How Savings Builds Wealth -- Why Save?
Several reasons exist to answer the question of "Why save?" These three remain at the top of my list:
- Saving is a form of investing -- making your money work for you
- Saving blesses those around us -- reduces the financial burden of our well-being on others, allows us to give and share with our children and grandchildren
- Saving prepares us for the unexpected -- helping to mitigate the cost of unfortunate events
Hopefully, this series on savings is the start of an informational and inspirational understanding of the time-tested truth of long-term savings. Look for future installments on the next few Fridays, based on my book, Baker's Dozen -- 13 Effective Principles for Financial Success.
ESTABLISHING A CONSISTENT SAVINGS PLAN
"AAAAGH," you say! "NOT SAVINGS! People tell me I must save money all my life, and I hate it. Why do all financial principles seem to start here?"
You may be one of those rare individuals already a successful saver. Whether you are or not, any book on the principles of financial success could not start any other place. Financial success begins by understanding the first universal law of wealth—accumulation, and it is the foundational principle of financial independence. To achieve financial success, you must develop the proper savings ethic. This strategy is a well-documented economic fact. But before we look at any methods for developing a savings ethic, let's study the sources of income.
THE SOURCES OF MONEY
Two primary sources of income exist, man or woman at work and money at work. People earn an income by rendering services. The more skills you have, the higher the pay. All you must do is look at the list of the highest-paid executives in America to see that some jobs dictate incredible incomes. Whether the president of a prominent public company or a famous athlete, the individual's value and job requirements dictate the pay -- compensation for skills brought to the job, as opposed to those paid based on the value of the job irrespective of their abilities.
PEOPLE AT WORK
What motivates getting up every morning, getting in the car, and heading to work? For most, the goal is to earn enough money to pay bills and have something left over for fun—vacations, toys, clothes, etc. The economics of earned income, derived from people at work, is easy to understand. The more an individual can contribute to their job, the more valuable they become. Hence, the more the person can earn as management recognizes the person's contribution to the organization's success. The government even subsidizes additional education through tax deductions if it is job-related. If a job is the sole income source, you must enhance your value and create your own "dividends" by increasing your value. Deriving surplus from earned income is the beginning of financial independence for most people.
Unfortunately, there is no way most wage earners can become wealthy by just earning a salary. By the time taxes and inflation erode the purchasing power of their surplus (even with raises), most wage earners have little left to show for their efforts. The age-old battle is finding a way to put some surplus income aside to create capital. You are doomed to live month to month unless you can overcome the inertia. The only solution is to convert income into capital.
MONEY AT WORK
Money works when invested in a company's growth that pays "rent" or "risk premium" for using your capital. Wouldn't it be great to have $200,000 of annual income, which was completely risk-proof and you knew would be there every year without fail? Capital, if invested successfully, is rewarded by earning a steady income, and the investment value generates a willing user's desired income or required growth. For instance, stocks pay income, called dividends. If the corporation earns a profit, the Board of Directors may vote to give a dividend to shareholders as a continuing incentive to remain an investor.
In addition, investors may enjoy an increased value (appreciation) on their stock holdings. If other investors think the stock's market value is worth more than the market value, they will purchase the stock from those who want to sell it. When this occurs, the price should rise as the bidding continues. But, of course, the opposite can happen. The stock could decline in value as buyers are willing to sell for a lower price. All the while, the investor may still be receiving a dividend. A dividend is an income earned by having your money at work. Appreciation adds value to your money when other investors think your investment is more valuable than what you originally paid for it. I call this the risk premium— value-added for having been willing to lose some of your money if the market value had declined.
Real estate pays a dividend, too, called "positive cash flow." Gross income is derived from the rent users pay to occupy the facility. Property owners must care for the property and incur expenses (mortgage payments, taxes, utilities, leasing commissions, and maintenance). They pay the expenses from the gross income. The cash flow is negative if earned rent does not cover these expenses. Negative cash flow means you will have to subsidize the shortfall from your other income. I call the income above the expenses "the money that money makes." Because of various risk factors, the return on your invested capital can be high, but it can also be relatively low. Economic success all depends on how an investment appreciates.
Of course, no one would ever buy an investment with the idea of losing money. Imagine Bill coming home to his wife and saying, "Ethel honey, I think I'm going to invest in this office building so I can lose $235,000." Hardly! Everyone invests with the idea they will make a lot of money when they sell the investment. But many investors are foiled by the unexpected.
The lack of planning or lack of liquidity has defeated many investors. They try to save the investment by pouring good money after bad (figuratively speaking) to save a losing venture and their original investment. From my experience, it is tough to let go and admit defeat.
On the more conservative side, you can always put your money under a mattress. But assuming that is not reasonable, you could invest your money in the bank at a fixed interest rate. The bank pays you an income as an incentive for depositing your capital in their institution. The bank takes these deposits and loans them to businesses (called commercial loans) or makes consumer loans. When companies borrow money, they assume the risk of failure and defaulting on the loan. The saver or depositor is paid a wage (interest) for providing the capital. Bank failures emphasize the nature of the saver's risk. If the bank fails and can't repay the savings accounts, the saver's only recourse is the FDIC insurance limits (currently $250,000). But understand that the saver receives no premium for taking this risk. The same risk also applies to money market accounts where the saver purchases a certificate of deposit or a banker's acceptance note.
(Watch for next week's article when we will discuss developing a savings ethic.)