When it comes to wealth building there are many variables to consider, but as I have stated in my monthly financial reports many times, it’s the savings rate that doesn’t get the attention it deserves. This is especially true in the short run and when you are trying to accumulate wealth as quickly as possible (20 years or less). Yes, the power of compounding is amazing, but it takes a long time to realize its true power.
Too many people focus way too much energy on investment returns. Let’s clear the air…You have absolutely no control over investment returns, but you do have control over your savings rate, and to some extent how much money you make. Instead of getting lost in an argument, let’s agree that the amount of income you earn is more controllable than the returns you receive on your investments.
What are the variables that impact your ability to build wealth?
For me, there are 6 KEY variables that drive wealth creation:
- Annual Income (how much do you earn annually)
- Annual Income Growth (at what rate is your income increasing every year)
- Effective Tax Rates (what portion of your income goes to taxes)
- Your Savings Rate (what is left over after taxes and spending)
- Duration (the amount of years your money is put to work)
- Compound Annual Growth Rate (how much is your money growing every year)
It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for. –Robert Kiyosaki
For the most part, I think that Robert Kiyosaki captured the wealth building process in his quote above.
Let’s break the quote down into bite size pieces…
It’s not how much money you make…
It doesn’t matter whether you earn $30K a year or $300K if you spend every last cent without saving and investing you will never be wealthy. The reality is that there are plenty of high earners that are living paycheck to paycheck. The person earning a $300K salary may appear to be “wealthy,” but it’s just a facade.
Financial rule #1 is to spend less than you make!
It’s how much you keep…
Remember the old saying “pay yourself first?” You do this by making sure that every time money comes your way you direct some to saving and investing before anything else. If you work for an employer and are offered a 401K or HSA, then this is a way to pay yourself before Uncle Sam takes his cut.
Note: notice my emphasis in Robert Kiyozaki’s quote above (It’s how much you keep). I did this because, in this post I will be showing you why this is the most important variable. Not only do you have the most control over it, but it has the most impact on how fast you can build wealth.
Financial rule #2 is to invest the difference wisely!
In optimizing how much you keep there are really 3 factors at play:
- Your Taxes – try to do anything and everything to ensure you are paying the minimum taxes legally allowed.
- Your Spending – remember rule #1, spend less than you make.
- Your Savings Rate – This is what is left after taxes and spending. The surplus goes to either your bank account or investment account. This is where rule #2 comes into play, so make sure you invest the difference wisely. The lottery is not an investment! Well, maybe it is, but it’s not a very wise one.
How hard it works for you…
This is really just emphasizing rule#2 to invest the difference wisely. You want to put your little green backs to work for you. Start thinking about every dollar you save/invest as a soldier in your army. This is war, you’re fighting for financial freedom, time freedom, and location freedom.
You want to put your money where it can appreciate and/or earn you cash flow (i.e. more income). It’s the best of both worlds when you can invest in an asset that does both.
Financial rule #3 is don’t lose money!
How many generations you keep it for…
Remember those 6 key variables I outlined at the beginning of this post? Duration is the key factor that determines the power of your compound annual growth rate. The longer your money can stay invested to compound the more impact the compound rate will have in building your wealth.
Over the long term it is compounding that will enable you to leave a legacy long after you pass away for generations to come. But it takes decades!
Beyond the Basics, Why your Savings Rate Matters Most (and the math to prove it)
For some of you the above might have been review. For others, maybe breaking down the wealth building process into bite size pieces was enlightening. Either way, we can all benefit from reminding ourselves how wealth is created.
Now that we have built up a solid foundation, I am ready to explain why your savings rate matters so much, and has the most significant impact when building wealth as quickly as possible.
In order to convey the importance of the savings rate I am going to use math and a few examples of different types of wealth builders.
4 Different Wealth Builders
- GYFG – Saves 50% of his income and would be considered an aggressive saver.
- Steve – Saves 5% of his income and would be considered the average American.
- Adam – Saves 10% of his income, which many financial planners tout as the sure path to wealth by age 65.
- Sally – Saves 15% of her income.
We are going to walk through several different scenarios, all with different assumptions. However, there are four assumptions that I am going to hold as constant:
- Taxes will be assumed at 25%.
- Duration will be 20 years
- The wealth builders’ savings rate defined above will be the same in all scenarios.
- Steve, Adam, and Sally are assumed to earn the historical market return of 8%.
In the proceeding scenarios, my goal is to show you the spectrum of results that will hopefully drive home the importance of your savings rate when it comes to wealth building. The assumption that will change in each scenario will be the assumed growth rate that GYFG earns.
One final note before we continue. There are unlimited permutations to this, but I chose the assumptions I did to keep this exercise on point, and to prove to you that your savings rate has more power than you may have realized.
