Are you just starting your career? You've probably spent four years and a lot of money earning a degree that will earn you money over the next 40 years. I hope that the four minutes you spend reading this post (and $0 investment) will give you more bang for your buck than those four years of college.
Anyone starting out in their career and just beginning the wealth building process may not have a big salary yet, but they have a luxury way more important. Time. The amount of you time you own investments is the most important factor in building wealth. Time beats out income, savings rate and return on investments as the factor that will play the largest role in determining your wealth. In wealth building, Just as in life, time is our most precious resource.
What makes time so powerful?
Compounding returns are the force that builds wealth, and the primary driver of compounding returns is time. As much as I'm a fan of saving, budgeting and day to day money management skills, it's the power of compounding that enables people to build wealth. Let's look at an example;
In this simple example, an investment portfolio has $100,000 in year 1. The investor makes no contributions. The money sits there and earns an 8% return each year. The graph shows what the balance will be at future time periods. The power of compounding over time is very apparent as the the amount the balance increases each 10 year period is magnified. From year 30 to year 40, the balance grows over $1 million, and again this is with NO CONTRIBUTIONS on the part of the investor. Most of us need to work 10-20 years at our jobs to earn $1 million, only to have it substantially taxed. This investor earned $1 million for simply having an investment portfolio for a long time.
What makes time and compounding returns so powerful is that at some point your investment balance becomes large enough that you begin to see an explosion of growth in your portfolio. Once you get to that point, compounding returns become so powerful it makes the other factors such as investment allocation and savings rate, nearly inconsequential. The obvious takeaway from this example would be to save and invest early to use the power of time to your advantage. That's true, but a closer look at the power of time shows that the explosion of growth doesn't happen until the investment balance reaches a substantial amount. So our lesson shouldn't just be to use time to our advantage, we should also figure out how to get the explosion point as early as we can.
Leveraging time to turbocharge wealth building
To expedite the time it takes to get the point of explosive growth, we need to turbocharge the process. Not everyone can do this, but if you're one of the fortunate people to have time on your side, there's a way you can. The people with the greatest chance of succeeding are obviously the youngest (millennials and those just leaving school and starting their careers). For the purpose of this example, we'll use the recent college graduate as our test case.
The big sacrifice
If there's one thing most recent college graduates have in common, it's that they've been living on a very tight budget. Eating cheap food and drinks, and not having much disposable income is something any college graduate can relate to. We've all been there. But being at that point in life gives us one enormous advantage over everyone else; college students are already accustomed to a low standard of living. This makes it simple for them to transition into the one big sacrifice that will lead to a lifetime of wealth.
For the first three years out of school, maintain your low standard of living and invest 50% of your income.
That's it. Save 50% of your income for three years. This one sacrifice will build your investment balance to a respectable amount early in life. When combined with the power of time that a young person has, the results will be astounding. Let's take an example.
Person A will save 20% of his income each year for his entire career
Person B will save 50% for just the first three years, and then 20% each year thereafter
Both people earn the same salary and generate the same investment return of 8%. They will both work for the same number of years. How much more do you think Person B will have at the end of their careers?
The answer is an additional $1 million!
This one step will generate an additional $1 million in passive income - income derived without working. College students are spending hundreds of thousands of dollars and taking on crushing debt for degrees that in many cases will pay them very little. But a little financial education goes a long way. And this approach, which anyone can do, will generate $1 million without ever setting an alarm clock.
The idea of saving 50% of an income to a recent college graduate will seem ridiculous. After all, they've been waiting their whole life to finally be paid a respectable wage and now that it's here they can only spend half of it?! But what many recent grads will fail to understand is that this is the easiest time in their
lives to do something like this, and it will have by far the largest impact. Making the same sacrifice 10 or 15 years down the road would not only be more difficult, it's affect on the wealth building process would be diminished.
How to do it
If you're a recent college grad you've been eating cold pizza for breakfast. Perhaps look for something healthier, but keep up the mentality of living on little money even though you have a real salary. If you have parents you can live with, do this for a few years and invest the money you would be spending on rent. You may find you like this frugal lifestyle, and if you keep it going for more than three years you'd be setting yourself up for financial independence at an early age. If you're older and feel this plan won't work for you, it will, but to a lesser extent. Do it anyway.
Do you know any college age students and want to give the advice that will earn them more money than their job may ever provide? Please share this article with them and start them on their path to financial independence.