Do You Realize What That Costs?
If you have read any financial advice books or blogs, you’ve definitely read some version of what I call the “Golden Rule” of personal finance. SPEND LESS THAN YOU EARN, INVEST THE REST WISELY, BECOME WEALTHY. I’ve written a post on the difference between rules and laws. Many rules of conventional wisdom are mistakenly treated as laws that can’t be broken. This situation is the opposite. This “Golden Rule” is a law because it is actually just a series of math equations that can be expressed like this.
Income - Spending = Savings.
Savings x Rate of Return Compounded Over Time = Wealth
This leads to the following questions: Which equation should one focus on if you want to retire as quickly as possible? Is it better to focus on earning more, spending less, or increasing investment returns for optimal results? Let’s take a look at this chart.
|Savings Rate (Percent)||Working Years Until Retirement|
This chart comes from an excellent post I found on the Mr. Money Mustache blog. I’ve seen similar charts on various early retirement sites. The exact numbers from different sources are slightly different based on variability in the assumptions, but the message is always the same and is very clear. If you have a high savings rate, at least 50%, you will be able to build up substantial assets to support you in retirement in a short time (about 17 years).** If you can increase your savings rate by even small percentages beyond that, it is very realistic to have a working career of less than 15, or even 10 years.
Going back to the original equations, notice that wealth is dependent on investment return compounded over time. The difference between masterful and average investors is only a couple of percentage points in return per year. The key is that those differences are magnified through compounding over the years. You have relatively little money the first few years of saving. With short working careers, your time frame is short when building assets for early retirement. Therefore, you lose most of the benefit of compounding during this accumulation phase. It is smart to start learning about investing when you are just beginning so the mistakes you make when learning are made with small amounts of money. However, the reality is that investing skill will have very little to do with whether you can build the assets to retire in only 10-15 years. When trying to achieve financial independence in the shortest time possible, savings rate is clearly the key.
Now that we see the importance of savings rate, should we focus on increasing income or decreasing spending for optimal results. Let’s look at the equations.
Expressed as a savings rate it would look like this:
Savings/Income= Savings Rate
We can combine the two equations giving us:
(Income-Spending)/Income = Savings Rate.
It would seem that if you earn $100 more it would have the same net effect as spending $100 less. However, as you increase the income in the numerator (top of the equation) you also increase the income in the denomenator (bottom half of the equation). When you spend less (numerator), this has no effect on income (denomenator). Therefore, the math shows that saving $100 is more effective at increasing your savings rate than earning an additional $100. Let’s try to clarify with an example.
A person makes $1000 in income, spends $900 and saves $100. He has a 10% savings rate: (1000-900)/1000= 100/1000 = 10%.
If income increases by $100 it looks like this: (1100-900)/1100 = 200/1100 = 18% savings rate.
If saving an additional $100 it looks like this: (1000-800)/1000 = 200/1000 = 20% savings rate.
If the math doesn’t excite you let’s look at the practical applications. What could the average person do to save $100 if he wanted to do so quickly. You could cancel your cable, shop your insurance plans, decrease your weekly grocery bills by $25 each, eat out 1-2 times less each month, etc. Any of these on their own could easily save the average person $100 and could be accomplished quickly. To earn an extra $100 you could increase your value (be more productive, increase skills or education, etc.) but this could take time. You could work more hours at your current rate, which would definitely take more of your time, if it is even available. You also may have to invest money to educate yourself and develop skills, requiring you to recoup that investment to get back to your $100. To recognize the extra $100 in the example above, you would have to actually earn more than $100 because your income is taxed. Depending on your tax rate, you may have to earn $130 or more just to take home $100. To save the same $100 you would simply save $100. Thinking beyond this example, being able to spend less will give you many opportunities to improve your tax situation. Conversely, earning more will require you to pay more taxes on your income and then pay even more taxes on the things you choose to purchase, further decreasing the efficiency of each dollar. Finally, when earning more you still need to develop your ability to save. When most people earn more, they immediately have several ideas for how to spend the money. If you don’t save your increased earnings, you can actually decrease your savings rate despite earning more. Sorry but we can’t escape those pesky laws of math!
In reality, the “Golden Rule” is that for a reason. It is absolute truth. All three aspects (earning, spending and investing) are part of the equations and all play a vital role in building wealth and achieving financial freedom quickly. However, most experts (media, financial advisors, etc) will spend most of their time and attention on investing, with some attention to increasing earnings, while spending is often overlooked. Be aware of this and attack the problem in the opposite sequence to put yourself on the fastest path to financial freedom. Not paying attention to your spending will cost you much more than money.
**It is interesting to note that we began our careers in 1999 for Mrs. EE and 2001 for Mr. EE. Until the past year we have had little investing knowledge and never had any tax plan. We project a net worth of 25X our annual expenses by 2015, and by 2017 or 2018 our investments (without considering home value) will reach this level if we continue on this path. We simply maintained a savings rate of approximately 50%, with no real strategy. This put us right on schedule with these projections. Imagine what YOU could do with this knowledge and a real plan. Also note that standard advice is to save 10-20% of your income for retirement. This would give you a working career of 51 to 37 years, which sounds pretty much like a standard career where you may or may not reach a comfortable retirement. All of this points to the extreme simplicity and importance of savings rate. Yet you somehow rarely, if ever, hear this from your financial advisor or financial “experts” in the media who instead tout the newest hot stock, mutual fund or investment strategy.
*Thanks for reading. If you enjoyed this content, you can find my current writing at Can I Retire Yet?. Enter your email below to join our mailing list and be alerted when new content is published.
1 comment on Do You Realize What That Costs?
Wow! I knew that cutting costs would increase the savings rate. I have masters degree in finance to figure that out, after all. But I never realized that the savings rate that comes from cost cutting is disproportionately higher than that from income increase. Thanks for the great math, EE! I am going to share this shockingly revealing formula with my pre-teen son.
Comments are closed.