Avoid losses and keep more of your money.
What has a greater impact on your ability to build wealth: higher rates of return or reducing costs?
While seeking out investments with the highest rates of return seems more exciting than figuring out how to avoid losing what you already have, it is the latter that has the greatest impact on your wealth-building.
Typical financial advice tends to focus on increasing the rate of return more than minimizing the losses.
Meanwhile, many people are unnecessarily exposing hard earned dollars to major wealth eroders like taxes, consumer debt, and other opportunity costs while trying to squeeze out an extra 1% from an investment portfolio.
Not only are people unknowingly exposing their money to these hazards while focusing solely on the rate of return, but most are not saving nearly enough.
Let’s take a look at these impacts over a 30 year period. Assume an income of $100,000, growing at 2% per year, and a rate of return on savings of 5%.
If you could somehow save every dollar you earn, with no taxes, debt, or other expenses of any kind, that $100,000 per year would be about $8.8 million after 30 years.
Now let’s add in some costs to see the massive effect on wealth building. Assume total taxes per year of 40% (that’s federal, state, local, sales, payroll, property, etc…). Don’t stop there. The average household devotes much of its income to paying others, whether it be for cars, a mortgage, private school, college, rent, etc… Factor in another 34% to debt service and 18% to lifestyle leaving a savings rate around the national average of 8%, you can see this person’s savings has dwindled to just over $700,000.
Ok, now let’s look at what has the greatest effect on overall wealth; increasing the rate of return, or decreasing costs.
If this person were able to double the rate of return on investment from 5% to 10% (an increase of 100%) by accepting more risk, total savings increases to just over $1.7 million. Not bad.
Ok, let’s put the rate of return back to 5%. Overall savings, remember, is just over $700,000 after 30 years.
What if we were able to reduce costs instead of taking on more risk to increase the rate of return?
Leaving lifestyle alone, because that’s the hardest thing for most people to cut, assume this person hired a fantastic tax advisor who was able to find ways to reduce taxes by just 10%, bringing total taxes down to 36%.
And, what if this person is able to reduce their debt service from 34% to 24%? That’s a total reduction in costs of about 15% as opposed to trying to double (or increase by 100%) the rate of return on investments. Savings would be more than $1.9 million.
By reducing costs 15%, and thereby increasing their savings rate, this person has $200,000 more dollars to spend after 30 years than if they would have doubled their rate of return.
And remember, that rate of return needs to be realized every single year for 30 years in order to actually compound as shown.
Reducing taxes and debt service enabled this person to increase their savings rate and build wealth more effectively than by taking on more risk in an effort to increase the rate of return.
Rate of return is only one aspect of financial strategy yet it is all too often the primary focus when choosing what to do with our hard earned dollars.
By adopting a big picture perspective, you can begin to see how all the pieces of your financial economy work together and make better long term decisions.
As always, contact us with any specific questions or ideas concerning the use of your policy, or if you are interested in learning more about reducing costs and building wealth more effectively.
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