Okay, first of all, if you’re an advanced reader, just skip ahead. But for the rest of you (and especially if you feel like you lack control when it comes to money), this needs to be said.
<start rant>It’s kind of ridiculous but a lot of people just don’t get these concepts involving what I consider to be “basic” 4th grade math.</end rant>
Without further ado, I present to you, the first of a series of #PassivePrinciples.
In the personal finance world, when it comes to building wealth, you typically come across 2 kinds of people:
- People that believe you need to “Earn more“
- People that believe you need to “Save More“
Which one is right?
The “Earn More” crowd (aka the Anti-frugality crowd) takes the stance that your expenses can’t be scaled back beyond a certain limit. You have to eat, you have living expenses, you need money to get around, and so on. It varies from person to person, but beyond a certain point, how much can you cut back, after all? They argue that it’s far better to raise your income, which (technically) has no upper limit.
The “Save More” crowd on the other hand, argues that if you don’t keep an eye on your expenses, they can balloon out of control. Typically, when the average person earns more, there’s a tendency to upgrade his or her lifestyle by increasing expenses, sometimes disproportionately so.
Let’s say you’re an average middle-class American family earning a combined income of $80K per year. Also, let’s assume you’re in the 30% tax bracket (for easy math). After taxes, you are left with $56K per year. Your expenses are $30K and you save $26K (more or less) for the year. Now, let’s say the wife gets a great job with a big salary bump, earning $160K per year, but it requires the family to move to San Francisco, where the cost of living is higher than in most parts of the country. Let’s scale everything up proportionally:
New income = $160KNew Income after taxes = $112KExpenses = $60KSavings = $52K, which is more or less double what it used to be.
<begin tangent>Bear in mind, the same $52K goes a lot further back home, compared to a city with a high-cost-of living like San Francisco. It you normalize across states, the financial picture can be wildly different. $100 in Florida only amounts to $88 in California…so you have to factor that in.<end tangent>
In this example, everything was scaled proportionally (roughly doubled, for easy math).
The problem happens when expenses scale up disproportionately when compared to income. Unfortunately, it’s not uncommon for that same family to spend $100K after the salary bump, justifying that it’s because the cost of living in California is “so out of whack”.
But is it? Is it California, or is it them? Why is it that some people, no matter how little they may earn, somehow end up saving and building up a solid net worth after a few years, while others struggle with debt and only find themselves deeper and deeper in the hole with every passing year?
Crazy, isn’t it?
Anyway, back to the point I was trying to make. Now you have a different cash-flow statement. Let’s take a look.
New income = $160KIncome after taxes = $112KExpenses = $100KSavings = $12K
The family is earning DOUBLE of what they used to, and yet they are saving less than half.
Unfortunately, this is a situation that is not particularly uncommon.
What should they have done?
First of all, let’s not forget that they did a great job of scaling up their income, which typically requires a greater amount of chutzpah and creativity as compared to scaling down their expenses. That said, they did a pretty poor job of keeping their expenses in check. Like anything else, setting boundaries and exercising restraint is all it takes, really.
Without a doubt, the “Earn More” versus “Save More” debate is an interesting one. But, both sides hold unstated assumptions.
The “Earn more” crowd believes that expenses are fixed, regardless of what the income is. They argue that after living expenses (and reasonable comforts) are accounted for, the surplus can be funneled into your savings.
The “Save more” crowd believes that expenses typically end up being a percentage of income, regardless of how much you earn (typically because of lifestyle inflation).
Which side is right?
In a way, both sides are right….but they focus on one side of the equation. The key is to focus on widening “the Gap”.
What is the gap? In layman’s terms, it’s the difference between what you earn, and what you spend.
The Gap = Incoming (what you Earn) – Outgoing (what you Spend)OR
The Gap = Income – Expenses
In short, there are 3 roads to wealth:
- Fixed income, lower expenses (via budgeting, forced savings, being frugal, etc)
- Increase Income, keep expenses fixed (via side jobs, increasing your hustle factor, etc.)
- Increase Income, lower expenses (attack from both sides)
The strategy you choose to follow depends on your unique situation. How do you choose? It’s not hard…but you have to know how your money is coming and where it’s going (which, I would hope, you do).
If you already earn $500K a year and feel “capped out” in your ability to earn more (because you’ve grown in your career or whatever), you may choose to start by lowering your expenses from $200K down to $100K (that is, if they can be reasonably lowered).
On the other hand, if you have a family of 4, earn $50K a year and spend $30K a year, chances are you can’t lower your expenses much further. You’d probably want to focus on increasing your income instead.
If you fall somewhere in the middle (or even if you are impatient like me), you may choose to attack from both angles.
In the end, growing the gap should be your sole focus, and it’s the size of the gap that matters more than anything else.
Which of the 3 do you prefer? Let me know in the comments below.
Now, for all you skeptics out there that go,
“What’s the point of saving money now, if I can’t enjoy it while I’m young?”
To you I say: the point, dear friend, is to stop being a slave to money and to put your money to work for YOU. Would you rather live a fabulous lifestyle for an average of 2 hours a day for 40 years of your work life, or would you prefer to live an “okay” lifestyle for the first 8-10 years, and a fabulous lifestyle 24/7 for the remainder of your lifetime? The choice is yours.
How do you put your money to work for you? We’ll look at that next.
PassivePrinciple #1: Widen the Gap