Last week I was reading a social media post where the author wanted to learn how to increase their net worth. This 20 something wanted recommendations of what do now and in the future to ensure a comfortable retirement. The general consensus was purchasing assets which would rise over time. I noticed one of the things overlooked in the replies was which assets to buy now that would only appreciate.
First, we do not know which asset classes, businesses, metals, or exotic investments are going to grow. There is a long accepted warning the financial industry provides which goes like this, “past performance does not predict future returns”. If we do not know which assets will grow and past performance does not predict future returns then how does one build wealth? It is really simple and predicated on two things. The first is a budget and second is compounding interest.
Before we go any further let’s perform an exercise. Take out a sheet of paper and draw a line down the middle. On the left, write down your assets. These are possessions you own including banking accounts, investments, and similarities. On the right, list your limitations. These are things you owe money for such as a car, line of credit, student loan, or mortgage. If the total on the left is greater than the right you have a positive net worth. If the total on the right is greater than the left you have a negative net worth.
Budgeting is the most integral part of a household’s financial success. Budgeting is not just for poor people or those living paycheck-to-paycheck. I have heard this misconception many times and refute it with passion! Melissa and I were married in 2005 and did not budget. We had no clue where the little money coming in was going. Five years later we produced an annual budget on an excel spreadsheet. Every January we sat down for an hour reviewing our income, projected bills, and goals for the year. We became more efficient but our annual savings was not congruent with projections.
The best way to stir curiosity is with facts. Facts motivate and provide substance about why to make a change. With that being said, this is not a comparison. The following information is a simple case study of one Upper Midwestern middle class household.
In complete transparency I calculate savings rate as gross income after federal and state taxes have been deducted. It is difficult to control what Uncle Sam and your state take from each paycheck. To demonstrate why using a budget is so important I would like to provide some facts. Using an annual budget, we saved 32% of our income. The last year we did this was 2015 and over the preceding three years our prognostications were not reality. We were not doing a monthly zero based budget. One year ago, we started, and our savings rate increased by 15%. We are able to allocate 47% of our income towards giving, retirement planning, means sinking fund, rule only mortgage payments, and college savings. If you are surprised about the difference so was I. Simply put, we became more efficient with our finances.
Compound interest is crucial to building net worth. In fact, Albert Einstein coined it the 8th surprise of the world. Compounding can work for or against you in the form of interest on debt or growth of an investment. My favorite metaphor is an anvil and rabbit.
Imagine debt as an anvil. It is bulky, heavy, and impedes free movement. Contrast the anvil with the exceptional reproductive capacity of the floppy eared mammal known as Mrs. Rabbit. A rabbit can produce 1-14 bunnies per litter and their gestation cycle is 28-31 days. Rabbits can be impregnated within minutes of giving birth and have a litter every month. Thankfully someone has calculated that one female bunny starting at 6 months and plugging away for seven years could have a family tree of 90 billion! Now it is not probable that any reader here will ever amass billions of dollars but just in case we accept donations.
The following two scenarios are provided to illustrate the effect of compound interest. Constants for this exercise are compounded annual growth rate (CAGR) of 8%, savings rate of $1,000 per month, and retirement age of 65.
As mentioned before, compounding can work against you in the form of debt. Let’s assume all readers are fiscally responsible and using compounding to their advantage. What I hope is taken away from these two scenarios is the time value of money. Another useful topic is the rule of 72 which we have discussed in the past.
Bob, Bill, and Brad all contributed $1,000 per month until retirement but they started at different ages. Bob’s nest egg greatly out attained Bill and Brad’s because of time. Are you surprised by the $2.4 million dollar difference between Bob and Bill’s nest egg? Brad would have needed to invest $5,000 per month for 23 years to come near Bob’s nest egg. By doing this he would have come a little short and his total contributions would have been $1,000,000 more!
Bob’s early start is once again apparent. He is able to generate a nest egg of ~ $4,000,000 and cease investing 15 years prior to retirement. It is interesting to look at 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 is difficult to start investing early but these examples solidify the importance of getting an early start. If Bob decided he wanted to retire early, he could take his nest egg and live a life of minimalism.
Finally, I hope you found today’s post valuable. Behavior is the single largest predictor of success with money. Of course, knowledge is important but delayed gratification and identification of need versus want always produces superior results. It is never too late to implement these recommendations. I do not care if you are 10 or 30 years from retirement, it is 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 on money matters together. Yes, this method combining your finances. I get it, one of you is a saver and the other a spender but that is not the point. Communication is imperative in a relationship and working together will create dialogue about fear, anxiety, life goals, and aspirations.