In the quest to achieve your financial goals through investing, you will need to increase the capital base that you invest over time. So which is better, to save more of the existing money that you earn, or to earn more? Of course, the easy answer is both, but what if you had to choose? The answer is – it depends. Let’s explore the facets of each option.
Saving more has a limitation – that you can only save, in the limiting case, 100% of what you earn. So if you make $50k a year, that is the maximum you could theoretically save. However, what saving more does do, is allow you to practice the discipline of planning, delayed gratification, and forgoing nice-to-have but unnecessary expenditures. You become what you practice. If you never practice discipline, you will not instantly be able to turn it on like a switch when you suddenly have money. And in that case, you will likely spend it all. It is important to exercise a little bit of discipline everyday, so that you can develop good financial behaviors.
Exploring further, let’s say you are able to save $5k/year on your $50k/year salary, which is a 10% savings rate. This means your annual expenses are $45k/year. Now, let’s say you exercise a substantial amount of discipline and begin saving $20k/year, which is a 40% savings rate. The obvious thing that occurred is that your savings rate just quadrupled, getting you to your goals substantially faster. But maybe something that is lost on a lot of people is that your expenses just decreased from $45k/year to $30k/year, a 33% decrease. This means, not only will you reach your savings goal faster due to saving at a greater rate, but that you will ultimately need a smaller number to achieve financial independence because your living expenses are lower.
How much will you need to save to reach financial independence? Generally, people say about 25 times your annual living expenses is required for financial independence. This number comes from a famous study called the Trinity study, where they found that a 50/50 portfolio of stocks and bonds had a 95% chance of avoiding depletion over 30 years, if a person only took out an initial 4% annually from the portfolio and in each subsequent year took the same amount but adjusted upwards at the rate of inflation. We will explore more on this in future posts, but for now, let’s look at our examples above. If we use the 4% rule, 4% will need to be equal to our annual expenses, which means we will need 25 times that amount for our entire portfolio (100% / 4% = 25). For the person saving $5k / year, they would need $45k * 25 = $1.125 million dollars for financial independence. Saving $5k / year at an annualized return of around 8%, this would take a bit over 37 years to achieve the target portfolio size (leaving inflation aside for now to avoid complication). In the second case, saving $20k / year, the person would need $30k * 25 = $750k in their portfolio for financial independence. This would only take a little over 17 years to achieve at the same 8% annualized return.
In fact, the time to financial independence is not a function of how much you make. Whether you make $10k a year or $1 million a year, if you save 40% of your salary and your expenses are 60% of your salary, It will still take just over 17 years to achieve financial independence. This graph shows how long it takes to achieve financial independence at various savings rates and rates of return in the market.
The higher your savings rate (and the lower your expenses), the faster you hit financial independence. For higher savings rates, the rate of return in the market matters much less, because there are fewer years of compounding between now and financial independence. This rate of return in the market is the real return (total rate of return – rate of inflation), since inflation will act as a drag on real portfolio value and will act to increase expenses over time. This assumes your expenses will remain the same in retirement.
For many people, expenses will fall dramatically in retirement (because there is no longer a need to support children, taxes are lower, they move into a smaller home, etc.). For a few others, they want to save a few extra years and then spend more in retirement. If either case is your plan, calculate the new number of years with the following formula:
tadjusted = ln {A*[(1+r)t-1]+1} / ln {1+r}
where
tadjusted = actual time it will take at your desired expense level
A = desired expense level in retirement / current expense level
t = original time to financial independence from the graph above
r = real rate of return after inflation
So for example, if you expect your expenses to reduce by 30% of the current expense level in retirement, and you currently save 40% of your income you would first find the number of years to financial independence at 40% savings rate and 8% real return from the graph above (17.3 years). Your expenses will be 0.7 times as big as that implied by the graph above (30% reduction), so A = 0.7. You would then do the following calculation:
tadjusted = ln {0.7*[(1+0.08)17.3+1] – 1} / ln {1+ 0.08} = 14.0 years
So, if you plan to reduce your spending by 30% in retirement, have a current 40% savings rate, and expect an 8% real return after inflation, you could retire in about 14 years instead of the 17.3 years implied by your current level of expenses.
As you can see from the graph above, increasing your savings rate can result in a substantial reduction in time to financial independence while also strengthening your mind through the ability to exercise discipline. It is not an accident that most of the superinvestors had a very high level of discipline and ability to save. With modest incomes, they passed doctors and lawyers by, leaving them in the dust and saving substantial fortunes over their lifetimes. However, it will still take patience and time for the plan to come to fruition, since, without earning more, you are limited to a theoretical maximum of 100% rate of savings, and practically, it will be substantially lower than 100% for most people.
