Sanjib Saha
14 June 2023
We’ve heard this a million times already: Getting rich quickly is hard, but building wealth slowly isn’t. To be sure, becoming wealthy is neither automatic nor overnight. But with three foundational pieces in place, and some patience, we can achieve it sooner or later.
What are the three ingredients of the wealth building recipe? I like the metaphor of a three-legged stool, where each leg represents a mandatory element on which our financial future rests. Each element is necessary, but not sufficient by itself. We need all three legs for the stool to be safe and secure. If two of them are great and the third isn’t, our financial situation would be as unstable as sitting on that imperfect stool.
Leg #1: Earning
No, we don’t need to bring in 7-figure annual income to be wealthy. For that matter, I’d argue that many of us don’t even need a six-digit salary. Still, our income must be enough to take care of not only our present, but also our future. If all we earn is barely enough to pay the bills, there isn’t much hope that this would change anytime soon. In fact, living paycheck to paycheck means we’d probably have to keep working indefinitely, give up most of niceties of life that cost money, and depend on others when we can’t work anymore.
Sure, we can ruthlessly cut our expenses and downgrade our lifestyle to give us some headroom. But there’s a limit to doing this. No matter how much we sacrifice, a minimum amount of money is needed to maintain a dignified lifestyle. It’s not a secret that for low-earners, happiness rises significantly with increasing income. While more money doesn’t necessarily uplift our life satisfaction beyond a certain point, lack of money for necessities will surely cause a lot of stress.
How do we know if we are earning enough? We can use a public benchmark to see where we stand. If we earn well above average earners in our region, we can perhaps move on to the next leg of the three-legged stool. On the other hand, if the income is closer to the bottom, we’d have to find ways to boost it while maintaining a work-life-balance. Do we need to improve our skills for a better job? Can we start a side-gig? Do we have any special skills to utilize for profit? Do we have spare time for a second job? It’s not about chasing jobs with higher pay, but about making sure that we aren’t wasting our precious human capital and time.
Leg #2: Saving
The next thing to focus on is – what do we do with that money? Do we spend it all on our current lifestyle and financial obligations to others, or do we keep some for our own future? When we get a bonus or a tax refund, does the windfall vanish quickly for a new gadget, or is any of it saved up for a rainy day? Do our pay-rises result in equivalent lifestyle upgrades or increased saving? These questions are important because of a simple reason. Our income capacity is finite. Like it or not, it’ll stop one day. Unless we regularly save a portion of it for our future self while keeping expenses on check, we’ll have to count on others to provide for us.
This isn’t a call to embrace stringent frugality or live on dog food. A good amount of our income should go towards maintaining a decent lifestyle, even occasional splurges. After all, what’s the point of making good money if we aren’t enjoying life? That said, we need to watch out for wastages and leaks. Just like we need to increase our income to avoid wasting our human capital, we also need to check our spending to avoid wasting our financial capital. Spending for the sake of keeping up with the Joneses, on things that don’t really give us lasting joy and fulfilment, is a waste of resource, and a costly one.
How do we know if we are saving enough? Do we need to count pennies and watch every single expense? Not quite. Simply look at the saving rate with respect to the after-tax income. Financial security is highly correlated with – not the absolute income – but the savings rate. Sadly, the personal saving rate for average Americans isn’t where it needs to be. I personally think that 15% is the minimum target for people with modest income. High earners should push it up much further, otherwise the extra income doesn’t make much difference in terms of attaining financial freedom.
Leg #3: Investing
Earning a good living and saving diligently are both necessary factors for wealth-building, but there’s a key ingredient missing from that picture – letting that savings grow on its own over a long time. Countless people earn a decent amount of money and save diligently but miss the third essential element- investing for growth. I used to be one of them myself in my early working years. I even used to spend a lot of time in finding bank accounts or CDs with highest interest rate. Unfortunately, these safe places for long-term savings aren’t even enough to beat inflation and preserve the purchasing power of that cash. We need to invest our long-term savings for growth, not for capital preservation. Why? Let’s take a simple example.
Suppose I make $100,000 after tax and save 25% ($25,000) for retirement. It means that my annual living expenses are $75,000. If I work for 3 consecutive years, I’d save up $75,000 ($25,000 each year for 3 years) – enough to live for a year without a paycheck. In other words, without any growth in my savings, 3 working years would buy me only a single year of retirement. If I work for 30 years, my retirement savings of $750,000 will cover only 10 years of retirement, even with an impressive savings rate (25% or my disposable income). This is certainly not the outcome that I want.
This is where the third leg – Investing for Growth – comes into picture for long-term wealth building. If I regularly invest my annual savings of $25,000 for 30 years with a conservative 6% annual growth, I’d end-up with nearly 2 million dollars at retirement, with most of the extra money coming from the investment growth, not my savings.
The upshot: Have a decent income, save a reasonable amount, and invest regularly to achieve your financial freedom.