Save, Invest, Pay Down Debt, or Spend?

There's a lot that goes into financial planning: cash flow projections, Monte Carlo simulations, portfolio design, cash flow management strategies, etc. However, at the end of it all, it seems that most of it boils down to this: how much should I save/invest/pay down/spend, and how exactly do I go about doing that?

If you were to ask this kind of question on reddit or bogleheads.org, you'd probably get a pretty straightforward and simplistic answer. However, if you were to ask a financial planner, they'd probably give you a pretty infuriating answer: "it depends."

Why? Why do we refuse to give a direct answer? Well, this is one of those areas where planners and engineers align, because as any engineer can tell you, it's pretty rare that you get something for nothing; it's all about understanding the tradeoffs. Now, it may be that you don't care about a certain aspect of a tradeoff, so you get something for very little -- which is great! -- but it's important that you understand what you're giving up, lest you get a nasty surprise later.

So: let's talk about what you might be trading for, or trading away.

Returns

Let's start with the most obvious tradeoff: return on investment. Putting your money in checking means it's going to earn nothing; savings might earn you more; CD's even more; stocks and bonds, even more. And for each, you're trading off something -- generally, either flexibility (in the form of liquidity) or stability.

But I want to stress this point: there is always a tradeoff. You are never getting anything for free. Sure, you may have found a savings account that earns more than what you were previously earning, with the same liquidity and FDIC insurance, but at the very least, you have to trade off current quality of life -- your time and effort -- to set up the account and move your assets there. Sit down and count the cost first.

Now, sometimes it's less clear how to compare return on investments. For example, if you're looking at paying down your mortgage versus investing, how do you know what the expected rate of return on your portfolio is? And how do you compare a fixed return versus a variable return? This is precisely where (a) financial planners with an eye on capital market return expectations, and (b) Monte Carlo simulations come into play. Which leads us to...

Stability

I've said many times that the single most important question in portfolio design is "what is your risk tolerance and risk capacity?" This question represents a direct tradeoff between volatility and return on investment: the higher the stock allocation, the higher the return, but also the higher expected volatility. How much volatility can your plan handle? How much can your stomach handle?

(An interesting exception: investments that are valued infrequently -- like private equity -- have the appearance of stability, simply because their value isn't being updated every millisecond like publicly-traded securities are. Make no mistake, though -- it's an illusion, and one that might be worth its own discussion...)

If you're looking at the short term -- say, you need the money next month -- stability is often the clear winner: the return on investment for a single month is very small, and the value of having the exact amount of money you need, when you need it, is very great.

And if you're looking at the very long term -- say, you won't need the money for 20 years -- returns are often the clear winner: you don't care what happens to the money in a year, or two, or ten, so you can sacrifice volatility for return on investment. (So, please: stop checking your 401(k) balance every day.)

There's a big fat gray zone here, and that's retirement: you need some of the money now, and next month, and next year, so how do you handle that? How aggressively do you invest? And this is where Monte Carlo simulations are extremely helpful: they can show you the tradeoff between returns and volatility in terms of your specific financial plan.

What's often interesting here is that there's a diminishing returns curve: as you make your portfolio more and more aggressive, you have to take on more and more volatility for less and less return on investment. If you're nowhere close to retirement, you may think, "but why do I care how volatile my portfolio is, if I know I won't need the money?" Ah, but do you know, for certain? Life comes at you fast, and we're all subject to the "end of history illusion" ; what if, as is not unlikely, you need the money sooner than you think? Might it be worthwhile to take a little off the returns in order to improve your flexibility? Which, naturally, leads us to...

Flexibility

There's another axis to this tradeoff graph we're creating, and that's flexibility: your ability to change course. CD's offer stability, and retirement accounts improve your rate of return (via tax-deferred or tax-free growth). But assets like these are inflexible: once you've put your money in, you pay a penalty to get your money back out (if you can get it back at all!).

And flexibility is extremely important, often more than we realize, thanks to the aforementioned end-of-history illusion. This is why I talk about "flexibility funds": deliberately keeping part of your portfolio outside of your tax-advantaged savings vehicles in order to better respond to the threats and opportunities that invariably come up.

This is the core of adaptive financial planning: planning with flexibility. Planning lets you head in the right direction, so that you don't e.g. unnecessarily delay retirement by not optimizing your finances, and flexibility lets you change course, so that you can e.g. decide to retire later and improve your current quality of life anywhere along the path! Which brings us to...

Current quality of life

Of course, all of this assumes that you're not spending your money...but spending your money is always a valid option! Just because you can save the money doesn't (necessarily) mean you must...if you die sitting on millions of dollars (and don't have a particular legacy goal), you may as well have lit that money on fire! It follows, then, that we never want to forget the tradeoff of current quality of life versus future quality of life.

However, there's another wrinkle in this: as I mentioned before, even if you do decide to save your money, you have to do something in order to execute whatever it is you're looking at. Backdoor Roth IRA's, opportunistic rebalancing, tax-loss harvesting, tax-efficient asset location, optimizing your credit cards, and any number of interesting optimizations can all be quite good tradeoffs when it comes to returns, volatility, and flexibility...but they take time and effort, and that alone can sometimes make them not worthwhile from a quality-of-life perspective.

Important note: when analyzing this tradeoff, don't fall into the trap of just giving your time a flat hourly rate. Your weekend time is worth more than your weekday time -- you need that time to recharge! And if something takes a lot of effort, leaving you drained and with less energy to do other things -- not to mention just less happy -- then that's a higher cost, too! Think hard about the value of your time; it's a worthwhile exercise! Again, just because you can optimize doesn't mean that you must; you get to choose what your time is worth. Which, finally, brings us to...

The real questions

Now that we've walked through several of the major tradeoffs involved in making financial decisions, there's something I want you to take note of: there's no value judgment anywhere in there. I hear people say, "I know we should put more money into my 401(k)," or even better, ask, "Just tell us -- what should we do?"

But as you can see, there's no should or should not -- only tradeoffs. You can put more money into your 401(k)...or you can improve your flexibility (by putting the money in an investment account) or stability (by putting it into savings) or current quality of life (by spending it). They're all valid options! The blessing -- and curse -- is that you get to decide.

Having said that, virtually all of these tradeoffs have "inflection points" -- eventually, you get to the point where you have to spend a lot of buck to get more bang. How much stability do you really need? How much flexibility do you want -- and how much would likely go unused forever? And how much would more spending really improve your quality of life?

These are the important (and often hard) questions. Once you've got a bead on those, though, the answers to the other questions will quickly fall into place.

And if you'd like someone to help you figure that out -- you know where to find me!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.