establishing a target growth rate for your stock portfolio. If, because of poor returns, your stock portfolio doesn’t achieve its target growth rate in any given month, you would increase the sum you save. If returns are better than expected, you would invest less. This somewhat contrarian approach can lead to better long-run results than dollar-cost averaging.

Next: Portfolio Building

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