The Only Way to Accumulate Wealth
I just wrote a A Simple Guide to Financial Freedom based on my experiences with Financial Freedom. Consider giving it a read if you are interested in this topic.
The formula for wealth accumulation is straightforward:
Income - Expenses = Savings
Saving, also known as spending less than you make, is the only way to accumulate and keep wealth. There are many ways to generate income, from business, jobs, inheritance, etc. And there are lots of ways to spend money. But being wealthy isn’t about the absolute values of income or expenses — it is about the relationship between them.
Lots of rich people aren’t wealthy. Their high income does not make them wealthy if they have expenses to match what they make. If they live paycheck to paycheck they still don’t have much financial freedom.
Similarly, people with a low income can be(come) wealthy. This is especially true if we consider wealth relative to how much we need to feel good/secure/happy. A family living in a house they own with a garden where they grow their food may be more wealthy than a family working two high-paying jobs but living above their means with increasing debt.
Businesses instinctively know that to be valuable they have to create wealth. Here the formula is often expressed as:
Revenue - Expenses = Profit
Businesses ultimately want to maximize profit. And they are good at it. So you may want to start thinking a bit more like a business to become more wealthy. Your profits (savings) are your accumulated wealth.
If you don’t like the idea of a personal business mindset, consider this: in a capitalistic society (ours), your income is the wealth you create for society. Your expenses are what you consume. And so your profit is the excess wealth you produce for society. If capitalism works, it is the good you do.
To be wealthy, you want to maximize your profit (savings). To do that you can either increase your income or reduce your spending. That’s it. You only have those two numbers to work with.
But there is another important factor to consider when we look at personal wealth in relative terms. It is an important insight I learned from the FIRE community: for relative wealth, reducing expenses counts twice. First, reducing expenses means you save more. Second, reducing expenses means you need less wealth overall to be satisfied.
So, to build (relative) wealth, this is the game:
- Increase your income
- Reduce your expenses
- (Reducing expenses counts twice)