Last week I was reading a social media post where the author wanted to learn how to increase his net worth. This 20 something wanted recommendations for what to do now and in the future to ensure a comfortable retirement. The general consensus was to buy assets that would rise over time. I noticed that one of the things that was overlooked in the responses was what assets to buy now that would only appreciate.
First, we don’t know which asset classes, businesses, metals or exotic investments are going to grow. There is a long-accepted caveat provided by the financial industry that goes like this: “past performance does not predict future returns.” If we don’t know which assets will grow and past performance doesn’t predict future returns, how do we build wealth? It’s really simple and it’s based on two things. The first is a budget and the second is compound interest.
Before we continue, let’s do an exercise. Take out a sheet of paper and draw a line down the middle. On the left, list your assets. These are possessions you own, including bank accounts, investments, and property. On the right, list your liabilities. These are things you owe money on, like a car, a line of credit, a student loan, or a mortgage. If the total on the left is greater than the total on the right, you have a positive net worth. If the total on the right is greater than the total on the left, you have a negative net worth.
Budget
The budget is the most integral part of the financial success of a home. Budgeting isn’t just for the poor or those who live paycheck to paycheck. I have heard this misconception many times and I refute it with passion! Melissa and I got married in 2005 and we had no budget. We had no idea where the little money that came in was going to end up. Five years later we created an annual budget in an Excel spreadsheet. Every January we sat down for an hour to review our income, projected bills, and goals for the year. We became more efficient but our annual savings were not consistent with projections.
The best way to arouse curiosity is with facts. Facts motivate and provide substance about why to make a change. That said, this is not a comparison. The following information is a simple case study of a middle-class household in the Upper Midwest.
With complete transparency, I calculate the savings rate as gross income after federal and state taxes are deducted. It’s hard to control what Uncle Sam and his estate take from each paycheck. To demonstrate why using a budget is so important, I’d like to provide some data. Using an annual budget, we save 32% of our income. The last year we did this was 2015 and for the previous three years our forecasts didn’t come true. We were not making a monthly budget based on zero. A year ago we started and our savings rate increased by 15%. We can allocate 47% of our income to donations, retirement planning, car sinking funds, principal-only mortgage payments, and college savings. If you’re surprised by the difference, so am I. Simply put, we became more efficient with our finances.
composition
Compound interest is crucial to building net worth. In fact, Albert Einstein coined it as the eighth wonder of the world. Compounding can work for you or against you in the form of interest on debt or growth on an investment. My favorite metaphor is an evil and a rabbit.
Imagine debt as an anvil. It is bulky, heavy and impedes free movement. Contrast the anvil with the remarkable reproductive ability of the lop-eared mammal known as Mrs. Rabbit. A female rabbit can produce from 1 to 14 rabbits per litter and her gestation cycle is 28 to 31 days. Rabbits can be fertilized within minutes of giving birth and have a litter every month. Fortunately, someone calculated that a bunny girl starting at 6 months and continuing for seven years could have a family tree of 90 billion! Now, no reader here is likely to rack up billions of dollars, but in case we do accept donations.
The following two scenarios are provided to illustrate the effect of compound interest. The constants for this exercise are a compound annual growth rate (CAGR) of 8%, a savings rate of $1,000 per month, and a retirement age of 65.
As mentioned above, compounding can work against you in the form of debt. Let’s assume that all readers are fiscally responsible and use compounding to their advantage. What I hope to take away from both of these scenarios is the time value of money. Another useful topic is the rule of 72 that we have discussed in the past.
Scenario 1
Bob, Bill, and Brad each contributed $1,000 a month until retirement, but they started at different ages. Bob’s savings far outstripped Bill and Brad’s due to time. Are you surprised by the $2.4 million difference between Bob’s and Bill’s savings? Brad would have needed to invest $5,000 per month for 23 years to come close to Bob’s savings. By doing this, he would have fallen a bit short and his total contributions would have been $1,000,000 more!
scenario 2
Bob’s early start is once again obvious. He can generate savings of ~$4,000,000 and stop investing 15 years before retirement. It is interesting to observe Bob’s situation in each scenario. There is only a $350,000 difference in the accounts and a total contribution difference of $180,000. It’s hard to start investing early, but these examples solidify the importance of starting early. If Bob decided that he wanted to retire early, he could take his savings and live a life of minimalism.
Summary
Finally, I hope you found today’s post valuable. Behavior is the single biggest predictor of success with money. Knowledge is important, of course, but delayed gratification and identification of need versus desire always produces superior results. It is never too late to implement these recommendations. I don’t care if you’re 10 or 30 years from retirement, it’s never too late to budget monthly and put your money to work.
If you are married with separate finances, this is for you. If you want to strengthen your relationship, work together on money matters. Yes, this means combining your finances. I get it, one of you is a saver and the other is a spender, but that’s not the point. Communication is imperative in a relationship and working together will create a dialogue about fear, anxiety, life goals and aspirations.