If you find yourself in this situation: slow down! Set the money aside, and pretend for the moment that it is on its way to you, but it has not yet arrived. If you're notoriously low on self-control, put it in an account that you can't easily spend it from, like a certificate of deposit (CD) at a bank. You've probably heard the stories that more than half of big-time lottery winners are bankrupt just a few years later. Your money pile might not be Mega Millions, but you still need time to think things through carefully.
Or perhaps that new raise is no surprise at all. It could be written write into your employment contract, or it might be the not-unexpected result of a new job title or a business expansion. In this case, you might have had some time to think about what you'd like to do with the larger numbers arriving in your bank account.
One-shot deal or permanent income increase, these events are a huge opportunity.
The Fate of Income
Every dollar has one of only two possible fates: it can be spent to increase your standard of living today, or it can be saved and invested to advance your financial standing. Whatever decision you make, compound interest assures that it will have a significant long-term impact on your financial situation.
With regards to this decision, let's look at the facts:
1) Increasing your standard of living is extremely unlikely to have a long-term positive effect on your happiness:
"Adaptation level theory suggests that both contrast and habituation will operate to prevent the winning of a fortune from elevating happiness as much as might be expected. Contrast with the peak experience of winning should lessen the impact of ordinary pleasures, while habituation should eventually reduce the value of new pleasures made possible by winning. As predicted, lottery winners were not happier than controls and took significantly less pleasure from a series of mundane events."'Less pleasure from mundane events'? That's exactly the opposite of what we want! This effect is psychological adaptation at its best, and it's related to the theory of the Hedonic Treadmill:
"... as a person makes more money, expectations and desires rise in tandem, which results in no permanent gain in happiness."These aren't new ideas. Epicurus, an Ancient Greek philosopher, had figured it out 2,300 years ago:
"Do not spoil what you have by desiring what you have not."Epictetus, student of the competing philosophical school of Stoicism, came to similar conclusions:
"Not what we have, but what we enjoy, constitutes our abundance."
"Nothing is enough for the man to whom enough is too little."
"If you wish to make Pythocles wealthy, do not add to his money, but subtract from his desires."
"Freedom is secured not by the fulfilling of men's desires, but by the removal of desire."For more thoughts on the subject, see my review of the book Happy Money and Mr. Money Mustache's article on Hedonic Adaptation.
2) Increasing your savings rate, not your income level alone, is the only way to reduce the number of years you will be financially compelled to work.
When you save and invest this newfound money, it will go to work for you and advance your financial standing. If instead you simply ratchet up your consumption, all you get is an increase in your standard of living that will be quickly forgotten. In fact, if you receive a raise and spend the entire amount of the raise, your savings rate will actually fall (assuming your savings rate is above zero to begin with!).
Once again, back to the old Financial Independence graph:
A Golden Opportunity
If you're not accustomed to it, increasing your savings rate by decreasing your expenses can be difficult. This is because your Frugality Muscle is horribly atrophied; like a lifelong couch potato attempting to run a 5k, you really don't stand a chance. That 5k is reduced to a pleasant morning jog with regular exercise, and when combined with the right attitude, cutting expenses can be a fun challenge.
But here, you have it even better: a raise or windfall is an opportunity to increase your savings rate without decreasing your expenses at all! You don't have to get rid of anything that you're already used to. Don't even think of the new money as spendable income—just invest it right away and forget about it. If you can do this through an employer-sponsored retirement plan like a 401(k) that operates through a voluntary salary reduction agreement, the money can be zapped right off of your paycheck and dumped straight into the investment account. It'll never even touch your bank account, so you don't even have to say goodbye.
This summer, I received a small windfall when my student stipend was unexpectedly and retroactively increased by $166.67 per month. I deposited the retroactive lump sum in my brokerage account as soon as it arrived, and increased my automatic monthly investment rate to compensate for the raise. Savings rate: enhanced.
So the next time this golden opportunity presents itself, take it: step off the hedonic treadmill and put that money to work. Future You will really appreciate it.