Everybody’s financial journey has to start somewhere. Focusing first on the expense side of your personal finances is arguably the most important aspect of personal finances to master early on. It sets the foundation for everything that’s to come. After all, it’s not about what you make, but what you keep.
Warren Buffett has a simple rule to live by when it comes to the preservation of capital. Rule number one, don’t lose money. Rule number two, don’t forget rule number one. The goal isn’t to save for financial freedom, but once you master the skill of preserving your money for wealth building, you’ll have a solid foundation to grow from. This foundation will provide the security you need to make risker entrepreneurial and investment moves that pay off way down the road. First save, then grow.
We’re not going to suggest that you prioritize frugality at the expense of everything else in your life. I know too many people who have taken frugality to the point where it negatively affects friends and family. Having fun experiences is important to living a happy and fulfilling life and money should be used to live life according to your terms. Remember, we’re not doing this for the sake of money, we’re doing it for the experiences and memories that money can facilitate for us. That being said, anyone who has hopes of reaching financial independence in the future needs to be prepared to sacrifice in the present.
Why is being frugal so important? Simple–compounding returns. Having a higher annual savings rate simply means that you are making more money than you need to live on. A frugal person can use this surplus to reduce the future working hours required to retire.
Let’s say that you make $100,000 per year at your 9-5 job after taxes. If you are only able to save and invest $10,000 per year, that means that you are living on $90,000 per year. A 10% savings rate would mean that you’d have to work 9 years just to save up enough money to take off work for one full year. If we were to be a bit more aggressive with our savings rate and save 30% of our annual income, then it would only take 3 years to save up enough money to replace a full year’s salary. That’s a massive difference in time. Do you think the sacrifice would be worth it?
Now that we understand the time value of frugal living and maintaining a higher savings rate, let’s discuss how to best optimize your savings plan.
Step number one is to take an inventory of all of your expenses. The easiest way to go about this is to create an excel spreadsheet and itemize all of your monthly and one-off expenses. We suggest that you go back three months to get a full picture of your spending habits. After you’ve inventoried your expense history, now it’s time to put a plan into action.
Step number two is to identify what spending areas we need to focus on. Conventional advice leads many savers down the “frugal at all cost” rabbit hole. Unfortunately, cutting out that Starbucks latte and making coffee at home isn’t going to get you materially closer to your financial goals. It helps on the margin, of course, but we need to apply the Pareto 80-20 Rule to optimize your efforts for the best results possible. To simplify, what are your biggest expenses that we can influence to yield the biggest cost savings? Make a game of it. Ask yourself, “is what I’m spending money on worthwhile at the expense of future financial freedom?”
After taxes, your average household’s largest expenses are going to be housing, transportation, and food. Optimizing these expenses is likely going to require the most effort, but at the same time will provide the most benefit. On housing, you can choose to househack a small multi-family so that your housing costs are 100% covered, or you could decide to scale down and live in a smaller home. On transportation, you can get rid of your gas-guzzling truck in favor of a compact car (or even a bike if at all possible!). On food, you can pack lunch everyday for work and host potluck dinners at home rather than going out to dinner and the bar with friends on weekends. These are just a few examples of the changes that could be made in your life, but the point is that you need to take a look at your lifestyle, what it costs, and think about the ways that you can enjoy a similar lifestyle at a lower, more optimized cost.
Step three is to build wealth. Now that you’ve optimized your spending and adjusted your living conditions to facilitate a higher savings rate, you’re now in an ideal position to focus on income and growth. We’ll save those strategies for another time!
There’s a huge psychological element to all of this, which you’ll come to appreciate after you dramatically increase your savings rate. A lot of people become trapped in bad financial habits because they spend the entirety of what they earn. That condition chains them down to a scarcity mindset because the first thought they have when analyzing any financial move is simply based on survival. How can someone risk $10,000 on an investment when you can barely afford to live? Being frugal enables you to recognize, and take advantage of, opportunities to increase your income. In a way, when you are able to save more, taking risks actually becomes less risky.
Becoming a good saver is a time-consuming and intentional process that takes years to master. Our best advice is to create systems and habits to support the goal and hold yourself accountable. It’s not easy, but it’s worth it.
Let’s kick the 9-5!
Decide. Commit. Take Action.
