Jan. 9, 2019
Everyone knows that they should be saving money, but when the benefits of saving money are closely examined, the importance of properly saving money becomes even more apparent. A few benefits are:
- It provides greater assets, which gives you more flexibility when it comes to the future.
- Saving a higher percentage means you are spending less of your income.
- More dollars are compounding for you, which helps get you to that magic number to retire.
Let’s dissect these three examples a little further.
If we start teaching ourselves to save right out of the gate, it is likely your financial health will look like that of a thoroughbred. Common consensus says to save 20% of your after-tax income, but you should save anything and everything you can. While 20% is a good threshold to keep in mind, the reality is you'll be teaching yourself great financial habits as you learn to save.
Those who save early and often are substantially better positioned than those who don’t. Whether it was their parents instilling this idea in them, a great boss or a mentor, these people who were trained to save from the get-go are financially on the right track.
The benefit is instead of spending money on something of potentially little value, these individuals are building a nest egg. They’ll be able to buy that beach house, put their kids through college, or perhaps have the pleasure of retiring on their own terms (not someone else’s).
Clients who were taught to save first almost always have more money. However, another important thing happens: They start to create healthy financial habits. These individuals don’t spend emotionally and have respect for saving.
Almost more important, though, is they are naturally comfortable living on less. This isn’t to say they don't have their “splurge” category. These individuals simply need less of their income on which to live. As their income increased through the years, so did their savings. Learning to live on less means that when it comes time to live off of these savings (which almost always needs to happen), they'll simply put less strain on it.
This behavior is financially healthy. When we use financial plans, it almost always leads to a higher probability of success. Those who save more can spend more in the future, even if they don’t always want to. They also live a more worry-free life and typically retire earlier.
My final key benefit to saving more is one of my favorite phrases in the English language: compound interest. Saving is both a marathon and a sprint. The marathon is you have to save for a lifetime to continually see the benefit. For most of your savings life, the largest growth in your savings will occur due to additions. There are two key parts to savings: how much you save and how long you save.
Let’s assume one starts with an initial investment of $1,000, receives 7% annualized interest, and has a working career of 40 years. Person A contributes $500 per month and Person B contributes $1,500 per month, so what is the difference? Person A will have roughly $1,328,718 saved for retirement. Person B will have about $3,953,531 saved.
If they subscribe to the 4% retirement withdrawal rate formula, Person A will be living off of $53,148 per year versus $158,141 per year for Person B. That is an enormous lifestyle difference.
For this example, let’s use the same Person B and basic assumptions ($1,000 investment, $1,500 per month, 7% rate of return, and 40-year investor). The twist in this scenario is that they saved for only 30 years instead of 40. (Remember, we’ve established that saving for 40 years at this rate would yield about $3,953,531.) Saving for only 30 years instead of 40 (a mere 10-year difference) results in saving only $1,838,072 (less than half)! This speaks to the marathon portion of savings; it isn’t until the last quarter of the race where your money soars past the competition. As one of my favorite childhood books suggests, slow and steady wins the race.
The sprint part of savings takes advantage of those good market years. The sooner your nest egg gets to a sizable amount, the more likely you are to have that advantage. Since we don’t know when they are coming, it is important to get there quickly.
For instance, 2017 was a very good year in the markets. Let’s say your investments did 20% last year. Those that got an early start and had $200,000 invested got essentially a free $40,000 in market accretion. That's likely more than what most of us are able to comfortably save in any given year. This portfolio increased by doing virtually nothing but collecting compound interest. If you were slow out of the gate and only had $20,000 saved in 2017, you unfortunately only saw a $4,000 increase. Not to worry though, we'll see great return years again.
Saving extra capital is not easy sometimes, but saving even a little bit more can have a large impact on your financial future and give you the flexibility you desire.
Recent article by Andrew Rosen: The Dangers of Lifestyle Creep