Me: Baby, how much should I save, and why?
Her: How much? A lot. Why? To make me happy.
We each have our own reasons for saving… what are yours?
How much should I save, and why?
Before we can answer this question, we need to ask another question: What is my time preference?
In plain English, this means: How long am I willing to wait in order to reap a greater reward?
Often, we are not very willing at all to wait: We want to enjoy life today, so we charge our credit cards, enter into debt, and spend years paying all of it off. Our governments seem to operate on the same philosophy: while millions of bureaucrats, politicians, and politically-connected executives enjoy nice payoffs and benefits, our roads are crumbling, our bridges are deteriorating, and the national debt is soaring through the roof.
Advancing technology means that we are going to live much longer and healthier lives than preceding generations
A famous economist once said “In the long run, we are all dead.” This is undoubtedly true. However, when he said it, people weren’t living lives quite as healthy and as long as we live them today. I fully believe that this is a trend that is going to continue into the future.
Can you imagine living 150 years or more? Surely the standard notion of saving up some money until you reach your 60s, and then spending it all over 15-20 years until you die, is outdated. What steps are you making in your life today to ensure that you will be equipped, mentally, financially, and physically, to cope with the changes coming up ahead?
How much do I need to start putting away today?
The world is going through a debt crisis, and a lot of capital has been needlessly and wastefully consumed in the process of central bank manipulation, bailouts and other political misadventures. I fully expect that this is going to hit us all personally in the form of lower growth rates and higher taxes in some form or another.
Eventually, we will get over this debt crisis and growth will take off again, but until we get there it will be a trying time with many swings up and down, and small steps forward.
With this in mind, I feel that this is the best time to be stashing a significant amount of money away. Squirrels prepare for winter by storing up nuts; we should be preparing for the financial winter by doing the same.
So, how much is enough? With stock market returns near 0% for the previous decade, do you believe that we will average 8% real growth rates from 2000 on anytime soon? It’s possible, but I think we’ll need to wait a while for it.
The “normal” guideline during good times is 10%, and that definitely isn’t a bad place to start. In current times, I feel that 30% to 50% of net income is a better goal to target.
What are the benefits of saving so much?
Here are three important ways I personally feel a high savings rate is beneficial:
- You learn to enjoy more, with less. Perhaps instead of a $50 movie, you take your girlfriend to a movie in the park, or you go for a picnic or have a romantic dinner at home. Maybe you’ll even find it more enjoyable, and because you go to the movies less often, when you do go those times will be more enjoyable as well. Instead of thinking about the crowds and the prices, you’ll be enjoying the popcorn and the company (perhaps!).
- You reduce your exposure to lifestyle inflation. This is related to the previous point. When you are saving 30% to 50% of your net income, you’re forced to make choices. Want a 55″ 3D TV and a vacation overseas? Well, you can pick one today, and another one in a few months from now. You can’t have both. Perhaps you decide that the vacation is what you really want, and you have such a great time that when you come back you’ve forgotten all about your lust for the big screen TV… at least for a while.
- It becomes easier to get out of the rat race. This is perhaps the most important point. When you are saving a lot of your net income, over a decent period of time, you gain a vast amount of financial dependence. Imagine having so much less debt over your head. Imagine having the freedom to take some time off your job, or at least not worry about how you’ll pay the bills because you have that covered for some time ahead. Doesn’t just the taste of that feel so good?
Why 50% of net income?
I could have said 33% of gross income or something like that, but tax rates vary so much from place to place and also with different income levels. For someone paying 10% tax, saving 50% of gross income is clearly a different burden than someone paying 50% tax and trying to save the 50% they have left, which is clearly impossible.
So, instead, consider the money that actually gets deposited into your accounts, and save 30% to 50% of that.
How do I calculate my net savings rate?
For the purposes of calculating one’s net savings rate, this is the formula I use:
Savings from direct income + Debt principal reduction – Depreciation
Savings from direct income: This includes savings coming from your primary job and from any side income which you may have. It includes bonuses, retirement savings matches, and other income directly related to your labour.
It doesn’t include interest income, capital appreciation, nor dividends.
The goal of savings is to build up your capital. If you include the returns of your capital as part of your savings toward your capital, then you might not actually be saving as much as you think you are. If your house goes up $50k in one year, are you really going to say that you don’t need to save anything else cause your house took care of it? You could, but if the market later adjusts you’ll find you actually didn’t save any money at all, and you would not have built up any capital whatsoever.
Debt principal reduction: Reducing your debt also improves your overall savings position, as it reduces the liabilities that you have outstanding. This should be considered as a balance between direct savings and paying down debt: you don’t want to do too much of only one or the other.
Depreciation: It’s important to also consider the effects of depreciation on your savings. If you take $10,000 and buy a car that you believe you can sell for $8,000, then that’s an additional $2,000 that you need to save in order to account for the fact that you’ll need to replace your car someday.
If for some reason your car became a hot model and its value went up to $20,000, then we wouldn’t consider it a loss, but for the reasons I outlined above, we wouldn’t reduce our savings rate below our target, either.
When do I reevaluate?
After a considerable period of time, you may have built up enough capital, or perhaps reduced your expenses and debt to the point where you don’t need to save as much. Reducing expenses is part of the philosophy behind early retirement extreme.
My income is low — what can I do?
I was once a full-time student with an apartment, a car, and part-time work at nights and on the weekends, and I was just barely getting by. If someone had told me that I should have been saving 50% then, I would have told them that they were crazy.
However, they still would have had a point. I still could have reduced my expenses; then perhaps I wouldn’t have needed to work as much, and I could have focused on my studies and done even better. Investing in yourself so that you can do better in the future is also a very important form of savings. Just remember the opportunity costs of your time as well.
So, reader, what are your thoughts? Am I nuts for suggesting that we should be saving 30% to 50% of our net income? Am I simply a miser who doesn’t know how to enjoy life? Or… am I positioning myself to enjoy it more fully and deeply?
I would love to hear your thoughts and your own views on the subject.