Category Archives: Frugality

Your Savings Rate: Why it is the most important metric in personal finance

euro notesA personal savings rate sounds like the most boring term in personal finance. It is something most people are not concerned about or have no idea what it is. However, I consider the savings rate as the single most important metric when dealing with finances.

Why it is important

Imagine that you are striving to achieve Financial Independence – a state in which you have assets generating income which exceeds your expenses. If you read this blog and follow the strategies, as a general rule you would need to have stock market investments which equate to at least 25 times your annual expenses. Such an asset base is huge and can take many years to build up.

As an example suppose your core monthly expenses are £1,000 and your monthly net income is £3,000. You would need an asset base of £300,000 to be Financially Independent (£1,000 x 12 x 25). At a healthy 50% savings rate (£18,000 per year) it would take 10 years to reach this goal as determined by the compound interest calculator below.

compound interest calculation example

300K accumulation at 50% savings rate

This calculation assumes a typical annual stock market return of 9.5%. As £300,000 is a lot of money it is easy to presume that the bulk of the amount would be raised due to investment returns. Surprisingly, this is far from true; compound interest, what Einstein called the eighth wonder of the world, only starts to kick in with a meaningful effect after a long time. Even this 10 year period is relatively short when thinking of investments.

Over 10 years the amount raised by savings would be £180,000, a proportion of 60%. If investment returns are less than 9.5% it would take a much larger proportion of savings to achieve the same goal within this time frame. It is entirely plausible for investment returns to be as low as 5%. At this rate the investor would need to save an astonishing £276,000, or 92% proportion, in the 10 years in order to achieve their goal.

Savings rate needed at 5% returns

Savings rate needed at 5% returns

These calculations prove that along with keeping investment costs low, avoiding debt and minimising taxes, a high savings rate is one of the sure ways to guarantee accumulation of reasonable amount of wealth.

Proportion of savings needed at a 9.5% return vs 5% return rate

Proportion of savings needed at a 9.5% return vs 5% return rate

You can not control or forecast investment returns but you can control how much you spend which directly impacts the savings rate.


Fascinating alternative scenario*

The above two investment return rates are very realistic. Just for fun, if we assume an overlay optimistic return rate of 20%, the size of nest egg generated would be truly astounding. I repeat that this is overly optimistic and would be in the world of the likes of Warren Buffett. Such a rate would result in a portfolio of nearly £600,000 over 10 years! This is very unlikely but to give yourself any chance at this the high savings rate would be key. The good old savings rate stops being boring here.

Portfolio value with very optimistic 20% savings rate

Portfolio value with very optimistic 20% savings rate


Calculating your Savings Rate

There are many ways out there for calculating a monthly savings rate. Here is my take on this. The savings rate has to be taken in context of net income which you can actually access rather than gross income. Therefore the savings rate would be the proportion of money which is put away in relation to the money which is actually made available. Savings rate = sum of savings / net income.

Sum of savings can include the following:

  • savings into cash accounts
  • investments in stocks and shares
  • personal pension contributions
  • employer pension contributions
  • government pension tax relief payments
  • income saved from other employment sources such as business proceeds

Regardless of which method you use, the key thing is to maintain a high rate. There is little point investing a tiny amount in even if you get exceptionally high returns. As this year has shown, market volatility is never far away. You can only control what you can and when opportunities arise it will be those who maintained high savings that will reap the benefits.

Interesting reading:

     

Heatwave – How to avoid blowing your budget in summer

Studies show that people spend a lot more money during the summer months than in the other times of the year. This is understandable as the days are longer and weather better, which leads to more fun activities to do being available. However, if the spending is not kept in check this can easily wreck your budget and derail any plans for financial independence.

This year’s summer has been impressive so far across the world, with temperature regularly topping 30 degrees Celsius in the UK with not a drop of rain in sight for weeks. Here are a few top tips to keep your finances on track.

Track expenses and stick to a budget

To achieve financial independence it is crucial to know how much you spend in an average month, which enables you to get an accurate picture of your annual expenses for determining how much net worth you need. There are many tools for tracking expenses like YNAB or Mint for US residents but I prefer to use spreadsheets as these can be tailored to produce specific outputs/ calculations.

