A Better Long-Term Wealth Builder

If I ever write a book, I think I might title it, “The Nature Of Compounding”.  Afterall, I spend more time writing and thinking about compounding more than I do almost any other topic on this blog.

Compounding itself is a fantastic thing — A magical mathematical force that allows for very small amounts of money to grow into a much larger nest egg.  Interest built upon interest, where it grows in an exponential curve towards infinity.

The difficulty of course is in actually achieving that compounding.  It’s not as easy as all those upward pointing graphs seen to imply….


Wherefore Art Thou Compounding

The first time I encountered the concept of compound interest I was around 10 to 12 years old.  I had just opened my first checking account.  I remember that milestone well —  At the time, I only had a couple thousand dollars saved-up.  It was all the money I’d saved from birthdays and odd jobs.  I could finally put that money in the bank and start earning interest!  The interest earned was small at 3.5%, but the idea was a powerful one.

The problem is, once you graduate to the “big leagues” of stock investing, you start setting your sights a little higher.  3.5% interest isn’t good enough anymore.  You begin to want bigger returns.

During booming stock market years, it seems like outsized returns of 20% are possible.  Eventually, those ridiculous notions of outperformance are going to come crashing down when the next recession appears.  Realistically though, the long term return of the S&P 500 averages hovers around 6-7%.  For the math-savvy in the room, this means your money doubles every 12 years at 6% or 11 years at 7%.

That’s some fairly slow compounding, and it’s certainly frustrating for investors that expect to doubling their wealth every couple of years.  After all, nobody wants to get rich slowly.  As a result, some investors attempt to invest in more aggressive assets (in the hope of achieving greater returns).

They might try investing in fancy managed mutual funds, invest in individual stocks, gamble on stock-options, and so on…. all in the hopes of compounding that money just a little bit faster.

The results (of course), are mostly a crapshoot.  Some years the more aggressive assets will outperform, other years they won’t.  What’s an investor to do?  How can we build wealth reliably AND quickly?

casino dice.
Returns from more aggressive investing tend to be unreliable.  This makes aggressive investing a lot like rolling the dice at a craps table.  You never know what you’re going to get.


Your Biggest Source of Wealth

Unsurprisingly, chasing higher returns isn’t likely to grow your assets faster than average.  But there is one thing that will grow assets faster (at least during the accumulation phase)…

Saving more.  That’s right, saving.  Boring old frugality!  It’s really the key to building the significant asset base that financial independence requires.

You see, in the early days most people don’t have a big enough asset base for stock returns to really matter.

Imagine you saved up $10,000 over the course working one year — A 6% return would only grow that asset base to $10,600.  An 8% return would only move the needle to $10,800.  $200 isn’t really a big deal.  The impact of the market returns is inconsequential when compared to the wealth building that comes from saving another $10k.


Beating That Frugality Drum

At least in the early years, leveling-up your personal savings rate is going to have a far bigger impact on your net worth than chasing those extra 2 percentage points.

In fact, it’s far easier to save a few extra percentage points of your income than it is to achieve higher rates of return from the stock market.  You could struggle for years trying to generate returns that exceed the market… OR you could just forgo a couple fancy purchases and quickly double the number of assets under your control.  It’s that simple.

Frugality wins… at least when the portfolio sizes are small.  This is why I beat the frugality drum so hard — For young people, saving is going to have a far far bigger impact than anything those assets are going to earn.  Just keep saving.

It’s not until that pile of assets grows into something a little larger (around the $1 million dollar mark) that the impact of stock returns really begins to matter more.  At that point, the return from a $1 million dollar portfolio can (on average) generate returns that reach $60k-$70k.

For most people, trying to save $60k-$70k in a single year is a difficult proposition.  At that point, portfolio returns begin to do the heavy lifting.

The trick (of course), is saving up that first million.


Frugality Everywhere?

Take one look at the personal finance blogs on the internet, and you’re bound to come up with thousands of tips for saving money.  While every little bit of money saved does matter, it’s optimizing the Big Three that will ultimately matter the most.

What are the Big Three?

1. Housing is typically the single largest expense in any household budget.  Making changes in your shelter can have a huge impact on your savings rate.  Moving into a smaller apartment or home can save hundreds or even thousands of dollars a month.  By the end of the year those savings could amount to anywhere from $2,000-$12,000.

Obviously nobody wants to sell their house and move into that run-down old shack by the river, but keeping your housing expenses affordable can have a huge impact on long-term net worth.

2. Transportation.  While it would be awesome to completely live a car-free lifestyle, the reality of the situation is that most people need cars to get around.  The world is big, time is short, and cars are expensive.  Expensive but necessary.

The trick is to optimize your life such that your car needs are minimal — Take the bus to work, ride a bike, or even walk for your daily commute.  Try to limit your car driving down to just shopping trips on the weekend and irregular road trips.  You’ll end up spending far less on fuel every month.  Oil changes and other maintenance will be much farther apart due to the lack of wear and tear on your vehicle. This lack of wear means you can keep your car far longer without needing to replace it as often. Rather than replacing your car every 7 years, you can replace it every 14.

