The Truth About Achieving Financial Freedom
In my earlier post - How to lower the cost of building wealth - I explained how investment returns compound over the long term to build wealth. But the reality for people in the early stage of their working lives is that how much they save each year will have a far bigger impact on the value of their wealth than the level of investment returns they achieve each year. In fact, it isn’t until you’ve done at least 10 years of regular savings that investment returns will outpace the amount of annual contributions to your portfolio. This phenomenon is known as the portfolio size effect.
The Portfolio Size Effect
Let’s assume you start saving £300 per month so that your fund grows to £3,600 by the end of the first year. There might be a small amount of investment growth by the end of the second year, but the increase in your pot will be driven mainly by the contributions, as a year’s worth of growth may still be less than a single month’s worth of contributions.
After 10 years of the same level of contributions, only half of the annual increase in the account balance is driven by new contributions, while the remainder is driven by growth on the existing balance. After 20 years, growth will drive 75% of the annual increases in the account balance. After 30 years, it’s almost 90%.
Source: www.kitces.com
Your Savings Rate
And how much you contribute to your long-term investment pot is also a critical factor in building wealth.
Take Alison and Rita. They are both aged 25 and earn £60,000 per annum each, which rises at 4% each year. They both invest regularly into the same investment fund within an Individual Savings Account, which achieves an annual return of 6% after costs. Alison and Rita are the same in every respect, except that Alison manages to save 7% of her gross annual salary, whereas Rita manages to save 17%.
At age 40, Rita has accumulated about £340,000 compared to Alison’s £140,000. And this disparity gets bigger over time. By the time Rita is 50 she is almost a millionaire, compared to Alison’s £373,000. And just five years later, as they hit 55, Rita’s investment pot is a massive £1.275 million compared to Alison’s £525,000.
Source: https://www.datapoints.com/
This example illustrates the stark reality that building wealth involves the drudgery and forgone pleasure of saving as much as you can for many years. That habit and behaviour, combined with a fair share of whatever returns stockmarkets deem to produce in the future, should enable you to eventually become financially free so that you can make paid work optional.