Note: This post was first published in June 2020 and updated in December 2021
Let’s kick off this weekend in style – and go on a little day trip.
Assume you are making 40k a year in the currency of your choice. Being a smart and foresightful person, you sock away 25% of that amount, to the tune of 10k a year.
You’ve also been reading this and other personal finance blogs, so you know that over the long run, the best (if not the calmest) harbour for your money is the stock market.
It can sure take you for a ride, but comes through at the end, delivering a return of 8%+ over long stretches of time.
So you crack open your laptop, register an account with a brokerage of your choice and click on “Buy”.
The first 10k you’ve put away doesn’t really do that much for you. An 8% return adds up to just 800 a year. You yawn – and go back to more exciting matters.
The following year, you are starting out with 10,800. You add another 10k. All of a sudden, you’ve got a 20,800 balance in your investment account.
If things go according to plan, that money should return 1,664 in year 2 (20,800 * 8%).
So far so good – and highly unimpressive. Thus, you set your investments on autopilot and forget about them.
As a matter of fact, you forget about them for years. There’s a life to be lived – and enjoyed.
But assuming you’ve stayed the course, a funny thing happens in year 9. You now have a pot of c.115k. At a return of 8%, that pot generates just a smidge less than 10k.
You’ve now reached your first major milestone. That is:
Your money is about to make more money than your annual contributions.
Have a look at the numbers below:
Now we are talking!
But that’s not where it ends.
Close your eyes and let another decade go by. To be precise, 12 years.
In year 21, your investment pot is now worth 494k. Add your 10k contribution and voila: at a return of 8%, your portfolio now generates just over 40k in annual returns.
This is the second major milestone:
Your money now makes more money than you.
This is when the real magic starts to happen. What you once thought is unattainable has now become reality – all through a combination of discipline and an undemanding savings rate.
For those of you more visually inclined, the graph below demonstrates the two milestones in a different way.
The intersection of the blue and yellow lines is the point when your investment returns exceed your contributions.
The point where the blue line crosses the orange one is where your investment returns exceed your total income.
Holding The Line
At this point, the more mathematically apt readers will realize the following:
It doesn’t matter how much money you make.
Play around with the spreadsheet that I’ve uploaded here.
The equation holds whether you are making 40k or 400k. Years 9 and 21 is when the magic happens.
Now, that doesn’t mean that making more money doesn’t leave you in a better place. Of course it does.
Clearing 100k in investment returns a year is far better than only getting 10k. But that’s not the point.
Instead, the fundamental observation is that regardless of your income levels, you can get to a place where your money works just as hard – and perhaps even harder – than you do.
Now, let’s play this out a bit more.
Moving The Dial
Clearly, not everyone gets to make hundreds of thousands a year. Instead, let’s flex another variable here – your annual pay increase.
Let’s say you are able to squeeze out a 3% pay increase every year, roughly in line with inflation, all while keeping your contribution rate at 25%.
Alas, it will now take a decade to clear the first milestone. And even 25 years later, your investment returns will lag your earnings.
But are you really worse off?
Clearly not – because your investment portfolio is still throwing off far more money at those points.
There are a few important observations to make here.
First of all, it’s the importance of investing in yourself. Just as with compound interest, small earnings increases really do add up over time.
That 3% raise may seem inconsequential – but makes all the difference over long periods. And if anything, you should stay ahead of inflation.
So the time taken to improve your skill set, broaden your network, and perhaps find a new job is generally well spent.
There are many techniques you can use to make more money at work. Use them.
The second observation is even more impactful. It’s the danger of lifestyle inflation.
If you keep spending 75% of your earnings, making more money can actually make retirement more challenging.
Sure, you’ve saved up more money. But you also have a much higher “cost base” to contend with.
One way to get around the issue is to save a higher percentage (let’s say 50%) of your raises. So if you get a 4k raise, instead of saving 1k (your usual 25% savings rate), try saving 2k.
Spend the other 2k any way your heart desires. Once you are on track, you deserve your journey to financial independence to be an enjoyable one, not a hunger march.
And it goes without saying that you don’t have to wait for 9 years. If you are the impatient type, just increase your savings rate instead!
Make no mistake, there are quite a few factors that can torpedo your vessel as you navigate it towards the calm harbour of financial independence.
The biggest one most people struggle with is actually putting their money into a vehicle that yields 8% over a long period of time.
An active fund won’t cut it. There is a vast probability that you will underperform the stock market.
An expensive or shoddily diversified index tracker won’t get you there either. What you need is a low-cost, global equity tracker. Unless you happen to have a soft spot for US equities, as I do.
Keep your eyes on those investment fees. The asset management industry has come a long way – but it’s far away from giving a fair shake to its customers.
You also need to come up with proper asset allocation. For those who are younger and have a sturdier stomach, a 100% equity portfolio will do. Others might want to sprinkle in a few bonds. Some others might even consider crypto as a small part of the allocation.
Whatever you do, don’t expect a smooth journey. The real path to wealth looks very different from what you see in personal finance blogs or investing books.
Finally, you’ll need to make an adjustment for your own tax situation. Everyone’s circumstances differ, hence I’ve excluded taxes from the analysis above.
Bottom line is, there aren’t many boxes to tick. But you better tick all of them.
It’s like tightening the screws on your wheels. It doesn’t take a long time, but you must do it if you want to make it to your destination on time – and in one piece.
What Happens Next?
No one knows for sure, but I can make a conjecture or two.
Perhaps you stop stressing out over your job. Why bother if you’ve got an equivalent income stream that doesn’t depend on the mood swings of your boss?
Perhaps you can take more risks – in and outside the workplace. Somehow, playing the game is much easier once you’ve faced down three breakpoints and are up 5 – 1 on the set.
Or you can choose to do meaningful work – even if that implies a severe pay cut.
But make no mistake: having your money making more money than you is a fantastic place to be.
Best of all, it’s fully within your grasp.
So take a few minutes. Play around with the spreadsheet. Day dream of what your life will look like, and… get on with it.