(I’m not kidding either — I have a 12 year old Honda that just reached 55k miles!)  If you’re thoughtful about how much you drive, the annual savings from less driving less can be substantial — on the order of $2,000 (or more) per year!

3. Food.  I spend plenty of time writing about optimizing food expenses on this blog, but it’s definitely worth a recap.  Why?  Because most people easily blow $5,000 a year (or more) on excessive food spending.

Here’s an example — Let’s say you eat-out regularly on the weekends, spending $150 for a couple of nice meals (including tax and tip).  Well, over the course of the year those regular meals out are going to cost you $7800.

And that’s just two nights a week!  Add in regular lunches or mid-week dinners and suddenly your annual expenditure at restaurants could exceed $10,000.  That’s fairly significant and easily overlooked due to the convenience of having someone else prepare your meals.

Doing a little more cooking at home can amount to a substantial annual savings.  The trick is sticking with it.


Final Thoughts

Getting to your first million isn’t going to be easy.  Many people dream of building that first million via outsized returns from the stock market, but few people actually achieve that feat.  The truth is very far from the fantasy of big returns.

Achieving outsized returns is HARD, and rarely achieved without taking significant risk.  Significant risk that can easily backfire and destroy precious capital.  It’s just not worth it.

While it might not be popular to say so, a few lifestyle changes is going to have a far bigger impact on your overall wealth building than trying to risk a few extra percentage points of annual return.  At least in the beginning when your portfolio size is still small.

Making those lifestyle changes isn’t easy, but they’re a far more reliable long-term wealth builder than the vagaries of the stock market.

If you really want to “beat the market”… just save early and often.


[Image Credit: Flickr1, Flickr2]

22 thoughts on “A Better Long-Term Wealth Builder

  • January 23, 2019 at 3:21 AM

    The good ole frugality drum. It has served me very very well. Earning more is great too, but if you don’t save those extra earnings you’re just spinning your wheels.

    • January 24, 2019 at 8:43 AM

      Absolutely Dave! While my spending slowly increases as I age, it has always lagged my earnings increases. Net, the savings rate slowly increases.

  • January 23, 2019 at 8:10 AM

    Save early and often… yes and yes. And yet we regularly struggle with it. Thank goodness for constant reminders from this community!

    • January 24, 2019 at 8:44 AM

      I know it’s a well worn drum, but it’s one of the most important pieces of advice! 🙂

  • January 23, 2019 at 8:48 AM

    “Rather than replacing your car every 7 years, you can replace it every 14.” Whether that sentence earns nodding agreement or shocked incredulity is a nice acid test on whether you’re talking to a frugal person 🙂

    • January 24, 2019 at 8:50 AM

      I think you may indeed be right! 🙂

      I was debating making that 14 years actually 20 years for the post, but figured most people would scoff at the idea. “That’s too long” and other such comments.

      Average car on the road age is around 10 to 11 years, and I figure your better than average frugal person can do better — especially if they try not to drive too much.

      Average car trade-in age is slightly under 7 years, which is where I put my minima. 😉

    • January 24, 2019 at 12:50 PM

      I bought my car in 1999, new from the dealer. In the decades after purchasing, I commuted 30 miles round trip to a full-time job via foot and train. The 1999 toyota currently has 120K miles; my mechanic says it could last for more than 200K more miles. Absent large expensive repairs, I’ll keep the same car for at least another decade. I think I pass the acid test 🙂

  • January 23, 2019 at 12:47 PM

    Completely agree with everything you said. Want to see what other people have to say about this information, and the only way to subscribe is to comment, so that’s what I”m doing.

    • January 24, 2019 at 8:51 AM

      Indeed, that is the easiest way to get email updates when someone comments on the post. Thanks for reading TJ!

  • January 23, 2019 at 2:06 PM

    Frugality works but it’s boring and hard
    I did forced frugality
    Buy as much house as you can but get Roomates or tenants to pay you’re mortgage
    Get a job that covers your car or transportation costs and cover food

    • January 24, 2019 at 8:53 AM

      Yup, some jobs will pay transportation costs. Back when I was working, I had employers that covered a significant amount of my bus pass every month, which was a boon for my savings rate.

  • January 23, 2019 at 6:41 PM

    This is spot on advice and something I have experienced first hand.

    I call it my capital snowball. In the beginning returns were very small because the amount of capital at play was small. But like a snowball getting bigger rolling down the hill the more capital you put in the more return you will get.

    It becomes a self feeding machine as mleh earned from investments gets added to the capital to earn even more.

    1 million of investable money is the tipping point I feel as well. They say the first million is the hardest to earn and takes the longest and the next one comes easier and so forth. That’s because like you said the money starts doing the heavy lifting and adding more than you do.

    Investment earnings also allow you to save more and my savings rate has been steadily climbing and easily topping 70% now

    • January 24, 2019 at 8:55 AM

      Thanks Xrayvsn! It really feels pretty amazing when the portfolio starts working harder than you do!

