Statement of the Problem
The personal savings rate for the average American was -1 percent in 2006. The average person gluttonously consumes Twinkies, Gasoline, and pretty much their entire paycheck without ever thinking about living within their means. A large part of this has to do with constant cultural conditioning telling us to buy things, because they will supposedly make us happier or enrich our lives. The free availability of debt allows people to spend above their means and causes many people financial misery. Debt may well be one of the major causes of the economic crises that will affect Generation Y (i.e. credit card debt, student loan debt, mortgages, and car financing). Despite this, the opportunity cost of paying off debt sometimes makes it reasonable to carry some amount of debt on your balance sheet: one can earn a better rate of return with the money in other investments, over what I save in unpaid interest cost. However, for the most part, you should seek to live a debt-free lifestyle – it will be better for your checkbook and your mental health.
Another thing — your annual wages or salary do not make you rich, necessarily. A doctor may make $300,000 a year, and not have a penny in his name as he spends the cash on lavish goods – a fancy boat, a couple Range Rover’s, a big McMansion, country club fees, etc – that he barely has time to enjoy. But once he stops going in to work, the checks stop coming, and now he cannot afford to pay for any of that stuff. On the other hand, you have another man who gets $100,000 from his McDonald’s franchises, $100,000 from various stocks and bonds, and $100,000 by renting a couple of houses. Obviously he is much wealthier — he can lay in bed all day while the doctor works, but yet still have the same purchasing power. I’d argue that true wealth is determined by cash flow generated from working assets.
If you desire wealth, you must learn to show self-restraint and consume much less than you produce. Despite what I read on one blog the other day, carrying around like $400 of cash with you will not make you rich. I’ll say it again, to become wealthy, you must consume much less than you produce. Think about the theory behind this by imagining we live back in a time before money.
Say you farmed a plot of land, and were able to produce X pounds of grain and Y pounds of vegetables and Z pounds of meat. If you ate less than what you produce, you were able to generate surplus. Surplus builds up through time and all the sudden, you can utilize your surplus to trade (to other people who aren’t farmers) for other goods you desire. The concept hasn’t changed in thousands of years. Now, you get paid wages to spend your days at some particular task, and you spend it on your necessities and luxuries. So by spending less than you make, you generate a surplus of claim checks on society. This is very important. You can cash these excess claim checks in to society in order to obtain goods and services immediately – or you can use these claim checks to buy assets that will produce more claim checks. You see, there is a trade-off where your claim checks have the potential to be worth more in the future
But then the hard part is coming up with the $4m cash (the amount the McDonald’s franchiser likely requires) to purchase these claim checks… However, the magic is that most of the cash needed to purchase more assets are generated from the assets themselves! The tipping point might be around $687,500; the point at which stocks with an earnings yield of 8% would generate $55,000 – the average family income in the US.
So the goal then is to acquire $688k as quickly & safely as possible. If we set the target to be 10 years (when I am 30), the nominal sum would be about $1M (assuming 3.5% inflation). Using the formula PMT = FV * (i-j) / ((1+i)^n – (1+j)^n) , we can calculate the amount one would need to save annually in order to hit their goal FV. Assuming 10% return and 3.5% inflation, one would need to save $55,000 in constant dollars.
Very interesting because once you have this sum, it would intrinsically produce the exact amount needed to re-generate itself in another ~8 years. Your money is making more money which is making more money. You wouldn’t need to save another dime, and your $1M would have grown into $2,593,742 – or $1.3 million in real dollars. At a rule-of-thumb 4% annual withdrawal rate, you would be able to generate around $52,000. So the trick – it seems – is to save $55,000 in constant dollars for 10 years in a row.