The laws of the universe and saving

Why is Einstein here? Compounding savings of course!

Why is Einstein here? Compounding savings of course!

Einstein himself said it, “Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it”. What he in essence is saying is that it is an amazing fact of life that something innocuous and consistent that compounds over time can become very large. In short, compounding and saving are a critical component of getting things right on a personal finance front.

So for me there are two important parts of saving, savings rate and how you save. so lets dive into this.

Savings Rate:

So this one is important as it’ll scale the timelines of things you can do with money and I’ll touch on later. To begin with, you’ll need to be able to save something, anything. If you cannot save anything at this time unless you’re on the poverty line it’s time to re assess what is really important to you and what you need to cut from your life that isn’t necessary. A good place to start is the multitude of minimalist articles out there on the interwebs. You can do this, or look at what you need to do to generate more income. For the vast majority of people in Australia though it’s a matter of reducing costs. The goal here is ultimately to be spending less than what you make, however you do that either by raising income or cutting costs is up to you.

From here, how much you can save is going to determine how much you can put aside and then generate more income with eventually. 10% of income for instance might be relatively easy to do, but you’ll be doing this for quite awhile on an average Australian income. 40 – 50% of income or higher is extremely difficult when paying your own expenses but possible. You’ll find alot of people doing this are either on high incomes or live with mum and dad but there’s a few rare people who manage this themselves, that said it’s not easy. 20% of income or so is decent and will certainly get you to some interesting positions. Keep in mind when working out savings rates in Australia, most comparable rates from overseas do not take into account our superannuation system, so 10% of net income (after tax) with 9.5% superannuation in Australia is a savings rate more like 19.5% for an American. Just obviously, with superannuation you’re not accessing this until retirement.

Lets use ASIC’s calculator as an example for after tax and superannuation situations. Below are three examples, Lets work this around an income of about $70,000 per annum which works out to be about $2086.00 a fortnight after tax.

This first example is over a 10 year time line, saving at 10% of net income. If you round this, you’re looking at about $200 a fortnight saved. Let’s assume a 3% interest rate which is about as good as you’ll get right now in a bank, your mileage may vary with other investments, interest rate changes and inflation effects;

Example 1

In this instance, this has returned $60,555. Not too shabby for basically something most people could do half asleep, but not huge either.

So let’s kick this up a few notches to 20%..

Example 2

This equates to $121,109, getting a bit better no?

Alright, let’s try 40% to see what’d happen if you really turned this up a few notches;

Example 3

This gives you $242,218, much better huh? This in many places in Australia is almost the cost of a house or more than enough to do some serious investing for better returns.

In any case, however you do this, what you probably noticed from the graphs was as you go along, the money that you put in ends up becoming smaller and smaller in comparison to to money that is returned on your investment. In short, this is the power of compounding at work.

 

How you save:

So after reading the above, you might be thinking, ok this is great, I’m going to try to build a surplus of income and start saving now. Great! However, how you do this and the consistent discipline are just as important to success as the actual ability to start saving itself.

What I recommend in regards to this is;

1 – Setup your savings isolated from your bank accounts you use for transactions, see my post here. This reduces the risks of impulse spending chipping into your savings.

2 – Setup a regular debit from your pay or immediately after you pay goes to your bank account to immediately go to your new savings bank account. This will ensure consistent savings and ensure there are always funds available to transfer.

3 – As you begin to adjust to life with a certain amount of income being cut off the top into your savings, up your savings rate slightly say from 20% to 25%. Eventually you’ll reach a point where it’s impossible to do more, however, this works like boiling a frog where if you do it slowly and consistently you’ll barely notice until you’ve reached the limit of your capacity to save.

It’s not much more complex than that really, there’s no secret formula the Illuminati have been hiding from you. Consistency, discipline and time are what’s most crucial here.