I feel that not enough has been mentioned about saving money.
For most personal finance articles, the focus has always been how to invest your money to generate returns so as to achieve financial freedom earlier. I'm guilty of that too.
Most of the articles on this blog have always been about investing rather than saving.
The truth is saving matters much more than investing for most people, especially if you are relatively young (50 years old and below).
Let's take a look at the infographic below.
HC represents Human Capital while FC represents Financial Capital. A person's sum of earning potential throughout life is the maximum at the beginning and will drop to zero as we approach our retirement age. On the opposite end, Financial Capital usually begins from zero and increases as we save and invest more in our lifetime.
In the earlier part of our life, we are constantly trying to convert our Human Capital into Financial Capital. For us to do so effectively, we will need to save a lot more than we invest as this is a faster way to accumulate our Financial Capital.
Let me give you an example.
Suppose you are a diligent saver and save $2000 every month at the beginning of your career. In a given year, you will be able to save $24,000.
As you are at the beginning of the career, you probably do not have much of an investment portfolio. Let's say you have $10,000 in your investment portfolio and your investment returns are super good with a CAGR of 10%, your investment returns are still only $1,000.
Compared with $24,000, your annual investment returns are a far cry from what you are able to save.
For your investment returns to beat this $24,000 return from savings, your investment portfolio needs to be $240,000 (at an investment return rate of 10%). This is an amount that will take some years of diligent savings before you can achieve that. If we adjust the investment return rate to be a more modest 5%, the investment portfolio required will then double to $480,000 which takes an average person a lot longer to reach.
This is why it is very important for most people to save in most parts of their career. The more you save, the less the number of years required for you to reach your ideal investment portfolio amount (which the investment returns will then start to be more than your saving rates). And the faster you reach this investment portfolio amount, the earlier you can retire.
Let's take a look at the example below.
This chart is based on an annual income of $150,000 and a 30-year future value based on scenarios of different savings rate and investment returns.
If the person only save 1% of his income and has an investment return rate of 10%, he will be able to achieve a portfolio value of $246,741 at the end of 30 years. However, if the person could just save a little bit more and increase its savings rate to 5%, he will have a larger portfolio value of $260,887 even if his portfolio return is just 1%.
I believe most of us understand that investment returns are a lot more beyond our control compared to savings rate. This is exactly why savings rates matter a lot for most part of our career.
Another reason why you should save more is due to lifestyle creep. Suppose you constantly save 15% of your earnings and spend 85% of your earnings. Throughout your career, your income will likely grow due to raises. If you end up spending more of your raise instead of saving it, you may end up delaying your retirement.
Let's have an example here again.
Suppose a person is initially making $100,000. He saves 30% of his income ($30,000) and spends 70% of his income ($70,000). If he gets a raise to $200,000 and maintains the save-spend ratio, he will end up having an expenditure of $140,000. Before the raise, he might only need a retirement sum of $1.75M (based on 4% withdrawal rate). After the raise, he will now need $3.5M to retire! This is going to be an even harder goal to achieve considering that there is only $30,000 more in savings every year.
This is also why you should save even more than you spend as your income grows!
If there is one thing you want to do today to improve your financial health, take a good look at your savings rate and investment returns. If your investment returns are far from your savings rate, please prioritise savings. Your future self will thank you for that.
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