Here is a very basic plan for achieving financial independence:
- Get a job
- Start to save
- Get raises
- Save as salary increases
- Take advantage of dollar-cost averaging (DCA)
- Benefit from a bull market
- Hit magic number
It sounds simple and straightforward on paper, but in reality, earning a high income does not automatically translate into a high net worth. This article will explain why.
Income and Expenses
When most people are starting out, they rent a small apartment. Getting married or setting up a living arrangement with a significant other generally results in a higher income, but it is also likely to lead to the desire for more space – often at the cost of the desire to make maximum contributions to a pair of individual retirement accounts (IRAs) or 401(k) plans. Unfortunately,there are many things that people may not know about an IRA, and the opportunity to increase savings often takes a back seat as living accommodations are upgraded to a single family home.
After a decision is made to have children, buying a minivan, paying for clothes, toys, soccer, hockey, ballet, and other associated costs results in an increased outlay of cash, not only eliminating the ability to save more, but potentially resulting in a diminished savings rate. Having children can also result in moving to a larger home in a better school district and,the decision to pay for tuition at a private school, and then maybe even a college education. All of these things start to take precedent over funding your own retirement savings.
Lifestyle decisions can also have negative impacts on savings rates, even as income increases. Scrimping and saving simply isn't fun. If you can afford to take a luxurious vacation, buy that sports car, upgrade the wardrobe, spend a weekend at the spa, buy that place at the beach or chalet in the mountains, don't you deserve it for all your hard work?
The desire to spend instead of save is also fostered by a quick look at the shenanigans on Wall Street and the poor investment returns in our portfolios. Anybody holding Enron, Worldcom or dozens of other failed firms in their portfolio aren't likely to be singing the praises of savings. A look at most investment statements during a bear market also serves as a reminder that a 20% loss is not recovered by a 20% gain. If you feel you're going to be cheated by the firms you invest in and watch your portfolio decline in value even when you diversify, it's easy to justify the purchase of something you will at least be able to enjoy in exchange for your money.
Geography can also work against the ability to save. In Silicon Valley, a modest ranch house can sell for $500,000. In New York City, private school tuition for three children can reach six figures and mortgage payments of $150,000 per year are not uncommon. Moving up in the world also places one in a different position on the socioeconomic scale.
If you are living the upscale lifestyle of an investment banker to the rich and famous, driving to a client meeting in a Ford Focus is out of the question. Similarly, if everyone in your social network has a housekeeper and vacations in the Hamptons, those items become an expected part of the lifestyle in order to maintain your social network and class.
The Eye of the Beholder
Although it might sound extravagant to people earning the national median of around $50,000 (according to Census Bureau figures), having more money (even much more money), doesn't always put people farther ahead. In fact, those earning more almost always have a lifestyle that leaves them with more things to pay for. That said, before class envy takes hold,individuals at the lower end are also not skipping lattes, nights on the town, cable television, cell phones, cigarettes, alcohol, new cars and other nice-to-have-but not-strictly-necessary expenses.
In the end, everybody wants whatever they can afford, and instant gratification is a whole lot more fun than watching a quarterly brokerage statement for 20 years or more. As a result, most people end up financing their lifestyle with debt. That can erode your future (see Stop Keeping Up with the Joneses – They're Broke).
The Bottom Line
Sticking to the seemingly simple plan of earning more and saving more requires serious discipline and sacrifice. It means living below your means, regardless of the level of your means, and making savings a priority. It requires having a plan, saving and maximizing the amount you invest in our 401(k) and other savings vehicles before spending on the extras. It may not sound like fun, but years from now, when you look back at all the people who seemed to have it all but were really just getting by, you'll be one of the ones laughing all the way to the bank.