Once you know the expenses you can create a budget for forecasting future expenditure. This can include an allocation for known unknowns which are expenses which occur every year but are not regular. These are not bills but for things such as holidays, car maintenance, repairs and presents. They should not be swept under the carpet or they will cause havoc to finances if you do not have an emergency fund. Staying within the budget should be done to avoid compromising other objectives.

Personally I do not set aside a specific amount for these monthly. Instead, I aim to invest as much as possible every month to ensure the cash is working as hard as possible and then directly spend on the expense as soon as it comes up. This ensures that there is a minimum amount of cash lying idle at all times. When an urgent unexpected expense comes this can be quickly dealt with by deploying and emergency fund which should be rarely used.

Plan for the future

According to Benjamin Franklin “Failing to plan is planning to fail”. This is entirely true when dealing with summer expenses. Advance bookings for holiday flights, trains, parking, car hire, foreign currency, accommodation usually saves a lot of money. Researching a destination thoroughly before you land also helps to avoid falling into tourist traps which are common as highest expenditure is ofter during the first 24 hours of a holiday.

I avoid package holidays where you can be ripped off along with other gullible tourists but plan things individually which provides more control and less cost. It is also important to get good travel insurance. Cheapest is not always the best here so it is crucial to read the terms and conditions.

There are also several activities which can be done for free or without spending much. I suggest having a few weekends like this in a month and then actually spending accordingly on what you value when the time comes. According to Noddle, the credit service report provider, British people typically overspend by £154 a month during summer. Overspending typically kicks off in April/May and just ramps up all the way until the end of the year, with may using credit and dipping into hard earned savings as a form of funding.

UK household net lending. Source: The Independent

The scale of the problem is illustrated by the chart above and ONS statistics showing that household spending is now more than income for the first time since 1988. This is through a combination of reducing savings levels and taking on more debt where summer spending can be a big factor.

These top tips, along with good discipline can help to ensure staying within a prescribed budget and avoiding short term lifestyle creep which can lead to long term financial impacts.

You might also like:

Interesting reading:

     

The Number 1 secret of the rich

The Sunday Times Rich List 2018 had some fascinating insights. The list, released on 13th of May, shows that self made entrepreneurs now dominate the top of the list as opposed to old money did in previous times. This got me thinking; what are the people at the top doing to get and stay there?

Rich Dad Poor Dad – Leveraging the Philosophy

Although the list is very diverse in the ways that the fortunes were made, there are a number of common traits which are possessed by the successful. The wealthy tend to accumulate assets which generate income instead of liabilities which can drain your finances considerably.

This methodology is clearly defined in one of the great investing books; Rich Dad Poor Dad by Robert Kiyosaki. However, in this article, I look into exactly how the wealthy tilt this strategy and do things in ways that others don’t.

In the belief that appearing wealthy needs one to have flashy property such as cars, clothes or jewellery, people tend to spend most or all of their savings or use credit to acquire these. This is not effective and will only result in you looking wealthy but you will really not be.

A carpenter’s tools are vital to them

The main difference is that the wealthy build up their assets (tools) first and then, like a carpenter, use the proceeds of these assets to help obtain other properties which can be classified as liabilities. You should not assume that these individuals are wealthy because they may already own fancy property but that the properties are a side effect of having other income producing assets.

Using this approach, it is easy to see how it is a lot easier to accomplish financial objectives once you have amassed substantial assets. This is best shown by an example:

Imagine if you want to buy a car worth £10,000. A person with poor financial literacy would probably use a loan or car finance to make the purchase as quickly as possible. At a typical loan rate of over 5% a year, the total payment can be over £12,000 after a few years. If the person saves £500 a month it would have taken them 24 months to raise the full amount.

A smarter approach would be to save up front and then buy the car for cash. At the same £500 a month savings rate it would take 20 months to cover the £10,000. That is a full 4 months better of than the borrower. Look at it as 4 months of getting up early and going to work every morning, dealing with everything that comes with it, wasted. Time is our most valuable commodity and is finite.

