Recession Spending: When a Need Is Really a Want
Keeping your finances in line with your budget is key during inflation and economic uncertainty.
The world’s largest retailers have noted a new challenge: rapidly changing consumer habits. Customers slowed purchases of “nice-to-have” discretionary items and increased spending on “must-have” items.
Households are finding it advantageous—and often necessary—to change spending in response to inflation and economic uncertainty. Learning how to budget during high inflation or a potential recession involves the sometimes-challenging process of distinguishing between “needs” and “wants” and choosing which extras are worth it.
We will discuss a couple of simple methods you can easily use to trim your spending and stick to your long-term investing goals.
Budgeting During Uncertain Times
Budgeting helps individuals and families divvy up their incomes to fulfill their daily needs and wants while sticking to investment goals.
Reviewing your spending is important, especially when high inflation significantly reduces your money's purchasing power. With inflation, money is buying less and less, and income growth is not bridging the gap.
Reducing unnecessary costs allows you to absorb rising prices for expenses you do value. Two-thirds of respondents to a recent consumer survey are intentionally cutting back on purchases to save money from price hikes.¹
Besides inflation, incomes are put at further risk if the economy enters a recession, which could bring layoffs and pay cuts. Lowering the cost of your lifestyle can help your overall finances cope with a severe economic downturn.
Beware of Behavioral Bias
Trimming current spending makes sense as a first step to preserving your financial goals, but human nature might make it hard to make prudent decisions. During uncertain times, investors can give in to common behaviors, such as:
Present bias: An investor focuses on present-day actions at the expense of their future. This can lead to forgoing savings and investing to pay for today’s higher price tags.
Action bias: Unease from the turbulent market can cause an investor to take unnecessary action to gain control. That could include selling investments and using the proceeds to maintain current spending.
Giving in to behavioral biases might jeopardize your future and your finances. According to behavioral expert, author and Harvard professor Cass Sunstein, simply being aware of these biases can help remove their power over us.
The next step is considering what you want and need and creating a list of alternatives before you take a course of action—hence, a budget.
Budgeting: Define Needs and Wants
The budgeting process begins by creating a list of your expenses.
Housing and utilities
Vacations and travel expenses
Hobby and sports-related expenses
Other entertainment-related expenses
Wants Masked as Needs
Sometimes “lifestyle creep” can occur, where your expenses increase in lockstep with your income. You may start seeing wants as needs.
Examples of this would be identifying a sports car as solely a transportation need or high-end dining as a food need. In fact, these expenses fall into a large gray area that exists between wants and needs. No one will dispute that going to a restaurant will satisfy your need to eat, but going to high-end restaurants three times a week is a luxury.
For these instances, break up the expense by estimating what amount of a cost is a need and what portion constitutes the want or luxury component.
While treating yourself to some extent is healthy, identifying all your wants is critical for relieving your budget of excess spending.
Methods to Value Your Wants
Review each discretionary expense. Here are a couple of different lenses to help you identify which expenses are worth keeping.
How many hours would you have to work to earn an expense? You pay for expenses with money that has already been taxed. For an expense that costs $1,000, you must actually earn an amount large enough so that after you’ve been fully taxed, you still have $1,000 left over to purchase it.
In the example below, the person has to work 26.58 hours to pay for a $1,000 item. Is it worth it? Maybe not if the item is a purse or a pair of shoes. Maybe so if it’s a new phone. It depends on the person.
As an example, a person earning a $150,000 salary with a federal tax rate of 32%, a state tax rate of 9% and payroll tax of 6.75% wants to value a $1,000 expense in terms of working hours.
Calculate the pre-tax cost of an item (cost/(1-sum of tax rates).
$1,000/(1-(32% federal tax + 9% state tax + 6.75% payroll tax) = $1,914
Calculate the person’s hourly wage (salary/40-hour work week x 52 weeks a year).
$150,000/(40 x 52) = $72 hour
Divide the pre-tax cost by hourly rate to find the amount of hours it would take to earn the item.
$1,914 pre-tax cost/$72 hour = 26.58 hours
Instead of looking at forgoing expenses as a sacrifice, what could that money earn if it was instead invested?
For example, a $1,000 expense turned into an investment with a 6% return could be $3,207 in 20 years. If the expense is $1,000 yearly, then those amounts otherwise invested would grow to $38,993 in 20 years.*
Looking at spending from different perspectives can help you identify what you value to keep in your lifestyle and expenses that can easily be forgone as you budget for inflation. It’s also a good starting point if you’re looking to recession-proof your finances for uncertain times ahead.
Stick With Your Plan
Taking action to trim extra costs through budgeting techniques gives you peace of mind.
Sticking to carefully laid out financial and investing plans supports both wants and needs in the future as well as today.
Morning Consult, “How Inflation Concerns Are Impacting Consumer Spending, August 4, 2022.
This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities.
These hypothetical calculations assume 1. a $1,000 initial investment over 20 years with a 6% return rate ($3,207), and 2. a $1,000 annual investments over 20 years with a 6% return rate ($38,993). Assumes reinvestment of all gains, dividends and interest, and does not include fees, expenses or taxes. If all taxes, fees and expenses were reflected, the reported value would be lower. Source: American Century Investments Investment Rate of Return Calculator. Financial Calculators from Dinkytown.net. ©1998-2022 KJE Computer Solutions, LLC.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.