Last Updated Jun 28, 2011 1:41 PM EDT
The purpose of money
When I ask people to tell me what money means to them, I hear words like freedom, security, and independence. Money, and having enough of it, allows us to do whatever it is that makes us happy. Whether or not we love our jobs, we still show up every day and do our best. And we do that in order to pay the mortgage and put food on the table.
That said, most people would rather be doing something else. I've yet to hear of anyone who revealed on their death bed that they wished they had worked more. Thus, money is essentially stored energy that allows us to do that something else, whether it's spending more time with family or sailing around the globe.
Financial freedom - years, not dollars
The measure I'm about to propose turns the commonly held perception of wealth on its ear. This benchmark turns some millionaires into paupers, and makes those with a modest $150,000 401K into the stinking rich. That's because it defines wealth in the following way:
Wealth in years = net worth / annual expenditures
Using this measure, a millionaire worth $2 million, leading an extravagant lifestyle costing $1 million a year, only has 2 years of independence. The person worth $150,000, who only needs $6,000 a year to supplement social security, has 25 years of financial independence. This person might never need to work again.
We would naturally expect their portfolios to grow, yet so would their expenditures as inflation and taxes eat away at their gains. It may, in fact, be reasonable to assume that their after-tax growth in their net worth might only keep up with inflation.
Though there may be a tendency to think that the millionaire would be happier leading that extravagant lifestyle, research shows he might only be marginally happier. Sure, the big house and luxury car might bring short-term happiness, but it would be followed by the anxiety of running out of money to support that lifestyle.
How to build wealth
Implications of this measure for building wealth are enormous. The two ways to build wealth are to earn more or spend less, or doing both of course.
Earning more is always good, yet actually has a far lower impact than spending less. And it does because earning more means giving some away in taxes, combined with the fact that you hopefully won't work forever. On the other hand, spending less has a much greater impact as the government doesn't tax savings and we can still spend less in retirement.
As an example, let's say that a 50-year-old woman can make $10,000 a year more and will retire in 15 years, which translates to $150,000. But if a third goes to taxes, she is only left with an additional $100,000. On the other hand, if she spends $10,000 a year less and has a 33 year life expectancy, that translates to $330,000 in savings.
A dollar saved is $3.30 earned
So in the above example, lowering annual expenditures by $10,000 had about a 3.3 fold benefit over earning $10,000 more. That means a dollar saved is worth far more than a dollar earned - in the above example, it equaled approximately $3.30.
So how much money you need to live on is a far greater factor in determining your wealth, as measured by the freedom to do what makes you happy. Say you get to Social Security age and have saved up $250,000. Depending on how much you need each year to live on to supplement your Social Security, your wealth could vary wildly from a couple of years to the rest of your life.
Spending less today has a double whammy effect. It increases the amount of your savings as you approach financial independence and decreases the amount of the portfolio you will need to spend each year. Both will build wealth at an accelerated rate.
Achieve your independence
Though the Fourth of July is a time to celebrate America's independence, you can also use it as a day to reflect on your own freedom and financial independence. Research shows that living more frugally is actually much easier to get accustomed to than we think it is. Simple things like driving a millionaire's car or using coupons will help you reach financial freedom faster than you might imagine.
Once you achieve this independence, you are free to do whatever brings you happiness. And don't let anyone tell you what that should be.
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