For a lot of people, becoming a millionaire is a title and status to be coveted. Financial independence will typically be in reach provided that spending habits are sensible and debts are cleared or well managed.
You imagine the possibilities of having that amount of money, the house you could buy, the car, and the luxurious holidays. It's surely easy to think about and plan how you would spend it, but have you ever really thought about how you would make that money in the first place?
For most people the immediate thought is "work hard and save my money" if it isn't "winning the lottery", but if you think about it that's crazy. Under normal circumstances it'll be impossible for them to save that amount of money even if you gave them their entire lifetime.
For the record, I fully support saving money as a practice as I believe that even small amounts saved can be almost equivalent to a decent sized investment, provided the amount being saved can be maintained and is well managed. However, in this article I want to explore the implications of "only saving" and not utilising your money in ways that can effectively build wealth over time, such as by investing into a globally diversified portfolio.
Take a look at the following cycle:
It may not be exactly the cycle you're following in your own life but I think most of you, if not all, will recognise the pattern.
This is the cycle that I believe the majority of people in the UK, and even the rest of the developed world, are following throughout their lives. Maybe there'll be some slight variations such as a few extra steps or in a slightly different order, and maybe at some point along the way the individual person will develop a little bit of financial maturity and start saving some of their money rather than spending it all each month. But essentially this is the cycle.
Is saving money last the real problem?
As you saw in the diagram saving money only comes in at the very end of the cycle, almost as though it's an after thought, and usually it's going to be a really small amount of money because the rest of it has already been spent. So that makes it even harder to save up that coveted million.
But... is that really the issue and what's a small amount of money?
Well, a "small amount" is obviously going to be relative to the person involved but let's say someone is saving £100 a month. This is just an example as it's a nice familiar number, and you'll see soon enough that it doesn't matter too much if you actually consider this high or low.
£100 a month equates to £1,200 a year, meaning it takes over 83 years to save up £100,000. Nope, no typo here, there isn't a zero missing. 83 years to make 10% progress towards that million, that really sucks; especially since you need to start from the moment you're born. Have you ever met a newborn baby who just happened to have a grand ready to deposit into a bank account?
Yeah I know, rich parents and all that; but in this blog I only want to deal with normal people. People like you and I who have to make their own way in this world and need to play by normal people rules when it comes to wealth and finance. Let's get back on topic.
Even if you doubled or tripled the amount of money being saved each month you'd still be less than half way towards the goal. So while it is a problem that people are only saving what's left of their money after they've spent most of it in the month, it's not the "real" problem stopping them from reaching the big milestone.
In fact, to make it to a million in that 83 year time frame you'd need to be saving just over £12,000 each year. Is the scale of this task starting to hit home yet?
I can take this up a notch; let's just say you are saving £20,000 each year from the age of 18 until the age of 68. That's 50 years of saving your money and at the end of it you'll have your million. Is that the time to celebrate your hard earned money?
Well firstly, it's still a pretty good achievement if you manage to pull this off. Saving £20,000 a year is no small task so there's definitely some praise to be given there. But considering it still takes 50 years in total to get to a million it really does show just how hard it is to get there "just by saving".
But let's keep going with this little train of thought.
The effect of inflation
Now is the time where I introduce you to inflation. This is where the cost of goods will become more expensive over time and causes the "buying power" of your money to decrease over that same period of time. £100 of today's money does not buy the same amount of goods as £100 of money from ten years ago (for example), because the cost of goods have risen since then.
Think about a packet of crisps; it used to cost £0.30 for a bag of salt & vinegar but these days it costs £0.60. You get the same amount of crisps, maybe even a little less, but you have to pay more money for it.
With £100 you could've bought just over 333 packets of crisps in the past at £0.30 each, but now you can only get just over 166 packets at £0.60 each. Same amount of money but less buying power, and therefore less goods bought; that's inflation.
Inflation is something that will happen as part of the financial system and provided that the inflation rate isn't too high it can represent an economy that is growing. This is super simplistic and maybe I'll cover the topic in another article but the key point here is that inflation is not always a bad thing even though it makes things more expensive over time.
The Bank of England has currently set a target inflation rate of 2% each year, and if you assume they manage to pull that off for the 50 years in which you saved your money there are going to be some implications on what that means in terms of your buying power and therefore "real wealth".
If you apply a 2% rate of inflation each year for 50 years you would need £2.69 in that future timeline to have the equivalent buying power of £1 today. That would mean your money in 50 years time is worth 2.69 times less in today's terms.
What this means is that your £1 million that you saved up is only actually worth around £371,747. You have the money of a millionaire but not their wealth.
You might say that this amount of money is still pretty good, and it is (you won't hear me complaining if someone offered to give me that kind of money), but when you put it into context and consider the hard work and effort over 50 years it's pretty disappointing. All of that saving still wouldn't have gotten you half way in "real terms".
What you really needed to save each year was £53,800 if you still wanted to have the equivalent wealth of a millionaire in 50 years time. Because you would need £2.69 million and if you divide that by 50 years you get the target amount to save each year.
Now you see how futile and difficult it is to try and "save" your way to a million.
So does that mean saving is ineffective?
