These Are the Two Most Important Factors to Grow Wealth

Jake - Wealthy Corner Author/Founder

Jake - Wealthy Corner Author/Founder

Hi, I'm Jake. I help people under 40 reduce money stress and grow 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. 

Monetary wealth is often defined as absolute net worth. 

I define wealth as net worth relative to the expenses needed 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. 

Armed with this definition, let’s take a look at the factors that are not the most important to grow wealth.

Infographic: The Most Important Factors To Grow Wealth

Income

From a young age, I thought high income, acquired through education and skills, was the key to growing wealth. 

But I was wrong. 

Over 40% of those in the U.S. making over $100,000 per year live paycheck to paycheck 1.

These high earners have low net worth. They spend on goods that decline in value like boats, cars, electronics and vacations.

They are not putting their money to work.

Infographic: A high income doesn't mean you will be wealthy

Look to Pro Athletes and Lottery Winners

Pro athletes and lottery winners have a hard time retaining wealth. 

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 took a look at lottery winners. They found that large cash transfers to those in financial distress just delayed bankruptcy3. More money was a band-aid solution – it just delayed the inevitable.

When Does Income Matters To Grow Wealth?

Income is very useful to grow wealth once you have control of your expenses. Otherwise, you’re expenses will creep to match your income. Good ol lifestyle creep. 

Extra income can help you grow wealth when it is used in a very specific way. It must be used to buy appreciating and cashflow generating assets such as stocks, bonds, and real estate.

Finally, income matters more when you barely make enough to cover essential expenses such as shelter, transport, and food.  At this point, you cannot cut expenses further and you must increase income to grow your savings rate.

Want to make good money decisions, but never learned how? 

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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

To beat the market you need to have knowledge that millions of others have failed to act upon. 

In addition, only 1.3% of stocks make up the total market returns. It is easy to find the 1.3% of stocks in hind-sight: TSLA, AAPL, GOOG and MSFT. 

The problem lies in selecting these 1.3% of stocks before they take off

Infographic: Index Fund

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. Read more about my biggest investing mistakes here

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.

Investment Expenses

High fees are the reason why so many actively managed funds underperform the market. 

By reducing fees, you effectively gain a higher rate of return of about 1% to 2.5%.

The extra return is great, but it is not significant enough to be the most important factor to grow wealth. 

Tax Efficiency

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. It has an effect similar to low investment fees. 

Tax efficiency is not the most important factor to build wealth. Canadians – Understand Taxes For Investing: A Guide for Canadian Beginners. 

Index Funds: A Simple Way to Invest

I invest in 100% index funds because: 

  • I know I’m not smart enough to beat the market. If I do, it’s probably luck. 
  • I know I professional fund managers will likely underperform their index
  • The approach is simple. It saves my time. I can use the time to write WealthyCorner content. 

You can learn more about index funds from these two posts: 

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: 

  1. A sustained high savings rate; and 
  2. Consistent investing.

Consistency

Growing wealth is a slow, long-term game. The game occurs over multiple decades and 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.

I use after-tax income. It is the amount left after you have paid all income tax. This is the amount that you have control over. 

Savings rate = (Savings ÷ After-Tax Income) *100

Infographic: What is a Savings Rate

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:

  1. Pay down consumer debt;
  2. Build an emergency fund; and
  3. 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. Once you reach FI you can use your time as you see fit. FI is a form of freedom.

The time required to reach FI depends on:

  • Your savings rate;
  • Your investment returns.

Investment returns are outside of your control, apart from your decision on asset allocation. 

That leaves your savings rate as the only factor within your control to influence how quickly you will reach Financial Independence (FI). 

Infographic: Savings Rate and Time to Reach Financial Independence

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 because of high valuations. 
  • I assumed a 15% tax rate on withdrawals in the FI stage. 

The savings rate is a catch-all metric for Financial Independence:

  1. It captures current income
  2. It captures current expense
  3. 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 Increase Your Savings Rate

There are a only two ways to increase your savings rate. You can increase income or cut expenses. This posthelps 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: Consistent Investing

Beating Inflation

A high savings rate is not enough. Your cash savings will erode to inflation. 

The savings must be invested to combat inflation over the long term. Such assets include stocks, bonds, and real estate. 

Infographic: Inflation

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. 

Infographic: Dollar Cost Averaging

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:

The first step to investing is to determine your asset allocation between stocks and bonds based on your unique risk tolerance. I talk more about human biases, risk, and asset allocation in this post.
 

What to Invest In

You need to find this out for yourself.

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 maximize your returns for a given level of investment 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, but hard.

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.

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.