Scenario #1 [Static Income and 0% CAGR for our Super Saver GYFG]
In this scenario, we assume that GYFG earns a compound annual growth rate of ZERO. I hope that many of you would agree that this is an extreme and is probably unlikely, but it really isolates the importance of savings rate by itself. Notice how in all cases, even after earning 0%, GYFG is able to accumulate more wealth than all of the other wealth builders. And this is over a 20 year period.
Over the 20 year period GYFG was able to save $750K. In the green highlighted section (table above) I have provided what the returns would need to be in order for the other wealth builders to keep pace with GYFG, given their respective savings rates.
- Steve would need to earn a CAGR of 21%.
- Adam would need to earn a CAGR of 15%.
- Sally would need to earn a CAGR of 11%.
I don’t know anyone who has consistently earned these kinds of returns, outside of the world’s best investors (hello Warren Buffett).
Let’s take a look and see what happens when GYFG also earns the historical market return.
Scenario #2 [Static Income and 8% CAGR for our Super Saver GYFG]
In this scenario, we assume that GYFG earns a compound annual growth rate of 8%, like that of his fellow wealth builders. This is at the other end of the spectrum from the 0% example above. Notice how in all cases [AGAIN], GYFG is able to accumulate more wealth than all of the other wealth builders. And this is over a 20 year period. The variance between the wealth builders triples when you combine GYFG’s 50% savings rate with the average market return (compare chart below to one above).
Over the 20 year period GYFG was able to save $1.7M. In the green highlighted section (table above) I have provided what the returns would need to be in order for the other wealth builders to keep pace with GYFG, given their respective savings rates.
- Steve would need to earn a CAGR of 27%.
- Adam would need to earn a CAGR of 22%.
- Sally would need to earn a CAGR of 18%.
I would not be willing to bet I could earn those kinds of returns, but they are nice to fantasize about.
Let’s take a look at another scenario, but this time assume that each wealth builder is able to increase their income 10% a year.
Scenario #3 [Static Income and 8% CAGR for our Super Saver GYFG & 10% Annual Growth in All Wealth Builders Income]
Holy cow!!! Look at the gap explode when you add a little fuel power in the way of income growth to the mix.
Over the 20 year period GYFG was able to save $3.9M. In the green highlighted section (table above) I have provided what the returns would need to be in order for the other wealth builders to keep pace with GYFG, given their respective savings rates.
- Steve would need to earn a CAGR of 31%.
- Adam would need to earn a CAGR of 25%.
- Sally would need to earn a CAGR of 21%.
I don’t know about you but these returns seem out of reach to 99.9% of the population. I guess it is possible if you build a business that does really well. But I have a hard time imagining market returns this high.
The Big Fat Take Away
There are a lot of variables that will affect your wealth building, but instead of getting overwhelmed focus on one thing at a time. I wrote this article as a way to simplify and prioritize the things that matter most when it comes to building wealth in the fastest possible time. The 20 year time frame was chosen, because I believe that it is possible for anyone committed enough to reach financial freedom in 20 years or less.
This post tells you how. And in case you missed it…
A HIGH SAVINGS RATE MAKES A HUGE DIFFERENCE IN YOUR ABILITY TO BUILD WEALTH (QUICKLY!!!).
This is the most important variable for you to focus on when building your own wealth. In case the tables and charts were not enough, I created one last table I would like to share with you. It simply summarizes the magnitude in the gap between the 4 wealth builders I presented you with today. It covers the full spectrum from 0% to 8% market returns.
- Against Steve GYFG is able to accumulate 4.4X to 10.0X more wealth [Steve saves 5% of his income].
- Against Adam GYFG is able to accumulate 2.2X to 5.0X more wealth [Adam saves 10% of his income].
- And against Sally GYFG is able to accumulate 1.5X to 3.3X more wealth (Sally saves 15% of her income].
You may be asking yourself why I threw in the income growth…and it is a great question. The growth of you income is priority number two when it comes to wealth building. It is going to be the next component that allows you to continue to increase your savings. You may not start out saving 50% of your income, but as you continue to grow your income you have the ability to continue to increase your savings rate, as long as you keep your lifestyle inflation at a rate less than the growth of your income. By growing his income 10% a year, GYFG was able to build a net worth of $3.9M vs. the $1.7M with a static income [that’s 2.3X more wealth]. We will have to have a whole other post dedicated to income growth.
The compound annual growth rate is the last variable for you to care about when building wealth. It matters, but not as much as you think, especially when you compare it to the power of a high savings rate.
SO, ON YOUR PATH TO FINANCIAL FREEDOM, IT’S YOUR SAVINGS RATE THAT MATTERS MOST.
IF YOU WANT TO REACH FINANCIAL FREEDOM IN 20 YEARS OR LESS, FOCUS ON INCREASING YOUR SAVINGS RATE.
Are you convinced? Have you been focusing on the wrong metrics? What is your highest priority in your approach to wealth building?
-Gen Y Finance Guy
p.s. if you want a copy of the data set you can download it here >> Savings Rate vs. CAGR
p.s.s if you want to see this taken a bit further, go and check out my this post from Go Curry Cracker!