A Great Moment To Build Wealth: Hold Expenses Steady When Income Rises

A common psychological trait that most people share is a desire to experience forward progress—the harnessing of that trait, after all, is one of the reasons why it is much easier to stick with an income investing strategy over long periods of time.

If you own a diversified basket of assets, and contribute to it regularly, and reinvest, it is almost guaranteed that you will increase your income year after year, seeing the wealth-building process unfurl before your eyes. Someone who judges himself according to the amount of income that his household income each year will experience the psychological satisfaction of seeing the amount of income that his household generates go up year after year, whereas it’s hard to craft a strategy that builds wealth over the long haul while also allowing you to see your net worth increase in a year like 2009.

For better and often worse, most people also associate spending more with progress. And when you have to go backwards, a lot of bad emotions like resentment, anger, and frustration start to creep in.

If I told you that a couple was moving from a $250,000 house into a $500,000 house while another one was moving from a $500,000 house into a $250,000 house, and you had to guess which couple would get divorced within the year, which one would you bet on?

Obviously, there are a lot of good reasons why people successfully purchase smaller homes, and there’s a lot of people who bite off more than they can chew with their home purchase decisions that can lead to financial difficulties and fighting. But there’s also a lot of people who would associate the downsizing with going backwards in life and it would lead to heartache that could have been avoided.

A great technique in the wealth-building process is to try and keep household spending constant, or at least increasing at a slower rate, than the changes in household income. If you’re spending $50,000 per year and see your household income rise from $70,000 to $80,000, good things can happen when you take that extra $10,000 and invest it.

That’s the funny thing about writing about investing so much—even though I spend a lot of time here talking about individual stocks and particular investments to make, what’s really important is your household savings rate. That’s going to determine your future much more than the particular success that you have in the aggregate with your stock-holdings.

If your household saves $300 per month and earns 10% for thirty years, you end up with $678,000 at the end of the period. If you get your savings rate up to $600 per month for thirty years, you only have to earn 6.7% to end up with that same $678,000. In terms of how you allocate your energy, most people are going to get more bang for their buck finding a way to increase the amount of their household savings rather than trying to find a way to get that extra percent on investment returns.

In the financial writing sphere, frugality is a very popular topic right now—it’s all about cutting costs. But handled wrongly, and it can be associated with a deprival lifestyle. If I had to pick my style of how to save $10,000, I’d rather do it by increasing my income $10,000 than by reducing my expenses by $10,000 (although from a tax point of view, reducing expenses is almost always more efficient). Sure, root out the ridiculous expenditures from your budget, and take a hard look at recurring monthly expenses that may be unnecessary, but I think the most psychologically satisfying way to do it is by deliberately structuring your life so that when more money comes in, you keep your focus on holding expenses steady and resisting the impulse of lifestyle inflation.

Originally posted 2014-09-19 08:00:16.

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