In financial wellness, the “Latte Factor” is defined as the following paradox: spending about £3 per day on something small like a latte (coffee) is not a lot a lot of money. However, if you instead invest that same £3 every day, you’d earn an enormous sum a few decades from today.
Specifically, if you stopped buying a croissant and latte for £3 each day for 365 days straight, you’d have an additional £1,095 to invest each year. If you invested this much each year for 40 years while earning 5% annual returns, you would accumulate a whopping £139,662.
If you earn 8% annual returns instead, you’d accumulate £306,678. You get the picture.
Numbers tell us the truth: if you invest a small amount of money each day for several decades, you can accumulate a serious pile of cash without breaking your back.
However, the issue is that the latte factor assumes that people enjoy cutting out a tiny expense. So, despite investing more money each year using this method, your overall quality of life might decrease. Imagine telling your friend after they ask you to grab coffee: “oh no – I can’t. I’m investing the £3 every day from now on”.
Instead, what if you considered the opposite of the latte factor? That is, instead of cutting £1,095 from your existing level of spending each year, try earning £1,095 more each year.
Case in point, imagine a family (household) that earns £90k and spends £60k each year. The latte factor would dictate that the family should cut the £3 morning coffee to free up the £1,095 to invest each year:
The opposite of this logic would be for the family to increase its annual income by £1,095:
In both cases, you get the same result: a £1,095 boost that you can invest every year. However, by taking the opposite route of the latte factor and increase your income, you can be carefree about that small daily expense that you enjoy with your friends or colleagues every day.
At the latte paradox’s essence, it’s trying to make an easy-to-understand yet profound concept noticeably clear: by investing a little bit each day, you can generate a huge pot of money over the course of decades. This post analyses where the money is coming from: a latte is a beverage many people are excited to buy each morning. We see the following tactic in the financial wellness world over and over again: cut expenses, more expenses, and even more expenses. But are you left with any joy if you cut everything for money? We don’t think so. There’s a point at which spending less may reduce your mental wellbeing.
The entire objective of cutting your expenses is eliminating spending while maintaining or even increasing your quality of life:
Consider a household that spends £60,000 per year. Suppose they make several life changes that target their big three spending categories of housing, transportation, and food and manage to reduce their yearly spending all the way down to £40,000 without reducing their quality of life.
In the above bar chart, you’re able to remove expenses that are small and don’t affect your overall happiness.
After the below bar chart’s second year, the only expenses that family could eliminate are the little bundles of joy, like their Netflix subscription, the occasional dinner at Soho’s coolest sushi restaurant, or that morning latte. Yes, cutting these expenses would raise investable cash, but could remove life’s joyous aspects.
At some stage, it’s more effective for any household – and you, for that matter – to switch gears from cutting on their spending to growing their income. It only makes sense that there’s a limit on how much you can cut your spending. There’s a limit. On the contrary, income has no glass ceiling.
Just like cutting a £3 latte could lead to a lot of amount of money if invested over several decades, so could a small daily increase in income:
Broadly speaking, financial wellness has two layers: income and expenditure. It’s simple to believe that decreasing your spending is always the best way to find your financial zen. However, it’s equally (if not more) important to remember that increasing your income can lead to the same financial zen without removing your expenditure on things that make you happy. “How do I increase my income?”, you ask? Well, let’s save that for another post.
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