The second part of the Asset Rich Income Poor strategy is relatively easy when you get overpaid, uh, increase the value, for what you do. I wrote about the basics in 3 Secrets to a Fat 401k. To achieve Asset Rich, we need to work on these 3 factors:
- the amount you invest;
- the rate of return; and
The Amount You Invest
Normally the amount you invest is linear to the amount you accumulate. Suppose saving $1,000 per month will get you X dollars in 20 years, saving $2,000 per month will get you 2X dollars. However, when you double your income, you don’t just double your savings; you are able to triple or quadruple your savings. Instead of 2X dollars, you will accumulate 3X, 4X, or even more dollars.
People with higher income save a higher percentage of their income. This dual effect is evidenced in this paper Do the Rich Save More? by researchers Karen Dynan, Jonathan Skinner, and Stephen Zeldes at the Federal Reserve Board, Dartmouth College and Columbia University respectively, and this chart, which draws from the research paper. Hat tip to freebeer on the Bogleheads investment forums for pointing to the chart and the paper. As a percentage of income, people with income in the top quintile save twice as much as people in the middle quintile. People with income in the top 1% save yet again twice as much as people in the top quintile.
Higher income multiplied by higher savings rate results in a higher amount going into investments. That’s why cultivating your human capital is so important.
While you work on the human capital, you can still jack up your savings rate. Every bit more you invest will multiply into the amount you accumulate.
The Rate of Return
I used to believe that one should start out conservatively, with a classic portfolio 60% invested in stocks, 40% in fixed income, even in one’s 20s. In this view, typical target date funds, including those offered by Vanguard, are too aggressive.
When you don’t have much invested in the early years, the rate of return on a low base just doesn’t matter much. On the other hand, the first $10,000, representing all one saved up to that point, feels like a much bigger deal than it really is. I remember when I first started I called my 401k provider wanting them to reallocate the $125 in my account. That was silly.
I’m having second thoughts on this line of reasoning after I read Dr. William Bernstein’s e-book The Ages of the Investor. Dr. Bernstein made a clear distinction between investing a lump sum and investing periodic contributions. Investing periodic contributions faces sequence-of-returns risk. If you have very little in the market when it’s giving good returns, you are going to "waste" those good times. One way to have more in the market is by investing aggressively in the early years. Even if you run into bad returns in the early years, they only affect a low base anyway.
With this in mind, maybe the target date funds aren’t too aggressive after all. Read the e-book yourself in case I misinterpreted it. It’s free from the Kindle Lending Library if you have Amazon Prime. It’s only $4.50 if you buy it.
I’m sure you’ve seen the usual illustration about starting early in 401k enrollment materials. Jane starts early, saves 10 years and stops. John starts late, saves another 30 years but still can’t catch up. I always wondered why Jane would stop. Don’t stop until you reach the finish line.
[Photo credit: Flickr user Dominic’s pics]
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A timely article in NYT on your step 1: http://www.nytimes.com/2013/07/22/business/in-climbing-income-ladder-location-matters.html?hp&_r=0
“A study finds the odds of rising to another income level are notably low in certain cities, like Atlanta and Charlotte, and much higher in New York and Boston.” and “The authors emphasize that their data allowed them to identify only correlation, not causation.”
I think it simplifies the point I was trying to make: human capital can grow only when there are opportunities and if you are in midwest and south then those diminish somewhat compared to the coasts.
Simon | Modest Money says
Great breakdown! Looking at this, I think that if for any reason one cannot maximize on their human capital…then focus on maximizing the value of time. Save an invest as early as you can and in solid investments with a good rate of return…then let compund interest do the rest. That said, I believe one should always strive to maximize their earning potential, whether through more education, side businesses etc…at the end of the day, it does make the jouney to asset rich shorter!
Simon, I completely agree with what you have said.
Like many, I was a 100% stocks guy in my 20s but I just don’t think that’s the best way to get used to the nuisance of investing in capital markets anymore. I was lucky in that I didn’t get scared out of the markets back then but what if one of those 40% declines scared me out for good?
The first $10,000 of my portfolio will become insignificant in the long run, but it’s practically my pride, joy and livelihood back in the days. Losing $4,000 in a matter of months would have been devastating.
On the other hand, the difference between 100% stocks and 60/40 (stocks/bonds) may mean a difference of a few thousand dollars even if the good years were front loaded in your career. Is that worth possibly missing out on a lifetime of investing?
MoneyNing – I see both sides (starting out conservatively or aggressively). I think William Bernstein also presented both sides. I don’t have the e-book with me at this moment. According to the first review on Amazon from Wade Pfau,
“Despite the fact that young people can take much greater financial risk, Bernstein argues that young people are actually quite risk averse and should probably start with no more than 50% stocks. Then, they should gauge their reaction after experiencing their first big market drop to decide whether their appropriate stock allocation might be more or less than 50%.”
So maybe I did misinterpret the message and I should stick to my original train of thought that starting out conservatively is the better way to go.
I see pros for both sides as well. Whether to start conservatively or aggressively is probably one of those topics, like paying off the mortgage early, where people will argue for eternity because there will always be solid reasons to start down either paths.
Matt Becker says
To me, the argument of starting of more conservatively or more aggressively is less a technical question and more a behavioral one. Because the amount invested is likely to be small, the actually difference between the two strategies will be minimal. But from a behavioral standpoint, starting out too aggressively can ruin your investment outlook for like. I like Rick Ferri’s flight path approach where you start out in the middle and adjust up as you gain comfort. I don’t know if there’s actual data to back it up, but intuitively it feels like a good approach for helping a young investor learn the ropes without getting scared off.
For quite a while, we were investing 100% of my wife’s paycheck. She was working half time so she could also be a mother. That allowed us to maximize all tax-advantaged space each year, plus save in a taxable investment account, plus put money into a 529. She has now increased her work hours to 3/4 time. We are probably spending more than we used to, but we are still saving more in terms of actual dollars. Living below your means and saving a lot are probably numbers 1 and 2 in terms of gaining financial freedom. Investing in low-cost passive mutual funds and staying the course over a long time is #3.
The one other factor, as Vanguard likes to point out in its advertising, is the cost of investing. Keeping investing costs low can boost returns by 1% a year and over time that ends up being pretty huge. That includes minimizing trading costs. My 401(k) is with Vanguard and I appreciate that they limit the amount of trades you can make from fund to fund. It lowers costs for all investors.
S. B. says
The way I always think of this is that high earners can potentially take advantage of “savings leverage”. For example, suppose you are someone who earns $100K but only spends $50K. If your income increases 5% to $105K, but you can hold your spending steady at $50K, then your savings increases from $50K to $55K. In other words, a 5% increase in income can produce a 10% increase in savings. This is a type of leverage.