Monetary wealth is often defined as absolute net worth. I view things a bit differently. I define wealth as net worth relative to the expenses required to live a life of well-being.
So, a frugal lady who lives a fulfilling life on $50k/yr is just as wealthy as someone with double the net worth who needs $100k/yr to sustain their lifestyle.
Given this definition, let’s start with the factors that are not the most important to grow wealth.
Income comes to mind when you think of the rich and wealthy. From a young age, I thought a high income, acquired through education and skills, was the key to becoming wealthy.
But I was wrong.
Income is very useful to grow wealth, but only if used in a very specific way. It must be used to buy appreciating and cashflow generating assets such as stocks, bonds, and real estate.
Most high earners do not use their income in this way. Instead, the norm is to buy goods and services that go down in value and take money out of our pockets.
Over 40% of those in the U.S. making over $100,000 per year live paycheck to paycheck 1.
Look to Pro Athletes and Lottery Winners
Pro athletes have a hard time retaining wealth, despite high lifetime earnings. The National Bureau of Economic Research found that 16% of NFL players filed for bankruptcy by year 12 of retirement2. Higher pay and longer career length had no effect on the bankruptcy rate.
Another study examined lottery winners. They found that large cash transfers to those in financial distress delayed rather than prevent bankruptcy3.
So, earning more money did not change how often these high earners went broke. Giving money to someone who can’t manage spending is like giving booze to a hungover friend. The hangover will be delayed, and it will be worse.
When Does Income Matter?
- When it does not provide buffer after you’ve paid for essential expenses such as shelter, transport, food, and clothing. These items are only essential to the point of providing basic functional value: a modest shelter (rent or owned), an economy car, simple clothing, and cooking at home.
- Income matters after you learn to manage expenses and suppress lifestyle creep. Only then can you increase your savings rate and invest. Compound returns will eventually do the heavy lifting for you.
After-Tax Investment Returns
Investing for compound growth is important to grow net worth. Your rate of return determines how quickly your investments will grow.
But returns are not the most important factor to grow wealth, because they are mostly outside of your control. Lets see why.
It Is Hard to Beat the Market
It’s hard to beat the returns of a market index over the long run. Nearly all information about future earnings and the risk of those earnings is embedded in the stock price by millions of smart buyers and sellers. This is called market efficiency, and it is beautiful.
If you want to beat the market, you need to find mispricing that millions of others have failed to act upon. Very few people can do this. If you can find mispricing, it will require immense time and effort.
What the Data Says About Professional Investors
Even professional investors have a hard time consistently beating the market. Over 86% of U.S. equity (stock) funds failed to beat their benchmark index over the 20 years from 2000 to 2020 4. And in Canada over 84% of active equity (stock) funds failed to beat their benchmark index for over the 10 years from 2010 to 2020 5.
Luck vs. Skill
Due to market efficiency, above-average returns are usually based on luck, not skill. I know sucks to hear – it took me 5 years to accept this fact.
It pays to understand the difference between good investment outcomes and good investment decisions. Lucky outcomes as a new investor (<5 years) can fuel over-confident behavior that may ruin a portfolio later down the road.
High fees are the reason why so many active funds underperform the market. By reducing fees, you effectively gain a higher rate of return – about 1% to 2.5%. And we’ve ruled out rate of return as the most important factor.
You can limit taxes on investment income by using tax-sheltered accounts and locating investments across these accounts in a smart way. Minimizing taxes is called tax efficiency. Tax efficiency increases after-tax returns, similar to low investment fees.
Tax efficiency is not the most important factor to build wealth.
For Canadians reading, check out this guide on taxes for investment income.
The Two Most Important Factors to Build Wealth
The two most important wealth-building factors are not based on intelligence, education or income. Instead, they are based on simple, but consistent behaviors.
These behaviors are:
- A sustained high savings rate; and
- Consistent investing.
Growing wealth is a slow, long-term game that occurs over multiple decades. This game is rooted in sustainable habits and systems. The book Atomic Habits does a great job of describing the importance of habits, and how to change them.
Factor #1: A High Savings Rate
What is Your Savings Rate?
Your savings rate is based on the gap between income and expenses. It determines how quickly you will reach Financial Independence (FI). Once you reach FI you can use your time as you see fit.
