The 20somethingfinance motto is “Get a Head Start on your Freedom”.
“Freedom” is a bit ambiguous really, and as with a lyric on a favorite song, you can take it to mean whatever you like. But if I’m being honest about what “freedom” means for me, it is “financial independence“.
Who wouldn’t want the freedom that financial independence can provide? So I thought I’d focus for a moment on a trap that I see some people fall in to and what truly matters when it comes to financial independence.
What type of things can contribute to you getting a head start or even a strong late start? There are many, but one of the most prevalent is to invest your money and let the magic of compound interest take over from there. Take a little bit here and there, invest it for a few decades, and Voilà! You’re rich one day.
It’s the promise that has been laid out by the financial industry. And if you are consistently maintaining/adding to your investment position through the good market years and bad, there is merit to it.
But there’s something that worries me a bit when I hear certain people say,
“I was able to sell off that old bike/car/toy/etc., get a few $K’s, and now I’m looking to invest it. Any recommendations?”
“I’ve crunched the numbers and put aside about 10% for retirement, which should be enough over the long haul with the 10% average investment returns.”
“You know that money I got from X, Y, or Z? I just put it in to a few of the best performing mutual funds.”
“I’ve got $5,000 saved. Where should I put it – a Roth IRA, a CD?”
The intentions here are mostly good. Saving money for retirement is definitely better than not. And investing it is better than letting it get eroded by inflation.
What worries me is that it often comes from someone who has poor spending habits and their mindset is:
“I’m going to be good and save and invest this, I’ll get a great return, my work here is done for a while.”
And then they resume normal spending behavior: getting takeout food every night, purchasing bottled water or soda, driving cars with $300+/month leases and/or getting 15 miles per gallon, buying a home that is too big and then filling it with stuff, accruing credit card and other high interest debt, etc., etc.
Here’s the thing: when you have low asset levels, personal savings rate > investment rate of return. Actually, I think that’s a bit of an under-statement, so lets try this: personal savings rate is 90% of the battle. Investment returns (i.e. asset allocation A vs. asset allocation B) are comparatively insignificant. Sadly, the average personal savings rate for Americans is now at 3.9%.
If you want financial independence, personal savings rate should be priority #1, 2, and 3 to get you there. And 3.9% isn’t anything close to being able to cut it.
And this stays true until one amasses a few hundred thousand dollars in assets or more. When one reaches those levels, then investment returns start having a much larger impact, and at some point can even surpass non-investment income.
So… it’s great that you’re saving early – congratulations. But there’s no need to obsess over investment returns. And if you truly want to look towards the future, you will have a much higher impact if you instead obsess over your spending habits, in order to boost your personal savings rate to 10 times 3.9% and beyond.