This may seem impressive but there is an even more fascinating way to look at this by using the number 1 secret of the rich.

For the third approach, imagine that you are an employee and first build a portfolio worth £50,000 which can consist of income generating assets such as stocks or rental real estate. Assuming an annual return rate of 10%, after a single year the portfolio would have generated £5,000 of income. If you decide to purchase the vehicle at this point it would only take another £5,000 of your hard earned income.

If you were prepared to wait for 2 years, the portfolio would generate £12,000. Enough to cover the purchase without the need for any hard earned cash at all. For a 3 year period which is typical for a car loan as in the first scenario, a very large amount can be raised which can allow you to by a more premium car without much effort.

This is just a small example but the same line of thinking can be used every time you purchase liabilities such as cars and a house you leave in. This requires a lot of restraint and delayed gratification but you will reap the benefits before you know it. Spending it all without having built up a substantial asset base is like taking the tools away from a carpenter.

How to create an effective Financial Independence budget

The key to achieving financial independence is to create an effective budget. I have found that a realistic budget can be the core of a number of calculations which help to determine various metrics related to financial freedom. In this article, I will have an in depth look at this often overlooked tool and show how powerful it can be.

Why You need a budget

A budget is the most basic element of any financial plan. It enables you to forecast how much you are likely to spend over a particular time period such as the next month, week or year. Once you know the likely number, for example, expected monthly expenditure, you can calculate how much money you can set aside for investments or savings by subtracting the amount from your take home pay.

Of course things are not always perfect and during some months you will spend more than expected. This can be mitigated by having a cash buffer in your current account; a minimum bank balance which you are comfortable with. This can be as little as £200 and it can also help to avoid bank charges for overdrawing.

Budget template for Financial Independence

Budget template for Financial Independence

Know your essential and discretionary expenses

As you can see from the budget template above, the expenses are split into various types: essential, discretionary and work. It is important to know your essential expenses as these will let you determine your progress towards financial independence. Essential expenses are a necessity, usually occur monthly and include food, accommodation, utilities, property or council taxes.

Discretionary expenses are not needed and can include travel, eating out, entertainment, gifts and recreation. These a lot easier to eliminate or reduce when required. I have also included work related expenses as these can be substantial depending on your occupation or how you travel to work.

Some jobs require costly clothing, training or travel which may have to be covered by the employee. It is not uncommon for UK commuters to pay upwards of £5,000 or $7,250 a year on rip-off train fares. Costs like this are life changing and can easily derail any plans for financial stability.

Calculating your Financial Independence numbers

Once the budget is ready and verified to be realistic it will be come possible to estimate how much you need to have in investments in-order to declare financial independence. Simply multiply the essential monthly expenses from the budget by 12 to get the annual figure and then multiply further by 25. Work related and discretionary expenses are excluded here.


Financial Independence Fund = monthly expenses x 12 x 25


Note that, based on the 4% rule, this would only provide coverage for your core essential expenses but not include any extras or lavish spending. Such a low amount may not seem sufficient but can have an extremely powerful psychological impact and I will explain why. You should also realise that the amount is low only as a figure, but as the money is generated as passive income it is worth a lot more than money generated actively. Active income involves work, is heavily taxed and requires your to trade your time for cash.


If you can cover your base expenses would you be more comfortable to step away from a job you don’t like or take several months or weeks off to go travelling without worrying about money? The answer for me is yes.


If you can cover your base expenses would you be more comfortable to step away from a job you don’t like or take several months or weeks off to go travelling without worrying about money? The answer for me is yes. A lot of other options will open up for you such as trying another occupation, becoming a contractor, self employment, volunteering etc.

Goal Progress –  a useful insight

A really useful insight that can be gained from this exercise is to determine how far you are from financial independence. As a percentage this is determined by dividing your total investments by the financial independence figure calculated above. I regularly do this calculation and share my result here.

The progress number will vary inversely to how big you budget is: an increased budget will reduce the number and cutting you budget will increase the number, bringing you closer to financial independence, which shows the important of cutting costs and saving more. Tracking these metrics will help to optimise your finances according to your goals.

Other articles on investing