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?
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.
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.
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.