Some time ago I blogged about the simplicity of wealth. At a very basic level there are only 3 levers you can pull to become wealthy: the amounts you save, the interest rate at which you invest and the time over which you invest. This is still true, but some of these levers are more easily influenced than others.
How much can you influence you rate of return?
Rate of return is the most difficult to influence. Simply because risk and rate of return are so intrinsically linked. Churning out a very high rate of return will require you to engage in speculative investments, using leverage, funding start-ups or starting your own business. All things that you might not feel comfortable with.
If you resort to conventional investments, expect to earn conventional rates of return.
At the time of writing these are returns you can expect to make:
Interest on a savings accounts: +0,5% (example used in this case is Belgium)
10 year government bonds yield: +0,91% ( example used in this case is Belgium).
Real estate in Belgium (gross yield): 4%-5% gross.
Stock market yield: experts opinions vary, but the general consensus is that in the next decade it is unlikely to see the average growth on the stock market exceed the 6%-7% range.
It is also unlikely that you could achieve higher yields for a similar risk in the market. 86% of active, professionally managed funds do not outperform the market.
But if your goal is to outperform the market, than I’ll say to you: ” Best of luck! May the force be with you.”
I’m grossly oversimplifying, but the typical investor has two choices for her investments: do real estate or invest in the financial markets. From an attitude or behavioral perspective there is not much you can do to maximize this lever. And for most of us common mortals, we won’t be able to significantly outpace what the market dictates these investments should earn.
And it doesn’t matter a single bit! The beauty of personal finance is that you don’t need to be a briljant investor to become wealthy. A sound, proven strategy will work for 95% of us.
What about the amounts you save?
So now that we have set rate of return aside in this analysis, lets focus on a 2nd lever: the amounts you invest. The amount you are able to invest in your portfolio will be the result of the following equation:
amount invested = net income * savings rate.
Add in the time factor and you have again three levers you can influence to become wealthy and financially independent.
The 3 levers to wealth (or the single 3 levers you need to know)
- Savings rate
And I ordered them in that way going from the MOST important to the LEAST important. Let’s start dissecting these levers by the least important:
You do not need a high income to become financially independent within a life-time. But it sure helps. I have yet to see a blogger reach financial independence before the age of 30 on minimum wage. A strong income helps. Let’s not be naïve. But even on a modest income, over time, through careful saving anyone can become financially independent.
Creating a high income is something that is totally within your span of control. I understand this is not something that is easy, but never give up on aiming for that higher income. How can you do that?
–> Choose a high income career
–> Pick an education that is marketable
–> Keep current on your skills
–> Learn new skills / follow trainings
–> Put in the extra effort and hours and go for that promotion
–> Negotiate your salary ruthlessly
–> Side hustles seem to be the next big thing on the internet. For now I still choose to concentrate on growing my career. But if you feel capped in your career progression, get a side gig going.
Stay out of your comfort zone. Keep hustling. Keep working.
Off course you can’t influence how fast time goes by. And boy, does it goes by soooo fast!
But what you can do: set realistic expectations with regards to your investment horizon. Building wealth is a long-term plan and you need to start with the end in mind. Some might pull of financial independence before 40, others will need to go until 65. It does not matter. Eventually anyone can get there.
Time works in you favor as the law of cumulative return kicks in. When you invest, you get a return on that investment. Which will on its turn generate a return, and so on. Until you have an unstoppable investment snowball that keeps on growing.
How do you make time work in your favor?
–> Save consistently
–> Don’t pull out when the market goes down, but hang in and ride out the tide
–> Set a realistic horizon: 10, 20, 30 years pending on your situation a savings rate
–> Start saving (or paying back debt) NOW if you haven’t already. The sooner the better.
I made the following calculation: If you were to invest 100 euros every month, how long would it take before your investments would add more than a 100 euros to your savings. I.e. after how long does it take for the law of cumulative returns to have a larger impact on your net worth than how much you are saving yourself?
How can you increase your savings rate?
–> Pay yourself first. The first item off your pay-check are savings (or debt reimbursements).
–> Follow a budget, review periodically and cut unnecessary spending
–> Buy second-hand or look out for deals
–> Buy quality and not quantity and look for a good total cost of ownership
–> Avoid lifestyle inflation
–> Don’t do expensive hobbies or collections
–> Use the wedge theory: With each increase in salary, funnel at least 50% of that increase into savings.
–> Avoid debt like the plague. If you have it, pay it of early.
–> Have a support system. Work together as team with your spouse (this is in my opinion the single most important item on this list). And let your loved ones know what you are up to.
You want to make sure that you have a savings rate of at least 20% of your income, which will lead you to being financially independent after 40 years of work. Remember, if you have an average savings rate below 15% you will never become financially independent within a normal working career. But ultimately you want to work towards a situation where you save 50% or higher of your net income.
Now savings rate is a tricky one to keep tabs on, because even if you think you have this pretty well under control, make sure you that your REAL savings rate is not lower than you think it is!
What does this mean?
There you have it. These are the three ultimate levers to build wealth and 20 money habits that pull those levers. You probably will not do everything that is on that list. But build a sound set of money habits and you will become financially independent. Start one habit at a time if you must and build on from there.
But keep in mind that the harder you pull these levers, the sooner you’ll become financially independent. But if you can’t pull on all three, THE single lever you want to be pulling is savings rate!
What about you?
Do you have any other money habits that can help build wealth? Feel free to add them in the comment section!