Now let’s explore earning more as an option. If the same person in the example above (i.e., the one that makes $50k / year and saves $5k per year) instead focuses on earning more, let’s say he / she is able to double their income to $100k annually. This might be through hard work and multiple job promotions, or it might be through starting a business that provides value to others. If their expenses remain the same, they will still need $1.125 million dollars to reach financial independence. How long will this take with an 8% rate of return, with their new savings rate of $55k ($5k + the new income of $50k)? It will take only 12 years! Notice that the annual savings amount for this individual is higher than possible for an individual earning only $50k / year but focusing solely on saving. If they are able to maintain the level of spending they had prior to increasing their salary, their savings rate would also jump from 10% to 55% without having to cut back on any existing spending.
Earning more does have the ability to supercharge savings rates. There is no theoretical limit to how much more you can earn, while there are limits imposed on how much you are able to save. It does come with some caveats, though. People who never practice discipline will undoubtedly spend most or all of the additional income when it comes, leaving them even further from their goal of financial independence than before, since it will now take a much larger amount of money saved to support their new spending level. This additional spending beyond a certain level necessary for comfortable subsistence, doesn’t even bring additional happiness according to studies. Instead, the brain hedonically adapts to the new level making it the new baseline level. Once hedonic adaptation occurs, no pleasure is attained from the new level of spending, only discomfort is experienced if attempts are made to lower the spending to the old level.
Further, generating additional income often takes a lot of time. People who started successful businesses and achieved wealth in just a few short years, often reported that they compacted their entire 30 year work life into a few years – working extremely hard during that time and sacrificing everything else.
Similarly, when you get a big promotion at work, you might get 10% more pay, but the implication will be that you need to put in 50% more time due to the increased responsibilities. Suddenly, a job where you had to put in 40 hours a week, and where you had time for your family becomes a more time-consuming 60 hours per week away from the ones you love.
Lastly, earning substantially more means being taxed more at a higher marginal rate on the additional income. Earning a dollar more, does not mean you get to save that entire dollar due to taxes. Saving more does not have this disadvantage – so in effect, a dollar saved is worth more than a dollar earned. It becomes more important to utilize tax advantaged accounts to help shelter any additional income if possible to ensure you can invest more of it without erosion by taxes.
There are personal tradeoffs to each path of course, and some people will have different lifestyles that suit each set of tradeoffs. A single person might be able to comfortably work more hours. Or a person that is particularly good at starting businesses can increase income in a time efficient manner, since they already have experience and have implemented processes which save them time. Or a diligent saver can keep their expenses extremely low by being disciplined and choosing their geography to live and work in a low cost of living area.
However, my advice would be this. Focus on the place where you could make the greatest gains, applying the 80/20 rule. If you are a disciplined saver that is already able to save 60% of your income, you might consider investing time into increasing your income instead. You already have the necessary discipline, and the gains you could make from saving just a bit more would require a great deal more effort for a little bit of gain.
If instead, you are a gifted earner, such as a high powered lawyer, or someone who has a knack for starting highly profitable businesses, you would do well to learn to exercise a bit of discipline, if you don’t already do so. You are already making a substantial amount of money, you now need to put it to work rather than waste it on frivolous expenditures. The time to start practicing discipline is now, and the way you start doing it is poorly and stumbling forward at first and then improving as you put it into practice. People in this category already have the recipe to be financially independent in just a few short years if they put some discipline into practice.
I know of one doctor who makes $700k a year, and is always begging other members of his practice for extra overtime work because he is short on cash. He has yachts and vacation homes sucking him deeper into debt, but he can’t enjoy them – the guy works over 100 hours a week regularly. Can you imagine being in this type of situation?!? Most people say, “that wouldn’t be me!” But they would be wrong, because without financial acumen and discipline, many will end up in this situation. Just look at how lottery winners fare. Without the tools to handle this windfall, many end up deeply in debt or worse after only a few short years.
If you are a super-earner, (i.e., you possess a very high paying job or are a very profitable business owner), there is one caveat to saving more. Super-earners’ most valuable commodity is time. So it wouldn’t make sense for a super-earner to try to save money by mowing their own lawn or cleaning their own home in some cases, because they could be using that time to earn at a much higher rate. It would literally be costing them more money to try to save on these tasks than to pay others to do them. For these situations, they can make a conscious judgment call, but they should still be in the practice of implementing some discipline where they can to develop the habit.
The 80/20 rule which I recommended above, also known as the Pareto principle, is an important aspect to improving many areas of life beyond the question of saving vs. earning more. 80% of the improvements come from 20% of the causes or changes you could make, so you should focus most of your efforts on those areas. We will explore this more in the next post to show how it can directly improve your financial and investing situation and even general well-being through application in various areas of life.
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