To find your savings rate, take your total savings divided by your after-tax income:
Savings rate = (Savings ÷ After-Tax Income) *100
Savings Rate Example
Sam saves $2,500 per month, and earns $5,000 per month after-tax. Sam’s savings rate is 50%. Very impressive.
Why Your Savings Rate is So Important
Your savings rate sets the foundation to:
- Pay down consumer debt;
- Build an emergency fund; and
- Invest for compound growth.
Savings Rate and Financial Independence
Financial Independence (FI) occurs when your investment cashflows from dividends, capital gains and/or interest cover your lifestyle expenses until you die. You never again have to rely on your human capital to make money. FI is a form of freedom.
The time required to reach FI depends on:
- Your savings rate;
- Your investment returns.
Th Numbers Behind Savings Rate and Financial Indepdence
To build the graph, I crunched numbers, with the following data:
- I assumed a compound annual return of 5.3% annually after inflation. That equates to global stock returns over the last 120 years (source).
- I assume a 3% safe withdrawal rate. I did not use the common 4% based on the Trinity Study.
- I assumed a 15% tax rate on withdrawals in the FI stage.
The savings rate is a catch-all metric for Financial Independence:
- It captures current income
- It captures current expense
- It assumes expenses in the FI stage will equal your current expenses.
By pursuing a high savings rate, you grow your investments quickly, while reducing the net worth required for FI. The frugal habits you develop while accumulating wealth are likely to persist into retirement. So, a smaller investment nest egg will cover your expenses in FI.
Focus on What is Within Your Control
Your savings rate – based on your income and expenses – is within your control, while investment returns are largely outside of your control.
I focus my energy and time on things I can control.
Other items within your control are income, investing consistently, and maximizing wellbeing within a frugal lifestyle.
How to Change Your Savings Rate
There are a only two ways to increase your savings rate. You can increase income or cut expenses. This post helps you determine if it’s better to focus on increasing income or decreasing expenses. As we saw above, income will not help unless you can first manage your spending. Expense management comes first. Income second.
Factor # 2: Consistently Investing
A high savings rate is not enough to make you wealthy. Your wealth will erode to inflation if you hold all savings as cash over a long period of time.
The savings must be invested in appreciating, cashflow generating assets to take advantage of compound growth and to beat inflation. Such assets include stocks, bonds, and real estate.
The Power of Compounding
Compounding investment returns are what grow wealth. Given time, your invested money will work harder than you ever can.
If you invest $1,000 per month for 30 years, you’ll have $1,220,000 at a conservative 7% return. A total of $360,000 was contributed over that 30 years. The remaining $860,000 came from compounded returns.
Hitting The Highs and Lows
By investing consistently, you will naturally catch the highs and lows of the market, increasing the likelihood that you will acquire the market return.
Investing as soon as money becomes available limits attempts at market timing, maximizes time in the market, and reinforces solid investing habits.
When To Invest?
Not everyone is ready to invest. I won’t tell you to invest. I do not know your specific circumstances.
I can say that it is time to strongly consider investing once:
- Consumer debt is paid off;
- You have an emergency fund;
- You educated yourself and understand investment options; and
- You understand your risk tolerance and asset allocation.
What to Invest In
I will not tell you what to invest in. Once you understand your asset allocation I suggest you start reading about indexed funds. The Canadian Portfolio Manager Blog is a great place to start for Canadians. Other great books include:
A low-cost portfolio of globally diversified index equity and bond funds will provide max diversity and reduce non-systematic risk. Indexed ETFs and Asset Allocation ETFs make it easier and cheaper than ever for anyone to invest in global stock and bond markets.
Growing Wealth: Simple But Hard
Building wealth is simple.
Consistently spend less than you earn and invest. Do this for a long time.
There is no magic formula, no special investment, no one-stop course, and no easily identifiable fund manager who will build wealth for you. Growing wealth is simple but hard.
It’s the same with fitness – a key source of non-monetary wealth. Consistently hit the gym and eat healthily. Your specific diet, workout regime, and supplementation do not matter unless you are consistently eating healthy and working out.
- Frugal habits are hard to develop.
- It is hard to develop knowledge, skills, and competence to increase income.
- It is hard to prevent emotional biases from limiting our investment success
- It is not easy to forgo nice things that you can easily afford. And it’s not easy to accept and suppress your own human biases when investing. It’s hard to suppress your ego.
- All of these require self-discipline. Self-discipline is hard.