Herein, I share the first of of a series of life lessons that I have stumbled upon:
A key to wealth is … saving and investing — not just making a lot of income! This is because of two factors. First, the weakness of a focus on simply making more money is that what we spend can match — or even overtake — what we make. The second factor is the power of compound interest.
First, many think that they can grow rich by simply earning or making more money. The problem with this approach is that, all to often, as our income goes up, we allow our expenses to go up as well. The increased expenses may cancel out the higher income, leaving one no better, or even worse off, than before. This is why one hears of even upper-middle class American families struggling to get ahead: they are earning more but spending more. But one hears of this not only regarding the moderately wealthy but about the very rich. Professional athletes and celebrities, in particular, are notorious for making perhaps millions of dollars, but then going broke. Cher and Michael Jackson come to mind. This may be because they allowed their extravagant lifestyles, and corresponding expenses, to outpace even their outsized income. Hence, building wealth is not just about making more money. It is about saving what you make.
Factor number 2: what really makes the case for saving and investing is the power of compound interest. By “compound interest” is meant not only drawing a return on your investment but reinvesting your return to gain greater and greater returns on the previous returns. The classic case for compound interest is the hypothetical of the two twins. Suppose that, with all other factors equal, one twin invests $4,000.00 a year, every year from ages 20 through 40, in a tax-free environment. Suppose twin number one makes a 10% compounding return each year on such investments. Now, in contrast, juxtapose the second twin starting to invest the same amount ($4,000.00 per year) when the first twin stops and continues to add to the investment until retirement age, holding all other factors equal. In other words, twin one has invested for 20 years (ages 20 to through 40), while twin 2 has invested for 25 years (ages 40 through 65). The question becomes, if each twin retires and begins withdrawing their investments at age 65 — which one will have more money?
One might be tempted to guess that the twin who put in more money (twin no. 2) would get out more money. In fact, twin 2 would end up with under $400,000.00 while twin no. 1 would finish with over $2,000,000.00 — over twice the amount of twin 2! This is the difference that saving and investing from an early start makes. It can give your investments that much more time to compound. Twin number 1 is the clear winner, showing how much of a difference the power of compound interest really makes.
In conclusion, a key to wealth is saving and investing money over time, in order to avoid the trap of expenses rising with income and to harness the incredible power of compound interest.