Last week I was having a beer with a good friend. Let’s call him Mike.
Mike’s situation looks like this:
- 6-month old newborn.
Pretty common, right?
We were talking about savings, retirement, and how his kid's college fund will look in 18-years.
Although Mike has a pension through work, he’s never really had time to sit down and go through all the possible investment options available to him, nor create an investment strategy for the long haul. With so many options available, and now with a newborn, he didn’t know where to start.
I explained to Mike, getting to retirement is actually not as complicated as it seems, and mostly, it’s the financial industry who make it sound complicated to justify their high fees.
setup your accounts
I asked if he had an RRSP and TFSA, which he does. Setting up these accounts is probably the most time-consuming part of the entire investing process, believe it or not!
change one small thing
Next, I asked Mike where he gets his morning coffee. He enthusiastically said Starbucks. I then asked Mike a simple question:
“What if you could have $78,000 in tax-free money with the option of retiring two years sooner. What would that be worth to you?"
He said, “Absolutely, that would be amazing! What do I have to do?”
I said, “Simple – all you have to do is start making coffee at home.”
He called bullshit, saying there’s no way his morning coffee was worth $78k and two years of his life! So, we crunched the numbers. Here’s how it played out…
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do the math...actually
Mike’s large morning cafe latte at Starbucks costs $4.15, plus tax brings it to $4.36.
Usually paying a $5 bill he tips the remaining $0.64. In total, his morning coffee costs $5.
Mike only goes to Starbucks on weekdays, so he spends $25/week on lattes.
$25 doesn’t seem like a lot of money to most. And on the surface, it isn’t. But what most people don’t visualize is the incredible opportunity cost, and the power $25 has to grow over time.
We kept crunching…
Know your opportunity cost
$25/week equals $100/month, or $1,200/year. Now we’re getting into some serious numbers!
My next question for Mike was, "When do you want to retire?"
In order to maximize his pension, Mike plans to work until age 60 – again, quite common. Currently 35-years old, Mike has 25 more years, after which he’ll collect approximately $45k in annual pension income.
25-years is a long time. A lot can be achieved.
Since Mike has a TFSA, I then asked how he was using it to save money. He explained it’s where he kept their vacation fund – a few thousand dollars for an annual Mexico beach trip.
I asked Mike,
“What if you simply invested your daily $5 latte into your TFSA, what would that look like by the time you’re ready for retirement in 25-years?”
$25/week works out to $30,000 over 25 years. Once we include inflation and interest, Mike's $5 latte is worth approximately $48,400.
Not bad, but we can do better...
The Key to an Early Retirement: Maximize your Opportunity Cost
Mike knows a bit about investing and stocks, but is no financial wizard.
I asked if he knew about ETF's. To my surprise, he was familiar with them, although had never bought one himself.
Most of Mike’s investment knowledge comes from his recollection of the 2008 stock market crash, and he assumes stocks are risky investments. No way did he have enough knowledge or confidence in his investing abilities to feel safe about not losing money.
Thankfully, given Mike’s basic education of ETF’s, he was able to understand how they are one of the safest and best-diversified investment options available.
Just ask Warren Buffet who recently won $2.2 million on a bet between himself and a group of all-star hedge fund managers.
Buffett predicted that a simple low-cost, basic index ETF would outperform hedge funds. He argued that, over time, active investment management by professionals would under-perform the returns of amateurs who were passively investing.
Alright, back to Mike...
By simply purchasing an index ETF and letting it sit on autopilot Mike’s $5 latte could, in fact, grow to more than $78,000 in tax-free cash by the time he’s ready to retire!
Again, Mike called bullshit. We crunched some more numbers…
How do we do this?
Firstly, I explained, by investing your $5 latte into your TFSA, any money you make (and subsequently withdraw) is completely tax-free, with no limit on how much you can make or take out.
This wasn’t news to Mike, but he never really thought of using his TFSA as an investment account. As the name implies – Tax-Free Savings Account.
Mistake #1: FIXED
Secondly, I explained, from 1950 to 2009, the stock market made an annual average return of 7% (after inflation and dividends). In fact, it’s the same long-term benchmark Warren uses.
So, I said,
“What if we invested your $5 latte into your TFSA, and instead of sitting there in cash, we simply bought an index ETF which tracked the stock market performance on an annual basis. What would that be worth by the time you’re ready for retirement?”
The answer: $78,304.19 to be exact.
The math doesn’t lie.
Mike was impressed!
Understand the power of lost opportunity
From his retirement pension, Mike will earn approximately $37,000 after tax.
If he invests the cost of his $5 latte into a low-cost index ETF, simply letting it ride on autopilot inside his TFSA, he’ll have more than $78k in tax-free cash, which is equivalent to making $106,000 before tax!
Thus, in reality, his latte isn’t simply costing him $5.
With an after-tax pension of $37k/year, Mike’s latte is actually costing him two years of retirement income! – two whole years he can retire sooner, spend more time with family, or pay for his child’s education (who will likely be attending university by then).
Always look at the bigger picture
Opportunity costs are one of the most overlooked aspects of spending and investing.
By spending $5 on his morning latte, Mike was effectively forfeiting his ability to earn $78k and retire two years sooner!
When assessing our day-to-day expenses, we can’t simply look at how much we’re spending. We must also look at the opportunity costs of our spending decisions.
To do this, ask yourself two simple questions:
1. If invested, how much could that money be worth? [Hint: use the calculator below].
2. Is it a must-have or a nice-to-have?
To those who don’t mind working until they're 85 and absolutely must have a trendy Starbucks cup with they're misspelled name on it, good luck.
Personally, I’ll skip a few nice-to-haves, and instead, opt for a pina colada on the beach while the Starbucks drinkers still slug-away in the trenches.
What’s one daily expense under $5 you could live without?
Use the calculator below to find out how much that expense is actually costing you...
- Leave the Initial Investment at $0.
- In the Monthly Contribution field, input the monthly value of a daily expense you could live without. Ex: $5 latte x 20 work days = $100/month.
- Leave the Interest Rate at 7% – this is how much our investment can earn.
- For Duration, input the number of years until you wish to retire.
- Final Balance = How much your daily expense is actually costing you.
- Divide the Final Balance by your projected living expenses (or pension income) during retirement to find out how many years sooner you could retire if you eliminate that daily expense.
Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions.
Before you invest be sure to register for my Building a Bulletproof Portfolio investing workshop, and get the complete guide on How I built a winning portfolio that sailed through the 2008 stock market crash without losing a dime.