To most people, one thousand dollars spent is just that.
It’s one thousand dollars you don’t have anymore.
Spend one thousand dollars on an expensive meal or clothes and you’re less wealthy by one thousand dollars.
But if you’re truly interested in being financially free, it’s essential to view that one thousand dollars differently than most people. It’s essential to look at spent money with the butterfly effect in mind.
If you want to accumulate enough money to have a lot of power and freedom, one obvious thing you must do is save money. It’s so obvious we won’t go on and on about it.
We will go on and on about the powerful, but hidden force that is released when you save money instead of spending it.
Knowing about this force will help make you financially free while not knowing about it will cripple your ability to build wealth. Know about this force and you’re ahead of 99% of Americans when it comes to money. We call it “the butterfly effect of spent money.”
Here’s how it works:
The “butterfly effect” is scientific concept that describes how small events can end up creating huge impacts. It’s from the idea that the flapping of a butterfly’s wings could theoretically alter the path of a hurricane.
There are many instances of the “butterfly effect” in life. For example, let’s say you sleep in a little and make it to the coffee shop 15 minutes later than normal but while waiting in line, you meet your future spouse. A home, a family, and a lifetime relationship results from you waking up late, something that seemed insignificant at the time.
Another example of the butterfly effect: You have a great meal at a new sushi restaurant and the next day you tell your friend about it. Your friend tries the restaurant. He enjoys it so much that he tells a dozen other people. Those dozen people try the restaurant, love it, and tell lots of other people. The restaurant gets hundreds of new customers as a result of your one meal, which seemed insignificant at the time.
It works the same way with money.
When you spend money, you surrender its ability to make more money for you down the road, which causes huge ripple effects over the course of your life.
When you spend money, you give up your money’s ability to compound for you over the span of years.
Compounding begins when you place money into an investment that pays you a cash return. Instead of taking the cash returns and spending them, you “reinvest” them, which buys you more of the investment. By doing this, your dividends earn more dividends and your interest earns more interest.
You can think of compounding returns like rolling a snowball down a hill. Though it starts small, as the snowball gets larger, it’s able to gather more snow, which enables it to get larger, gathering more snow, making it even larger, and so on. Eventually, your snowball is the size of a house.
Compounding is the ultimate way to turn a little money into a lot of money. It’s one of the great secrets of wealth. Given enough time, a good compounding vehicle will turn tens of thousands of dollars into millions of dollars.
For example, let’s say you invest $10,000 in an investment that pays a 5% dividend. Your intention is to compound over the long term.
In Year 1, a $10,000 investment paying 5% in dividends will pay you $500. You take this money and buy $500 more of the investment.
In Year 2, your investment has grown to $10,500, but still earns 5%. That year, you’ll earn $525 in dividends, which you can use to buy more of the investment.
In Year 3, your investment has grown to $11,025, but still earns 5%. At the end of that year, you’ll earn $551.25 in dividends, which you can use to buy more of the investment.
You can see how it works…
After 10 years of compounding, a stake of $10,000 throwing off 5% in dividends will grow to $16,289. After 20 years of compounding, a stake of $10,000 throwing off 5% in dividends will grow to $26,533. After 30 years, it will grow to $43,219. After 40 years, it will grow to $70,400.
And remember, this number assumes no further money is added as the years go by or that the investment produces any capital gains.
As you can see, long-term compounding produces extraordinary effects.
Compounding is an important concept for young people to learn because they have the power of TIME on their side. The longer you can compound, the more extraordinary the results.
After you learn about the extraordinary power of compounding, you’ll view every “spend or save” decision in a brand new light. You’ll realize each dollar spent is a dollar that is not compounding for you. You’ll realize that due to the “butterfly effect of spent money,” small spending decisions end up having huge long-term impacts on your wealth.
Let’s say you have the choice to buy a $10,000 car or a $20,000 car, for example.
You could easily get by with the $10,000 car, but the $20,000 would be a bit nicer. Tt would have a better brand name and it might impress a few people.
Let’s study how this decision will affect your wealth over the long-term.
First, say you spend $10,000 on the car and place the other $10,000 you could have spent into an investment yielding 5%. You compound that wealth for 10 years.
As I mentioned, a $10,000 investment compounding at 5% a year for 10 years grows to $16,289.
The money you spent on the car didn’t just fly out the window. You bought something of value, but the value of that car (like almost any consumer item) will depreciate.
As soon as you buy a car (or almost any other consumer item), it starts losing value. Most 10-year old cars with substantial miles are worth less than 10% of their purchase price. In a normal case, your $10,000 car would be worth around $1,000.
This means that the decision to spend $10,000 on the car and invest the other $10,000 left you with $17,289 after 10 years (the $16,289 investment and the $1,000 car).
Now, let’s say you spend the whole $20,000 on the car. The car will be worth about 10% of your purchase price in 10 years, or $2,000.
The entire $20,000 was placed into something that depreciated in value, rather than something that compounded in value.
The long-term difference between the two decisions is $17,289 (spend less) versus $2,000 (spend more).
The decision to buy the lower-priced car means you end up with 8.6 times more money.
The butterfly effect is massive.
A seemingly small decision produced a huge difference in your wealth over the long-term.
Imagine making hundreds of decisions, big and small, to save and compound instead of spending and consuming over the course of your life.
Choosing to save $500 here, $300 there, and $2,000 there.
Over the course of your life, these accumulated decisions to save rather than spend can literally mean millions of dollars to you.
The biggest and most important “butterfly effect” decision will most likely be your decision on what house to buy.
This is the biggest spending decision of most people’s lives.
Will you try to keep up with the Joneses and buy a $600,000 house?
Or will you buy a more affordable house for $300,000?
The butterfly effect here is HUGE.
A home may maintain its value but buying a more expensive house almost always means spending a lot more on furniture, curtains, decorations, light fixtures, electricity, upkeep, taxes, and insurance. Spend an extra $100,000 on this stuff now instead of saving it, and you can subtract more than $1,000,000 from your wealth over the long term.
Don’t get me wrong. I’m not saying don’t spend any money. (Far from it.) Buy some nice dinners, buy some vacations, buy some “toys.” Enjoy life. I’ve spent lots of money on experiences.
I’m simply saying that if you want to become wealthy, don’t go wild with your spending. If you do, you’ll cripple your ability to compound over the long-term.
The next time you’re thinking about spending a few grand on something you don’t really need, remember the butterfly effect of spent money. You won’t be parting ways with just a few thousand dollars, you’ll be missing out on tens of thousands of dollars that compounding can produce for you over the long-term.
If you consistently choose to “save and compound” over “spend and consume,” it will cause enormous positive effects on your wealth.
Hundreds of accumulated decisions will end up making a million-dollar impact on your wealth and vastly increase your financial freedom.
In the next essay, I’ll discuss how investors can get rich without trying or thinking very hard.
Regards,
Brian
