Most of the financial advice you’ve heard during your lifetime is full of lies and half-truths. I’m sure you’ve heard some common advice like:
- Max out your 401K plan
- Slow and steady wins the race
- Compound interest over time will deliver millions of dollars
- Stop drinking $5 coffee and you’ll be a millionaire
- Cut up your credit cards and only pay cash to cut spending
- Save 10% or more of your salary to live like a king in retirement
- Real estate is the key to building wealth
- Mutual Funds are the key to building wealth
- Saving is the key to building wealth
- Dividend paying stocks are the key to building wealth
Could anyone possibly follow all this advice at the same time? How many paths can be the “key” to building wealth? How many people do you know who have followed these strategies and become rich?
If you take a moment to look at the larger picture, you can tell something isn’t right. There must be a way to find out which advice really works, and which advice will never have a chance of working.
Math can help. Don’t worry; you won’t have to do any math. The calculations will be done for you, but the beauty of math is that you can grab your calculator and verify everything. You don’t have to believe the advice; you can test it yourself. The examples show why the advice you’ve been taught doesn’t lead to the results you thought it would. Financial formulas may seem confusing, but they can show with 100% certainty if an investment strategy or savings plan has any chance of success.
Let’s start out with a simple, but critically important formula:
INCOME – EXPENSES = PROFIT
Think about a family budget. Income is the salary earned from a job. Expenses are all the things you spend money on like rent, groceries, gas, and electricity. If you subtract what you spend (expenses) from what you earn (income) you’re left with profit. If you spend exactly what you earn your profit will be zero and you won’t be building any wealth. If you spend more than you earn your profit will be a negative number and you’ll be losing wealth. Just plug in some example numbers to prove this.
| INCOME | - | EXPENSES | = | PROFIT | |
|---|---|---|---|---|---|
| $3,500 | - | $3,000 | = | $500 | Building Wealth |
| $3,500 | - | $3,500 | = | $0 | Going nowhere |
| $3,500 | - | $4,000 | = | -$500 | Losing Wealth |
It shows with absolute certainty that you should never spend more than you make if you want to become rich. Is there any doubt that someone who spends $4,000 per month but only makes $3,500 per month will never get rich? If you want to get rich you absolutely must spend less than you make.
How about a basic savings formula? Saving $5 a day instead of buying a latte sounds like a good place to start.
SAVINGS PER DAY * NUMBER of DAYS * YEARS = TOTAL SAVED
This first formula can prove one very simple bit of financial advice:
“Spend less than you make.”
Take the $5 that would have gone to the coffee shop and deposit it in a savings account. If you purchased a coffee every day of the week you multiply the $5 by 365 days per year. Next take the total savings for one year and multiply by the number of years you expect to save.
| SAVINGS | * | DAYS | * | YEARS | = | TOTAL SAVED |
|---|---|---|---|---|---|---|
| $5 | * | 365 | * | 1 | = | $1,825 |
| $5 | * | 365 | * | 5 | = | $9,125 |
| $5 | * | 365 | * | 10 | = | $18,250 |
| $5 | * | 365 | * | 30 | = | $54,750 |
| $5 | * | 365 | * | 50 | = | $91,250 |
Once again, we’ve got some interesting results! At the end of one year, saving $5 instead of buying a coffee would grow to $1,825. That’s a good amount of money but not enough to retire on yet. Even in the absolute best-case scenario where you start working at age 15 and retire at 65 (50 years) your total savings would be $91,250. Could you retire with $90,000? Would you feel rich?
A slightly modified version of this formula is the basis for the $20 Challenge which is a quick way to build up a $1,000 emergency fund in less than a year.
Several items have been left out of this formula to keep it clear and concise. The formula assumes that your savings do not earn any interest. This is equivalent to taking $5 a day and stuffing it under your mattress. Inflation also isn’t taken into consideration. Compound interest and inflation are covered elsewhere. Rest assured, the formula above shows a much brighter picture than reality and still falls far short of a road to riches.
The two simple math equations above show that you should never spend more than you earn and that giving up a $5 daily coffee won’t make you a millionaire. This is basic math that anyone can do. Don’t take celebrity financial gurus at face value. You have the tools to test their advice and you should.