Saturday, June 03, 2006

Levels of Frugality and Wealth Creation

There is a lot of personal finance advice out there on the web and a lot of it is quite good, but of course little or none of it is tailored for people's specific financial situations. The things that are going to be important to focus on are going to change not only with people's life stages but also with their wealth and income relative to expenses. I've seen quite a few discussions in the blogosphere about whether paying attention to the latte factor makes a difference or whether PF bloggers are saving too much for retirement. And then there are people with negative net worth giving advice to supposed multimillionaires.

So here are some random thoughts:

1. If you are a student or on a low income the key is not to get into a level of debt which will be hard to stablize or pay down once you start working or get into a higher income job. Being very frugal is going to help. But it doesn't make sense to make undue sacrifices if you know your future income is likely to be much higher. My Dad told me I should be saving when I was a grad student rather than borrowing. I ignored his advice, to my mind that made no sense.

2. If you are earning roughly the average income for your city, country etc and can't make ends meet, then serious frugality intervention is required to get back into balance. This is where the stop buying crap, latte factor etc. are going to be important. Otherwise, I think even if you expand your income, your expenses probably will expand at the same rate. This has never been a problem for me or some others. We are just lucky to have had the frugalness meme instilled in us I guess. So I don't discuss this at all in my blog.

3. Once you have that under control then I think income expansion becomes the next focus whether increasing salary, or business and investment income. My focus in the blog is on the latter and how to manage the money. The key I think is to expand expenditures slowly and smoothly over time so that they always remain far behind income.

4. Once you have money to save then the natural focus is where to put it. When your monthly savings are still relatively large compared to your total wealth, managing the money is probably less important. For example, if the stock market goes down, the dollars you lose will not be very many and your new savings will buy more shares through dollar cost averaging. At this stage all the usual PF advice about building up emergency funds, index fund investing, different types of retirement accounts etc. is most relevant.

5. Soon enough you have more wealth than annual income or several times more wealth than annual income. The absolute dollar impact of each investment decision becomes greater. At this stage, searching for superior investment managers, seeking true diversification, thinking about market timing strategies etc. becomes much more relevant. That is the stage where I am at with financial wealth equal to more than four times annual income. So it's what I am mostly going to blog about. Buying real estate (or not) I think should come in at this stage. Most middle class people are house rich and financial asset poor. No surprise that I'm not a big believer in the usual advice about buying a house. To my mind it would usually be a good idea to get beyond stage 4 at least first, but this will differ with local conditions and personal preferences.

There are stages beyond here of course - when true wealth is reached and you can live off of business income, investment income, or retire. Or take an increasingly proactive role as an investor.


makingourway said...

I agree with your thinking and have heard it before.
Income expansion is absolutely critical and a priority when your investment base is small.
Likewise, later on, your investment decisions have a far greater impact when your savings are multiples of your income.

One key issue plaguing a few of my friends in their 30s and 40s are false income plateaus. They simply don't think they can make te career changes to earn more than they currently earn. Even though their aspirations are a bit greater. I suppose this is where risk tollerance comes in.

What concerns me is that the same people become much more aggressive in their financial investments while letting their careers stagnate.

In my book, they're putting their career income at risk as well as their savings growth at risk.

The ultimate question is how do you know when your earnings have peaked?

Which risk is worth taking:
career risk (job change to earn more)
principal risk (more aggressive investing to offset stagnation of income)


mOOm said...

This is actually exactly how I see myself. I have done well in my career up to this point and got to be a highly published tenured professor at a research university. In the last few years though I have applied for many other jobs across the US and not received one interview. My girlfriend is also in academia - completing her PhD this coming year. The chance she gets a job in my area is very low (she is a foreign student and I am still waiting for my green card). So I would like to have the flexibility to move (and my previous relationship broke up partly because the difficulty to move due to career and visa issues on both sides). I am working on improving the trading in order to get to the stage where I could live off it. If I could pull that off the income growth potential is far higher than in my current career path too. Last pay rise was 1.5% after getting a strong/excellent evaluation. In trading your income can rise as fast as you can save. If you can make enough to live wirthin your means you can get on a fast track trajectory. But that take off point is crucial.