      It is one of my favorite memories — the day when I finally felt all that saving had paid off. 🙂

  • January 24, 2019 at 7:32 AM

    Focus on what you can control and that’s your saving rate. Just keep saving and investing and it will work out in the long run. Living moderately makes a huge difference when you’re not making much money. You can save more.

    • January 24, 2019 at 8:56 AM

      Yup! Great advice Joe! Anyone can find a way to squeeze just a little bit more blood from the income stone.

  • January 24, 2019 at 7:59 AM

    I came to this post looking for another better investing vehicle, not “save more” which I’m already doing! 🙂 😉

    It’s still weirdly helpful to hear this IS the effective way to get there and reinforce our plans to keep our 15 year old cars another year, and another year, and maybe another if we can.

    • January 24, 2019 at 8:57 AM

      Saving more is a better investing vehicle! And it will serve you well over the years!

  • January 24, 2019 at 10:46 AM

    Good article Mr. Tako. Would add one the the Big Three to make it the Big Four: vacations. A family vacation can cost as low as a few hundred dollars to over 10k…

  • January 29, 2019 at 3:48 AM

    So true. Our biggest financial mistake was jumping out of the market after 2009 (ironically to save a downpayment towards buying a house), and missed out on 3 years of the bull market. Luckily, we still saved our way out of it, because at high savings rates (50% and up), your savings beats your investment gains. Tackle the big 3 items: housing, food, transportation and even if you spend 5000-10,000 a year on vacations like we did, it’s no big deal.

  • February 6, 2019 at 9:06 AM

    Great post, Mr. Tako. This is why I always say – frugality is the basis you should build the rest of your financial life around. There’s no point stressing about tiny index fund differences if you’re blowing thousands on unneeded stuff.

    Want to save more? It starts with frugality.
    Want to build up your portfolio? That starts with frugality too.
    Want to try and boost your income? Great… but it won’t move the needle unless you’re rooted in frugality.

    At some point, the portfolio gets big enough that the frugality won’t matter as much, and people can start spending a little more freely. Until then, it all starts with frugality!

  • March 7, 2019 at 10:23 AM

    Excellent advice and so true on every single point that you made. Your article described my wife and I.

    We are real life examples of following your advice and reaping the financial benefits.

    About 25 years ago we got married with about 20k in student loan debt. And about 3-5 thousand dollars in savings.

    We were in our early and mid twenties with modest incomes, teacher and police officer salaries.

    After getting married, we paid off her loans within a year and bought a modest 3 bedroom home, around 1600 square feet for $170,000 in 1997.

    As a result the mortgage payment was affordable and so were our taxes and utilities. Our house didn’t put us in the poor house.

    It was nothing extravagant but in a nice safe neighborhood with good schools and enough room so that we could have kids, which we did, 3.

    We took out a 15 year mortgage and then refinanced to a ten year mortgage. And eventually paid the home off after 12 years of ownership.

    We drove older used cars. Cars which were reliable but cheap. On average we’d pay 3-5 thousand and then sell them for half of what we paid. And in one case, I sold one for what I paid, several years later.

    As a result we never had a car payment and insurance was cheap.

    We mostly cooked and brought our lunches to work. But we’d splurge on eating out when we wanted but it wasn’t excessive. And we’re talking cheap meals like pizza not elegant prime rib dinners.

    We took vacations but not expensive ones. We mostly visited family in Florida that live across from the Gulf of Mexico with beautiful beaches.

    And with small children it was easier to visit family and more relaxing than running around Disney world with two strollers. Which we also did on the cheap, because my sister works for Disney and got us in for free.

    It was exhausting to say the least.

    Right after we got married, we opened up IRA’s and contributed the max to those and our 403b and 457’s EVERY SINLE YEAR without exception.

    In addition to funding those to the maximum, we then invested left over money in taxable index funds.

    We bought and hold VTSAX for twenty plus years and continue to do so in all of those accounts, with the exception of my 457. It’s held at Fidelity in their Total Stock Index Fund.

    We kept our investment costs to a minimum with Vanguard and plowed as much money as we could every single year since we got married.

    We averaged savings rates over all those years from 35 to 55 percent. And we did this with three kids.

    We started investing in 1997 with a few thousand dollars and in 2019, we have accumulated 1.8M

    The portfolio generates about 40k in dividends alone and we continue to max out every single available retirement account. And we front load them.

    Mr. Tako, it can’t be stressed enough how a frugal life couple with HIGH savings can do more for ones wealth than compound interest alone, especially in the beginning.

    And I would also like to add that we never felt deprived of anything. We didn’t live like misers. We didn’t clip coupons. We didn’t wear second hand clothes.

    We just kept the four big tickets items in check, Housing, Transportation, Food and Hobbies which allowed us to widen the gap between what we earned versus what we spent.

    So simple but yet so difficult for many because it require patience and discipline.


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