“Compound Interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t…. pays it.” – Albert Eistein
I met a good friend for lunch the other day. We get together every so often to shoot the breeze and catch up on life. As usual, my buddy was complaining about work. Specifically about how he is working so hard, putting in a ton of hours, but has still not been promoted. He also complained about his finances. Although he and his wife make a lot of money (he is a lawyer and his wife is a dentist), they don’t seem to be getting ahead. They have just enough money for their expenses, but after covering all their bills and some leisure activities at the end of a long work week, there is not much leftover. They are in their mid 30’s and have very little saved for retirement. Plus their net worth is modest. My buddy is of the mindset that he just needs to make more money. If he could just increase his salary, then his financial problems would be solved. So he spends his time (and our conversation), talking about what he can do to make more.
Does this sound familiar? Have you heard someone say something similar? Perhaps you have had similar thoughts yourself.
Most of the people I meet who are not in the financial situation they want have the same common mindset. It goes something like this: “…things are going ok. I have enough money for the things I need and to save a small amount. But I never get ahead. Retirement??? pssst…. that is something far away that I will worry about later. Right now I am just focused on making more money. If I could just get to that next level (whether it’s the next tax bracket, next promotion, next income level, etc…), I will be in much better shape.”
My “translation” for this situation -> Being successful financially means making a lot of money. I need to adjust my earnings to fit my lifestyle. And I enjoy, …no, I deserve the finer things in life. And those do not come cheap. So I better focus my energy on making a lot of money.
Now don’t get me wrong. There is nothing wrong with wanting to make more money. I love money. And I continue to be in the pursuit of accumulating more of it every day. So if you are able to increase your earnings, by all means you should do so.
But it is not the only path to great wealth or financial independence. Instead of focusing on simply increasing your earned income, the key is to focus on increasing your savings or your wealth. Consider this simple equation:
Earned Income – Spending = Savings
I realize this formula is pretty basic. But the point is that most people really only focus on their earned income. They do not consider their spending habits or the fact that they need to prioritize the accumulation of wealth. They focus on simply increasing their salary, or hourly wage. Instead of looking at where their money is going.
In one of my favorite books the “Rich Dad, Poor Dad”, Robert Kiyosaki describes how most people use their earnings to simply buy liabilities. Or items that make them poorer. A classic example of a common liability is a boat. Most people would look at a boat as an asset. In my life as an accountant, we would represent a boat on the balance sheet as an asset.
But a boat, like many other luxury items, sucks money from you. You need to buy fuel, insurance, registration, storage, maintenance. It is very expensive to own and operate a boat. And by the way, the boat DECREASES in value over time. So buying a boat is not only expensive on the front end through its price tag, but it will only drain more money from you over time.
In contrast a real asset is something that generates cash flow. Stocks, bonds, real estate are a few examples of assets. Using your money to accumulate these types of assets makes your richer.
So before you concentrate all your energy on increasing your income, you should be thinking about ways to save more. And invest those savings into assets. Real assets. And the sooner you accumulate these assets, the more impactful they are.
The amazing thing about generating “savings” from the equation above, and then investing in assets, is those assets begin to generate Income themselves. We call this passive income. For those not familiar, it means money that is generated without us needing to work for it. It is fucking awesome!
Another cool thing about Savings and Passive Income, is the more of it we can accumulate and put to work, the more Income we can generate. It feeds on itself. Generate income, spend less of it than you make. Invest the remainder into assets that generate passive income. That passive income now can be reinvested into more assets. And those assets start to generate passive income.
I like to think of it as a snow ball at the top of a mountain. You pack a small ball together and give it a push down from the top. At first, it is small, and not much to get excited about. But as it rolls, it builds on itself. Getting bigger and bigger, without you doing very much after that initial push. Wealth works the same way. You start by accumulating a small amount which is invested in assets. Those assets generate their own income which you masterfully invest in yet more assets. You do this over and over until your passive income is greater than your earned income. I get excited just thinking about it!
Your goal should therefore be creating as much passive income as you can. That has been my goal since I learned this little golden nugget of knowledge years ago (my dirty little secret). And I continue to work at it everyday.
We can add to the simple equation above. Instead, it should look like this:
Working Income + Passive Income – Spending = Savings (wealth accumulation)
The beauty of this is that the more Savings you can accumulate, the more passive income you generate. And the whole Savings side of the equation continues to grow. Let’s look at an example. Take a young couple, Bob and his wife Julie, who are each 23 years old. They both recently graduated college and just started their first adult jobs. Bob is computer technician making $50k a year. Julie is a nurse making $40k for a combined household income of $90k.
Both like their jobs. But they also like their freedom.
Bob and Julie are average, but both very motivated people. And, they understand the value of passive income. So they concentrate on saving their money, and investing it. In doing so, they can be quite wealthy in a relatively short period of time. To do so, they focus on keeping their living expense to a reasonable amount and save (as an example) half of their income ($45k). A reasonable assumption given that they just graduated and were living a very modest lifestyle during the last several years of college. Investing that $45k at 7% interest each year for 10 years, leaves the couple with $622k at the end of that 10 years. At which point they are only 33 years old.
What is even more magical about this scenario is that this $622k they have accumulated will continue to produce passive income. In fact, that amount of money invested at the same 7% will generate approximately $44k per year…. Forever! Very close to the $45k of living expenses the couple spends every year.
So let me reiterate this truly spectacular scenario. A young couple who make a fairly average salary can retire in as little as 10 years. They are not doctors or lawyers or any other profession that generates a huge salary. Just two fairly average people who live a reasonable lifestyle.
Most people cannot grasp this concept. Or have not been introduced to it. For people like my buddy and his wife, they are so focused on making money from their earned income, that they are missing the real problem with their situation. Which is that their expenses are too high, and their savings rate is too low. They live in a very upscale neighborhood in a huge house. They both drive brand new leased vehicles. And they spend a lot of money eating out, going out for drinks, and vacationing to extravagant areas. They believe in “working hard, and playing harder”. But spending almost all they earn leaves very little for savings.
Contributing to the problem is that most people in this scenario think that their expenses are fixed or a variable that cannot be altered. So they only have one lever to improve their financial situation…. make more money. But increasing your income can be tough, and in most circumstances is more of a long term pursuit. In the meantime, people should take a look at the expense side of their financial statement. This is something you can improve almost immediately. And in most cases, it does not even require much effort or sacrifice.