Optimising Your Wealth Building

By firebynumbers

There are three main functions which will determine how you can build your wealth –

Savings Rate
Monthly Income (earning potential)
Investment Return

I have talked about the importance of savings rate in this post, and I believe it is the most important factor in determining how quickly you can build wealth and how you can reach the goal of FIRE.

A lot of people then try to focus on investment return, they want to squeeze every % out of their investments to try and build the largest portfolio they can. I believe this approach is misguided, where earning potential should be the next focus to build wealth.

The main reason for this, is simple, your earning potential is essentially limitless. There is nothing stopping you from earning more money. Whether it involves re-training and improving your career or starting a side hustle which grows into a real money-making endeavour. There is no (basically) no limit to how much you can earn, and yet this focus seems to fall by the wayside in hopes of chasing an extra 1.00% in investment return.

Do not get me wrong, you should obviously maximise your return as much as possible, but if you spend hours upon hours trying to optimise your investment return, all those hours spent would most likely have been better suited to actively improving your earning potential.

In this post I want to explore how improving each of the three factors above has an impact on your overall investment portfolio, to try to illustrate with numbers which factor should be the focus. It also needs to be considered, that with savings rate and investment return, there is a limit to how high this number can be and still be within the realm of possibilities.

Calculations

Let’s start with a starting point with the following factors –

Savings Rate – 25%
Monthly Income – $10,000
Investment Return – 7.00%

So, we have $2,500 invested every month, with $7,500 on expenses.

After 10 years of investing, we will have a total value achieved of $435,236.17 in our investment portfolio.

Now I want to do a sensitivity analysis and adjust each factor by 10% to determine which factor has the greatest impact. However, it should be noted that raising savings rate or monthly income by 10% will have the same result. So, I will keep the expenses the same when I increase the monthly income and adjust the savings rate accordingly.

Comparison 1)

Savings Rate – 27.5%
Monthly Income – $10,000
Investment Return – 7.00%

Now, we invest $3,500 each month and have $6,500 on expenses.

After 10 years of investing, we will have a total value achieved of $478,759.79. This is a 10% increase in value compared to our starting point! All from just a 10% adjustment in our savings rate. But from the previous post we already know how important savings rate was.

Comparison 2)

Savings Rate – 31.81%
Monthly Income – $11,000
Investment Return – 7.00%

So, we have $3,500 invested each month with $7,500 on expenses (remember I wanted to keep the expenses the same as the starting point)

After 10 years of investing, we will have a total value achieved of $609,329.07. This is an amazing 40% increase in return from the starting point. Of course, it is going to be the rise, our income as increased, and so has our savings rate. But we have maintained the same lifestyle as before.

Comparison 3)

Savings Rate – 25%
Monthly Income – $10,000
Investment Return – 7.70%

After 10 years of investing, we will have a total value achieved of $452,675.75. This is only a 4.01% increase in value compared to our starting point. As you can see it is almost insignificant compared to increasing income or savings rate.

Conclusion

But, all of these numbers need to be taken with a grain of salt. There are almost infinite individual variables that need to be taken into consideration. I am just trying to show that it is important to look at each factor individually and think about how much of a change you can make on each one.

A couple of examples:

Your savings rate might currently be 25%, but you can realise by reducing spending in certain areas you might be able to increase this number up to 50%. In this case, obviously you should work on increasing this number.
You may currently be investing in conservative defensive assets (bonds for example) and if you were after a higher risk investment you could easily shift your assets into a 100% equities portfolio which might increase your return from 4.00% up to 7.00%.

But these sorts of factors will have an upper limit, you can only cut your expenses by so much before you really start to sacrifice your living standards and increasing your investment return can only go so far before it becomes completely unrealistic.

Small disclaimer – your savings rate can continue to grow to near 99.00%, but it will require you to increase your income ridiculously high, so you are able to live on 1.00% of your income for example.

However, your income potential can continue to grow with almost no limit. So, if you are looking to grow your wealth as quickly as possible, it makes sense to look at avenues to increase your income as much as possible.