Before you decide that saving is hopeless and you might as well splash your cash since it'll become worth less and less anyways, let me tell you that it's possible to reach "millionaire" status in 50 years by just saving £185 a month (£2,220 a year). Sound impossible?
With the power of compounding growth it certainly is possible.
Compounding growth allows the money you save to built itself up over time, so that it will earn money automatically without you doing anything. At the start it will only earn a small amount, but given enough time it will grow into something that's actually quite big in comparison to what you put in.
Most people, if not everybody, has a bank account for their savings. The bank offers interest on the money you keep in that account and that means you are effectively getting paid to save your money. Let's imagine you had £1,000 saved in an account that offers 1% interest each year, after a year you will get paid £10 for keeping your money in the account:
Savings Balance: £1,000
Annual Interest Rate: 1%
Interest earned after a year: £10
(£1,000 ÷ 100)
New Savings Balance: £1,010
So now you've earned £10 even though you didn't do anything. Awesome right?
Here's something even better; the next year that passes you will earn £10.10, £0.10 more than the first year even though you did absolutely nothing.
Savings Balance: £1,010
Annual Interest Rate: 1%
Interest earned after a year: £10.10
(£1,010 ÷ 100)
New Savings Balance: £1,020.10
The extra £0.10 comes from the £10 that you earned in the first year (£10 ÷ 100) and it effectively means that your interest is earning its own interest. Given enough time, this will keep building up so that you're earning more and more without actually doing anything besides keeping your money in that account.
So that's the basics of compounding. Here's the question you're probably wondering:
How does that mean £185 a month could become a £1 million in 50 years?
Well, firstly by not saving it into a bank account that's for sure; not at the current interest rates being offered at least. The problem with saving it into a bank account is that interest rates are really low right now and you will need much higher returns in order to hit the target of a million.
Fortunately there is an alternative option and that is by investing your money so that it grows over time in the financial markets. By taking £185 each month and investing it into a globally diversified portfolio that tracks an index you can get a return on your money that is around 7% each year on average, over a long period of time. What's a long period of time?
Shall we say... 50 years?
Here's a table to show you how much money you would have saved by yourself and how much you would have gained from investment growth at a rate of 7% each year:
In the first year of saving you will have put away £2,220 of your own money (£185 x 12) but the investment value at the end of the year will have grown by £86 to give you a total of £2,306.00. This is calculated by applying the monthly equivalent of an annual 7% growth (7% ÷ 12) and applying that growth at the end of each month.
As you can see things start off relatively slow but it doesn't take long for the amount you gain from growth to become quite substantial. After 5 years time the amount you have gained in total would be £2,221.95 which is more than the amount you are putting in yourself each year. So it's basically like you saved 6 years of money but only used 5 years of time to do it.
Fast forwards to 10 years and you would have gained just over £10,000 in growth; almost half the amount that you put in yourself. That's like getting £1 free for every £2 you saved for yourself.
And this trend continues as the years pass by where the amount you gain from growth just increases even though the amount you are regularly saving each month stays at £185 right up until the end. After 50 years you will have saved "only" £111,000 of your own money (50 x 12 months x £185) but you would have gained £902,772.50 from investment growth. For every £1 you saved, you got an extra £9 on top.
And that's how you can turn £185 into £1 million over 50 years.
Even if you take into account inflation which makes that future £1 million value be equivalent to around £371,747 in today's money, you would have still more than tripled the value of your money since you only put in £111,000.
So it turns out saving isn't so ineffective after all; you just needed to do something smart with your money and you don't necessarily need heaps and heaps of it for this to work. I would personally find it hard to come up with £20,000 or £53,800 each year but I'm pretty sure I could work out a way to save £185 each month.
When it comes to investing you have to remember that there is going to be some level of risk involved; just as it could rise, the stock markets can also fall. But generally speaking it isn't unreasonable to expect your investments to grow healthily over a long period of time (at least a decade), and based on historical data you can indeed forecast returns of around 7% in real terms provided you are reinvesting the dividends received from holding stocks or funds.
For many people, investing can be a scary and unfamiliar area as they have never done it before. In the near future I'll be writing articles to talk about how I personally get involved and what strategies I use to make myself feel comfortable with the rises and falls of the value of my portfolio, but for now let's wrap things up.
Update: See my investing approach here and learn why timing the market is unlikely to work in the long run.
Just saving your money, even if it is a lot, is probably not going to be enough to make you a millionaire. Yes, 50 years of saving £20,000 will get you there "mathematically" but let's be honest, who does that?
It would also appear to me that the problem isn't the amount being saved, nor is it really because of the bad spending habits and cycles that most people get stuck in; although you'll want to break free from those habits if you can.
And even if you manage to pull off the awesome feat of saving a huge amount every year, you're only going to lose that value to inflation anyways.
All of these things will make that millionaire status almost unreachable. But when you start to look at your money and wealth building in a different way by utilising the power of compounding growth and returns, you'll realise that huge amounts of savings isn't actually what you need, even though it would definitely help.
As long as you take a relatively small amount of money and invest it regularly, consistently and persistently over a long period of time, it will turn out that becoming a millionaire isn't actually that hard after all. So, you ready to start investing yet?
My mission is to help people understand their money by making financial scenarios or concepts easy to understand.
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