“The rich invest their money and spend what is left; the poor spend their money and invest what is left.” – Jim Rohn
Becoming financially free is a numbers game. I don’t want to start the article by putting out an equation but my engineer’s brain is dying to put out a simple but a power equation when it comes to building wealth. This is the only equation you need to know to become wealthy:
A = P(1+r)ˆn
where P= Principal (amount invested)
r = annual rate of return
n= number of years
The only three variables that will determine your wealth are P, r, and n.
For compounding to go nuts, you should increase P, r, and/or n:
(1) To increase ‘P’ – invest more
(2) To increase ‘r’ – achieve high returns
(3) To increase ‘n’ – stay invested for a long time
You might be thinking “Is that it? Only three variables will dictate our wealth. It can’t be that simple.” But it actually is. It may look simple but not easy.
Now, let’s look at the things that we have control over:
(1) P (Principal)
P is the amount invested. We have complete control over how much we save and invest. We can invest more by either earning more or spending less or doing both.
(2) r (rate of return)
You might think that we have complete control over how much return we get. Studies have shown that it is very difficult to beat the stock market in the long term. Instead of trying to beat the market, I believe in buying the whole market and holding it. What is in your control is to minimize fees and taxes when you buy the whole market. Invest in low-cost index funds.
(3) t (time)
We can’t speed up time. We can’t compress 10 years into one year. The only thing we have control over is when we start investing. The earlier we start, the longer we can stay in the market.
Remember that ‘n’ is the only variable that is not multiplied or added but it exists in the exponent. It is the only numeric that the entire expression is raised to the power of. It explains why time is the most powerful force in investing.
The only variable we can control:
From the above scenarios, it is clear that the savings rate is the only variable that we have complete control over. I can’t control the returns of the stock market (r). I can’t control time – I can’t compress 10 years into 1 year (n). It all boils down to the amount saved and invested which is totally in your control. Saving is the first step in building wealth. Increase your savings rate and invest more to become wealthy.
“Do not save what is left after spending, but spend what is left after saving.”
— Warren Buffett
The larger the amount of money and the longer the money is kept, the faster you become wealthy.
Note that in the compounding equation, if either the rate of return or time is zero, the whole equation isn’t zero. However, if the amount invested (P) is zero, the whole equation becomes zero. No matter how much return you get or how quickly you get, there is no net worth without savings.
It is worth repeating – there is no wealth without savings. Period.
It is not how much you make that counts, but how much you keep.”
— Robert Kiyosaki
Let’s look at how some wealthy people have become rich and what variable they have optimized to become wealthy.
| Name | Variable Optimized | Success Secret |
|---|---|---|
| Warren Buffett | n (time) | Became wealthy by starting early and staying longer in the game |
| Elon Musk | r (rate of return) | Became wealthy by starting a business and earning high returns |
| Early Retiree | P (Amount invested) | Becomes financially free by saving more (>50%) |
For Warren Buffett, the secret to success is time. Many people have written about the secret behind his investment success w.r.to stock picking, complex analysis, etc. But, the truth is he started investing at the age of 11 and stayed in the game even in his 90s.
For Elon Musk, the secret to success is high returns. He took bigger risks and achieved high returns which made him one of the wealthiest people in the world.
For early retirees in the FI (Financial Independence) community, the secret to success is – the amount invested. The majority of them have a high savings rate which makes them financially independent at an early age – 40’s, 30’s, even 20’s.
Unless you’re an entrepreneur, if you want to build wealth – you need to save more and invest it.
Most people, when they want to become wealthy, focus on (1) obtaining high returns (r) picking stocks, and (2) getting rich right now. Instead, the focus should be on saving and investing.
“Investing puts money to work. The only reason to save money is to invest it.”
— Grant Cardone
Conclusion:
Wealth building is simple but not easy. It requires a lot of determination and consistency. Focus on what you can control – the savings rate. Increase savings and invest more. Think long-term. Trust compounding. The score takes care of itself.