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THIS SIMPLE EQUATION is arguably the most important in personal finance: income – expenses = savings.
Think back to your early paychecks. Most of your after-tax salary likely went toward housing, food and maybe a few debt payments. For many of us, little was available to save each month for the first year or two of our working lives.
Then one day, on the last day of the month, there was money left over. From then on, we had a seemingly infinite choice of how to invest that leftover money: stocks vs. bonds, exchange-traded funds vs. mutual funds, pre-tax vs. after-tax, traditional vs. alternative assets, and self-managed vs. advisor-managed.
Mr. Miller, my high school economics teacher, called this the “pleasant dilemma of adulthood.” It’s pleasant when you have more than enough money to live comfortably and you can start building wealth. It’s a dilemma because personal money management is a significant challenge, with many variables and pitfalls. How do we invest for the future without making mistakes?
The answer is, we can’t. We all inevitably make mistakes, Mr. Miller said, but reducing the number and severity of these errors was crucial to successfully building wealth. He told us to diversify, invest with a long-term outlook and remove emotion from investment decisions, so we reduce the risk of self-inflicted blunders.
To help us prepare, Mr. Miller asked students to select a portfolio of five stocks from the newspaper listings and track them for one month. I chose Gillette as one of my holdings, well before it was acquired by Procter & Gamble. My primary selection criteria was that I recognized the company’s name when I came across it in the business section.
A month later, my Gillette “investment” had increased by 8%. Despite Mr. Miller’s cautionary words, I decided my successful experiment meant I had a knack for picking stocks. I did not, which became clear over the decades that followed. Though I own individual stocks today, I can’t attribute my accumulated wealth to superior stock selection. Instead, my wealth results from 25 years of spending less than I earn.
Mr. Miller’s advice back in 1994 jibes with the standard financial advice we hear today. To reach the pleasant dilemma, we need to spend less than we earn. We should then use our savings to buy broad market index funds, hold them for the long term and don’t try to time the market. Time and persistence are far more powerful than any insights we might discover in some elaborately designed spreadsheet.
For me as a young man, Mr. Miller was a fortunate financial influence, alongside my Dad and Uncle Jim. His foreshadowing of the pleasant dilemma was motivation to live below my means and save money every month from an early age.
Do-it-yourself personal finance enthusiasts spend countless hours analyzing investing strategies, fund choices and market trends as we try to fine-tune our portfolios. We read articles, compare charts, and scratch around for ways to reduce fees and taxes even further. We do this, in part, because we enjoy it. But there’s a point at which the additional time spent on such activities provides diminishing benefits.
My contention: Our ability to create personal wealth is less about all this portfolio fine-tuning—and more about how good we are at earning and saving money. Annual stock market returns of 15% don’t equate to much if there’s only $50 to invest each month. The implication: Younger savers should devote more brain resources toward increasing their earned income.
Bored at the office early in my career, I’d open a spreadsheet and get lost in a 30-year portfolio projection model, or I’d find another $10 to cut from my monthly budget. That felt like I was being smart with money. But a better use of my time would have been to build my network of business contacts, angle for a promotion or cultivate a lucrative side business to supplement my salary.
Craig Stephens writes about personal finance and investing at Retire Before Dad and Access IPOs. Follow him on Facebook and on Twitter @RetireBeforeDad. Craig’s previous articles were Gift of Knowledge and Not Dad’s Retirement.
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Makes sense Craig. I too keep looking for that big find in a single stock only to be let down. Thankfully, 30 years of consistent dollar cost averaging investing, I have choices on working because I want to vs have to. Appreciate all the knowledge I’ve gained from your Retirebeforedad site.
I’d “argue” that a better equation to build wealth is: Income – Needs (food, shelter, basic transportation to work) – Savings = Wants (any other purchases)
Good article. It sounds like we think alike. I’m retired now, but early in my career, right out of college, I was making good money as an engineer. I found more satisfaction investing in mutual funds then buying a new car or boat, like many friends did. Needless to say, that approach paid off down the road. More young people need to take a long term approach to managing their income.
Thanks for your article! It’s a reminder to mentor the young people in our lives.
Good points, but I would tweak your equation.
net income – savings = ALL spending (not just expenses)
Yes, increasing income is the long-term key to success, but always saving first and always increasing savings as you move along is essential or you may end up subject to lifestyle creep.