TIP 28
START SAVING 20 PERCENT OF YOUR INCOME
I do want to get rich, but I never want to do what there is to do to get rich.
Most people have a natural tendency to be either savers or spenders. The good news is that although you may have a natural predisposition to save or spend, you can change this—but you may need a compelling reason to do so.
My client, Lou was a big-time spender. He loved expensive antiques and thought nothing of paying full retail price for a whole new designer wardrobe each season. He didn’t really see the point of saving. Didn’t you save so you could buy something later? Savers are probably quivering at this point, but this was his basic outlook at the time. Since action follows thought, it should come as no surprise that Lou had credit card debt and nothing in savings. He was completely tapped into the overdraft on his checking account so that every time he got paid, it just paid back the line of credit.
This turned around for Lou when I explained the concept of financial independence—having enough passive cash flow or income streams to cover your living expenses so that you don’t have to work for a living (Tip 29). What an appealing idea! Lou had never thought this possible. After all, he wasn’t from a wealthy family, and he wasn’t going to inherit a business or piles of money. He was making a decent salary but was spending more than he made. Lou had always thought that financial freedom was for “those other people,” but here was a coach telling him that he could achieve it. Lou’s whole perspective changed. For the first time in his life, he had a reason to save that appealed to him. He wanted the freedom and security of knowing that he didn’t have to work for a living.
The key to financial freedom is to start saving 20 to 25 percent of your current net income. Have it automatically deducted from your paycheck or checking account to go into a passive, indexed mutual fund. You are now on your way to financial freedom. Now that is a goal worth saving for! Either cut your expenses by 20 percent or increase your income by 20 percent. Better yet, do both and get there twice as fast.
One colleague, now in his late fifties, said that when he got his first job at 18 he figured he should be able to live just fine on 80 percent of his income and save the other 20 percent. He steadily stashed away that 20 percent, and without any struggle, with just his regular jobs, he is now a multimillionaire. That was all it took. No fancy investments or gimmicks, no get-rich quick schemes, just 20 percent of his income went into savings invested in low-fee, no-load indexed mutual funds. He figured out how to live on the rest. The secret formula for financial freedom is consistent saving over time. If at age 22 you took advantage of your annual IRA (or ISA in the United Kingdom) contribution and invested $5,500 at 8 percent, by age 65 you’d have over $2 million.
I’m always amazed at the number of people who aren’t aware that they can sock money away every year into a tax-deferred retirement account as well as contribute to their company’s pension plan, which is often matched by your employer (free money, so don’t leave it on the table). The fact that interest earned is tax-deferred until you withdraw is a big bonus as the interest can compound and your account will grow much faster than it would in a taxable account. As a general rule, the more you stash away in tax-deferred investments, the better. To find out what is best for you, speak to your accountant for advice. Keep in mind that every country has its own rules about retirement savings.
The tremendous payoff in security, freedom, and confidence is well worth the lifestyle changes you need to make in order to save 20 percent. If you really truly can’t save 20 percent right now, even after slashing expenses (Tip 23), try this simple technique for gradually increasing your savings over time. Start by saving 1 percent of your income this month, then next month increase to 2 percent, then 3 percent the next month until you are at 20 percent or more. That being said, most people naturally and effortlessly save 10 percent simply by paying cash for everything and hiding their credit cards. When you have to hand over real cash, you suddenly think, do I really want this thing? The only flaw with gradually increasing your savings is that you may forget to increase your savings each month so make sure that you create an automatic reminder that will hound you until you do it. That is why I often recommend going for 5 to 10 percent to start because most people can save 5 percent without even feeling it.
The Nest Egg Trick
If you are struggling to start saving, try the nest egg trick. A nest egg is literally a fake egg put in a hen’s nest to stimulate her to lay more eggs. Apparently, a hen sitting on an empty nest is less likely to lay an egg. Humans are like chickens in this respect. If you don’t have any savings, it is hard to even see the point of savings and hard to get started. Once you have some savings, it is easier to add to them, and the interest helps your money grow over time. You can create your own version of a nest egg in a number of ways. Let’s say you decide not to have your usual designer coffee today, and instead you put that money saved into a jar. Then instead of taking the subway to work, you opt to walk and throw that extra change into a jar (carrying a coin purse helps!). At the end of few weeks, take the contents of your jar and convert it into something that feels valuable to you—a silver coin for example, or just let the change accumulate.
Let’s say that you decide to make a large purchase such as buying a new washing machine. You’ve done your research and are prepared to spend $500. You go to the store and haggle with the salesperson until you get the best possible deal, shaving $70 off the price. Now take this $70 and add it to your nest egg. This is a great way to create a natural savings incentive without feeling deprived, and you’ll very quickly see your nest egg grow. When you have numerous jars of change, deposit the money into a separate savings account that isn’t linked to your ATM card. When you have saved enough, open a low-cost, indexed mutual fund such as Vanguard’s. To reap the benefits of tax-deferred savings over time, max out your retirement savings first.
If you are in your early twenties, you can get away with saving less (10 percent) because you have time and the amazing power of compound interest on your side, but if you are older, then you may need to save much more aggressively to catch up. The key is to establish an automatic monthly direct debit so that you don’t get your mitts on the money first—this is paying yourself first. Set up another reminder to review your accounts once a year to calculate your net worth because it is motivating to see your nest egg grow.
Once you’ve set up automatic investments, you’ve made an excellent step toward reaching financial independence. Don’t procrastinate another day! Procrastination is the number one wealth destroyer. Time is truly on your side when it comes to creating financial independence. Set up your automatic investment today, and you’ll be on your way to financial freedom. (See Appendix D.) Create a nest egg, automate your investing, and relax, knowing that you are being responsible for your future.