The Importance of Savings

We have all heard the idiom “Don’t work for your money; make your money work for you.”  This is the very essence of how passive income works.  You save, invest, or accumulate money in any way that you can, and then you put it into an asset that throws off cash for you regardless of how you spend your time.  However, getting started down this path can be very frustrating at first.

I have previously written on how I first got started saving money, and I used the example that if one were to invest $1,000 in a dividend yielding stock with a yield of 3.5% then they would only receive $35 a year in dividend payments.  It can take a lot of work to save $1,000 especially if you are working paycheck to paycheck.  To go through all of that work and then be rewarded with a seemingly paltry $35 leads many people to believe that saving money to invest is simply not worth it for them. 

It is unfortunate that this phenomenon pops up only during the beginning of the process of accumulating great wealth.  What do I mean by this?  If you work for a salary of $65,000 a year, and you work it into your budget to save $1,000 a month then your wealth will grow in large part due to your savings.  If you start with nothing and invest $1,000 a month for a year at a rate of 10%, then you will end up with about $12,540.  The majority of that money came directly from saving $1,000 a month.  In fact, $12,000 came from savings and only $540 came from investing it (capital gains, dividends, option premiums, etc…) 

If you saved $1,000 a month for 5 years at a rate of 10%, then you would end up with approximately $76,500.  Again, the majority of that money has come from you saving directly.  $60,000 of it is from savings, and only $16,500 is from investing.  This example goes to show that when you first start out to build your future great empire of wealth in your investment account, the majority of the gains in your wealth are seen from direct deposit savings.  Your monthly deposit of savings is the essential factor that keeps growing your net worth and not the actual investment returns that so many people believe.

Savings is the gunpowder and big stick early on in the game of building wealth.  It is one of the most important things when you first start out.  Consistently saving is more important than chasing yield or maximizing returns the first few years of wealth building.  Now let’s take a look at the later years, the years that everyone imagines when they first start out.  Let us say that you have worked hard and maintained your plan of saving $1,000 a month for 30 years at an assumed rate of 10%.  You would have accumulated right around $2,060,000.  Of that total about $360,000 is from savings and about $1,700,000 is from investing.  Whoa.  What a complete turnaround right? 

The amount of money from savings is dwarfed by the amount of investment gains made from the initial savings.  In fact if you were to gain 10% on your $2,260,500 the next year, you would make about $226,050.  At this point you really do not need to save that $1,000 month for your investment account.  The savings have now become largely insignificant in comparison to the sums of money you are now working with.  You could choose to spend that savings every year on a new car payment, new wardrobe, exotic vacation, home renovations, et cetera.  Later on in the game of building wealth, saving money every month is not as important as the amount of money you are earning from your investments.

The lesson to learn here is that your main goal when you first start saving money is not to focus on your returns.  I have seen too many people get discouraged by their $35 dividend payment earned from their $1,000 and simply give up on building wealth.  If they only knew that dividend payments were the least of their concerns and consistent savings was the main priority, then they may have continued on and fought through the hard times of building a capital base to work with.  The first $1,000, $10,000, and $100,000 are by far the hardest milestones to meet.  This is because reaching these milestones relies on savings for most people.  After $100,000 you begin to have very meaningful returns from your capital base built by savings.  This is why many people regard $100,000 as the tipping point in wealth creation.  Do not get discouraged when you first start the journey of attaining great wealth for it is the hardest part for most.  Stay strong and continue to build your capital base, so that one day your capital base can take over and start working for you!

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