It’s tough to plan for your future when you don’t know what that future holds.
For one, the world around you is constantly changing. You may be sure of your current situation, but what will your life be like five years from now? Ten? Odds are you can’t come close to making an accurate guess. (In some cases, it’s tough to predict just one year out!)
For another, you change. As you grow and develop, your priorities and values grow and develop too. What made you happy in the past may not make you happy in the future. In 2006, Harvard psychology professor Daniel Gilbert published Stumbling on Happiness, a book about that explores this topic at length. In this presentation from the 2004 TED conference, Gilbert compresses his ideas into bite-sized pieces:
Gilbert says that because we can plan for the future, our preference is to structure our lives in such a way that we’re happy both now and later. The problem is: We don’t know what will make us happy in the future! In fact, Present You usually does a poor job of predicting what Future You will like.
Which future would you prefer? One in which you win the lottery? Or one in which you become paraplegic? Which would make you happier? […] A year after losing their legs, and a year after winning the lotto, lottery winners and paraplegics are equally happy with their lives.
The problem is impact bias, our tendency to overestimate the “hedonic impact” of future events. Put another way, the things that we think will make us happy usually don’t make us as happy as we think they will. Winning the lottery isn’t a panacea. Having an affair with your hot new co-worker won’t be as thrilling as you think. And losing a leg isn’t the end of the world.
Present You vs. Future You
How tough is it to predict your future path?
Here’s a simple test: Think about where you were five years ago — where you lived, who you spent time with, what you did. How does that compare with where you live today, who you spend time with, and what you do with your time? Chances are your life today is different than it used to be — possibly much different than you might have predicted.
Here are two examples from my own life:
- When I was a junior in college, I expected to graduate, settle in a big city, get a job as a counselor or therapist, get married, have kids, and live happily ever after. I had no inkling that five years later I’d own a house in my hometown, work at the family business (something I swore I’d never do!) in a job I hated, and have over $20,000 in consumer debt. No inkling. (Only the “get married” part of my expectations proved to be correct.)
- Five years ago, I was still married. I lived in a hundred-year-old house with lots of land on the outskirts of Portland. I had five cats. I had a vast collection of comic books. I was fat. I was only just beginning to travel. Today, I’m divorced (although still have close contact with my ex-wife — just mailed her Christmas present this morning!). I’m living in Savannah, Georgia with a woman I hadn’t even met five years ago. I’m fit. (Well, fitter. I gained some weight on our RV trip.) I don’t have a comic collection anymore, and I don’t have any cats.
Sometimes your future life fails to live up to your expectations, and sometimes it exceeds them. But in nearly every instance, you cannot predict where life will take you. No wonder Present You often does such a poor job of setting things up for Future You.
So, what can you do?
You have to make best guesses based on your past. When you set goals, you have to base them on your current values and priorities. Sure, some of these will change with time, but there’s no way you can know what shape that change will take. At the same time, you shouldn’t ignore the future. Instead, it’s best to plan for it in a general sort of way.
That’s why it’s important to keep an emergency fund, a pool of money to handle unplanned negative expenses.
The Emergency Fund
The first step on the road to financial freedom is to eliminate debt. The second is to save for emergencies. Your emergency fund acts as self-insurance, cushioning you from small disasters.
Life is full of unexpected surprises, many of which cost money — a thief smashes the windshield of your car, your son gets sick, your water heater boils over. When people live paycheck to paycheck without any savings, they’re at the mercy of these small crises. Sometimes a tiny problem becomes a huge one because the victim wasn’t prepared for possible trouble.
That’s where the emergency fund comes in. By setting aside $500 or $1,000 to cope with life’s slings and arrows, you alleviate worry that a flat tire or a broken bone might prevent you from doing the things you need to do. And once you’ve saved even more — I keep a $5,000 emergency fund — you might find that you sleep more soundly at night.
Studies show that those without emergency savings are more likely to accumulate debt. An emergency fund is like cheap insurance. If you have a cash cushion, your financial plans can’t be derailed by a single unexpected event — unless it’s huge.
Not every unexpected event is unwelcome. Sometimes life brings us lucky breaks — but these opportunities can still cost money. That’s why it makes sense to also keep a chunk of cash in an “opportunity fund”.
The Opportunity Fund
I first learned about opportunity funds from reading about billionaires and business owners. These savvy savers often set aside money specifically to take advantage of unexpected opportunities.
I once read an interview with Mark Cuban, for example, in which he described how a person should handle a windfall. “First, I pay off all my credit card debt and evaluate paying off any other debt I have,” he said. “What I have left I put in the bank.”
Why? “Because then it’s available for when I get a good opportunity. Every five years or so there is a bubble bursting or amazing deals available because of a change in the economy.”
Jim Wang from Wallet Hacks is a strong proponent of opportunity funds. “Missing out on an opportunity is often as bad as being struck by an unexpected expense,” Wang wrote for U.S. News a couple of years ago. “In reality, both funds are important if you want to be financially responsible.”
Although I don’t strictly keep an opportunity fund the way I keep an emergency fund, I do keep enough cash on hand to take advantage of lucky breaks. For example:
- When a friend wanted investors for his business, I had money to contribute. I’ve earned a handsome return because I could afford to take a risk. Similarly, I recently was able to help fund the Wayfinding Academy, a new college that hopes to redefine higher education.
- When I spotted a great deal on a last-minute Alaskan cruise, I was able to book a fun (and relatively cheap) vacation.
- When I found a deeply discounted display model at the local warehouse store, I was able to purchase a top-rated television at a bargain price.
Your opportunity fund doesn’t need to be as accessible as your emergency fund, so it’s okay to put the money in mutual funds or certificates of deposit. The fund will start small. But as your financial situation improves, you can contribute more and more to the account. In time, your opportunity fund will become large enough that you can do some truly amazing things — like take time off for a round-the-world trip with your best friend, or quit your job to start your own business, or buy that classic car you’ve always wanted.
Over the past five years, I’ve spoken with dozens of people who have achieved financial independence. These folks have accumulated enough capital that they’re no longer compelled to work for an income (although some choose to work for other motives). Many have remarked that money hasn’t bought them happiness; rather, it’s bought them freedom. When an opportunity arises, they can afford to take advantage of the situation.
This is an important point. Financial freedom isn’t an absolute thing. It’s not like you either have it or you don’t. Financial freedom exists on a continuum.
- When you eliminate your debt, you increase your financial freedom.
- When you build emergency savings, you increase your financial freedom.
- When you boost your savings rate (whether by increasing income or decreasing expenses — or both), you increase your financial freedom.
- And so on.
As you progress along the continuum of financial freedom from “enslaved by debt” to “financially independent”, you achieve certain milestones. For instance, you eventually reach a point where you have “Screw-You Money” a cash cushion large enough that you you could quit your job, if you wanted.
The bottom line: Set aside money in savings so that you’re prepared for both emergencies and opportunities.