I recently had an interesting conversation with my friend, and he commented that he would never earn enough to retire. He was surprised when I told him that out of the total amount of wealth a person has, annual earnings do not play a major role. After laughing, he said there is absolutely no way wealth and income are not highly related to one another. I explained in my experience accumulation of wealth has to do with many other factors other than just income.
Jeff Desjardins wrote an interesting article regarding an analysis by a personal finance site DQYDJ (Don’t Quit Your Day Job). DQYDJ analyzed the 2013 Survey of Consumer Finances from the Federal Reserve Bank. The research indicates there is a positive relationship between income and wealth; however, it is not as strong as most would assume. Income, as a factor, could only explain about 33% of the of a person’s wealth. So the question is, “What are the other factors that correlate to accumulating wealth?” In my experience, there are four other factors that influence the amount of wealth a person has: spending habits, savings rate, time and investment results.
It’s not about what you make; it’s about what you keep. Sound spending habits are essential in the creation of wealth. You really need to understand the difference between “needs” and “wants.” Everyone needs a roof over their head and food to eat. Despite how much you might want it, you do not need a 5,000 square foot home and to eat at a gourmet restaurant every night. Building your spending habits around your current income and budgeting accordingly are necessary.
Understand the determents of debt. Never purchase a want today with an idea of paying for it in the future. Try to avoid impulsive buying habits. Don’t get me wrong, treat yourself to things you want from time to time, but not at the expense of your financial future.
Closely related to sound spending habits is your personal savings rate. It is a basic formula: Income – Expenses = Savings. A question that comes up frequently is, “How much should I save each year?” The answer is not simple; it really comes down to how long you want to work, and what kind of life you want to enjoy during your retirement years. For example, do you have the goal of traveling more in retirement than you do now? This is an example of why developing a personalized financial plan is necessary. Most people prefer rules-of-thumb, so we advise clients to save 15-20% of their income each year; however, this is usually not enough. There are two other savings principles I advocate: increase your savings rate by half of your annual pay increases, and save at least 1/3 of any annual bonus income you receive.
Time is a potent factor in the accumulation of wealth. Saving earlier in life offers two great choices and one phenomenal tool: not needing to save as much each year, getting to financial independence more quickly, and the phenomenal tool of compounding interest.
Einstein supposedly quipped, “Compound interest is the most powerful force in the universe.” Whether he actually said this is up for debate, but the statement is beyond reproach. Starting earlier allows your savings to do more of the work for you. A 25 year old that saves 15% of their $35,000 income per year will have more wealth by the time they reach 65 than a 50 year old that earns $150,000 and annually saves 25% of their income. Assuming they each receive 2% pay raises each year and earn a 6% rate of return on their savings, the 25 year old will have a little more than $1.2M by age 65, while the 50 year old will have only $1.16M.
Investment results and time are closely related. The more time you allow your wealth to accumulate, grants you the freedom of being more conservative or more aggressive in your investment approach. Many make the mistake of starting too late and try to compensate by being overly aggressive in the hope of getting a high return. There is a significant difference in a person’s willingness to take on risk in the pursuit of higher return and their ability of actually achieving this.
Negative investment results and investor biases also contribute to the accumulation or lack of wealth. People tend to make emotionally-charged investment decisions at seemingly the least opportune time. A number of organizations, such as Morningstar and DALBAR, have completed research, which indicates the average investor has significantly under performed the market due cognitive and behavioral biases. A key in allowing your savings to work for you is to adhere to a disciplined investment process. Doing so should reduce the biases and create a structure for making sound investment decisions. To learn more about investment biases, and how to avoid them, check out our article.
The wealth factors of income, spending, saving and time are interrelated and can collectively explain a bulk of a person’s wealth. Investment results are influential, but not nearly as important as those other factors. If you are serious about becoming financially independent, you need to take control over the wealth factors. Don’t worry about keeping up with the Jones; remember becoming financially independent is a marathon, not a sprint.