Physicians overlook one rather obvious fact: income and wealth are completely different things. Despite a high income, you will not become wealthy if you do not save. Wealth is based on savings. News outlets describe people with high incomes (e.g. 250k) as “rich.” This ignores the obvious difference between the two.
Focus on Wealth, not Income
Financial Freedom springs from wealth, not a high income. Freedom may mean less dependence on external funding to start or grow your business. For you, that may mean cutting back to part-time. For others, it may mean taking a sabbatical or early retirement. The peace of mind and freedom give you options.
Many of us experience “hedonic adaptation.” It takes more and more spending to maintain our lifestyle. No matter how many raises and bonuses come along spending increases in proportion. As a result, we are financially insecure. When the recession of 2008 hit many high-earning people realized they were not high net worth people. They didn’t have so many options or freedom after all.
Bank Your Earnings
How much money you have right now is determined by how much you made versus how much you spent. What you have “in the bank” is the difference between the two. For a shocker pull out your social security statement. Add up all that you have made in your lifetime. Subtract what money you have. That is how much you spent. I bet it is a huge and surprising number – at least it is for most of us.
Did you spend your wealth on cars, T.V.s, exotic trips, and keeping up with the Jones’s? Any regrets? Forget the past and look to the future: Could we be more diligent in our spending going forward?
Live Below Your Means
If you ever want to become wealthy, you need to “drive a wedge” between your earning and your spending. The key to wealth is living below your means. The larger the wedge, the faster your wealth grows. This is often thought of like a savings rate. The larger it is (the steeper the wedge’ slope), the quicker your wealth will pile up.
Save Your Way to Freedom
Question: How long will it take to save 1 year of income at a 5% savings rate?
Answer: 19 years.
(Years to one year of income = Spending / Savings (all as a percentage). Therefore, if you save 5%, you have spent 95% (100 – 5). So, it would take 95/5 or 19 years to save one year of income).
The average American saves between 0 and 5%. What if you follow the advice of many personal finance advisers and save 10% of your income?
Well, let’s see: (100 – 10) / 10 = 90 / 10 or 9 years until you save one year’s income. If you want to end up with 1M and you make 100K a year, it will take you 9 x (1M/100K) or 90 years to save 1M.
At 20% it would be (100 – 20) / 20 = 80 / 20 or 4 years to save one year’s income. With this savings rate, it would take 4 x (1M/100K) or 40 years to save 1M. That doesn’t sound like a quick path to freedom to me.
Consider Extreme Savings
OK. Now let’s think out of the box and get a bit radical here. What if you saved 75%? That would be (100 – 75) / 75 = 25 / 75 = 1 / 3. That means you can save three years’ income in one year! That adds up fast. After 10 years, you could have 30 years of expenses saved up.
75% savings rate is likely too high for most of us. But could you save 30-40% of your gross income? I bet you could. That would lead to Financial Independence (FI) in 15-20 years. Financial Freedom at age 50 is invaluable – trust me!
Make a Savings Plan
Most of us are amateurs when it comes to savings. We focus too much on boosting income. We may have an investment plan, an education plan, an income-boosting plan, a tax plan, and a career plan. It is worth creating and implementing an aggressive savings plan.
High savings rates seem daunting but are achievable with a solid strategy. Fortunately, others have done it and are willing to share how.
Jacob Lund Fisker wrote a great chapter for Michael L. F. Slavin’s book, One Million in the Bank. Jacob created the website, Early Retirement Extreme (and a book by the same name). He preceded Mr. Money Moustache. Here are some of the points from his chapter.
Wealth and Savings
Jacob points out that many focus on tiny expenses. If you switch to a cheaper brand of paper towels or avoid using them altogether you will save some money. Switch from daily cappuccinos to a daily home-brewed coffee and having a latte on only weekends will save money. The problem is there are hundreds or thousands of these little decisions. They can add up to a lot but in the process, you can develop decision fatigue. You might get burned out from making hundreds of frugal choices daily.
Use the Pareto Principle
There is a better way. It comes from an Italian economist, Vilfredo Pareto. It is usually described as the 80/20 principle. If you figure out what your biggest expenses are and go after them in a big way you can save tens of thousands of dollars with only a few choices.
Use your own expense data if possible. Rank them per size from largest to smallest as a percentage. If you don’t have your own data or struggle with that analysis, use data from the Bureau of Labor Statistics. They publish categories and their percentages in the average U.S. family budget.
Pick the Big Rocks
1. Housing (33%), a large fraction is utilities
2. Transportation (17%)
3. Food (13%)
4. Clothes, personal grooming, and entertainment (10%)
That adds up to 73% (the sum of 33 + 17 + 13 + 10) of spending is in only four categories.
Three-quarters of the average household budget is spent on just 4 categories.
1. Housing and Utilities
Most people own too much house. They are cash poor. The standard American mantra of “buy as much house as you can afford” doesn’t serve us well. It may be fine if you are a lousy saver and don’t want wealth and don’t mind working for 30 years. If that does not describe you, consider other options. Spending money you don’t have on a house that barely appreciates annually is not the best choice. Buy only as much house as you need. Don’t confuse your needs with your wants.
For most of us, a house is mainly for two needs: a place to sleep; and a place to store our stuff. Does it make sense to you to spend 30% of your income on storage and a sleeping area? Smaller may be better. The upfront costs will be lower (purchase price, closing costs, loan fees, etc.). It will cost less to heat, cool, maintain, repair, and improve. About 2/3 of the expenses are furniture and utilities and they are both dependent on size. Property taxes are often proportional to the house’s price.
Most American households have a car. In fact, it accounts for 1/5 of their budget. Does it make sense to spend that much just to get from place to place? Maybe you are living in the wrong location? You are paying to overcome this inefficiency. Could you live close to a grocery store? Could you bike to work? If so, this would save time, gas, maintenance, and repair costs. Not to mention your health benefit and the environmental impact.
You may not need a car at all. If you do need one, buy something reliable that runs forever. Affordable cars like a Honda Civic or Toyota Camry are comfortable, safe, and fuel efficient. They come with many convenience features that were unavailable in luxury cars a decade ago.
It is normal to want to impress people with your possessions. Just remember the financial freedom you sacrifice in the process. Either way is a personal choice. Just make a conscious decision either way.
The average American household spends $550 per month on food. About ½ of that is for eating out. Eating out is more for convenience and entertainment than a need. The other ½ is on expensive pre-processed foods. Food made at home costs ½ as much as grocery store prepared foods. Consider growing a garden or buying from a local farmer’s market. We all love the convenience and variety that restaurants provide. Just consider the effect on your waistline and wallet. Consider taking a cooking class. You can use fresher and less expensive ingredients. The food can be made quicker, healthier, and tastier for 1/5 of the cost of a restaurant meal.
4. Clothes, Grooming, & Fun
Do you have more “stuff” than you need or will use? Most of us do. One way to reduce the “stuff” is to move or pretend to move. You put it all into boxes. As you unpack, do so only when you need that item and leave the rest in the box. After one year, get rid of the boxes and everything in them. You can hold a yard sale or donate the items.
When considering a new purchase, consider if it is a need or a want. Either is fine, just don’t confuse the two. What is the item’s typical useful lifespan? What is the cost per use? You can figure this out by the formula: (initial cost – residual value when you are done with it) / # of uses (or # of years expected life of the item). Considering the annual cost may indicate that the cheapest option isn’t always the best option. Often it is worth paying extra for quality when it adds to the lifespan or helps maintain the residual (resale) value.
Rather than cut down on hundreds of items or dozens of categories it is much higher yield to focus on these big four. How could you avoid being penny-wise and pound-foolish by drastically cutting one or several of these expense areas?