Updated: Jan 6, 2020
Whenever I discuss the concept of financial independence, there will be a handful of people who pushback and say that the concept of financial independence and financial freedom is only available to people that make a lot of money.
While it is true, people who make a lot of money have the potential to build wealth more easily, it is possible for just about anybody. There are a lot of choices we can make every day that can help us build long term wealth.
Stop saving & start investing
I can' think of a single person that has ever created meaningful wealth by sticking all of their money in a savings account. Unless you find a way to make your money work for you, it will be a long time before you reach financial independence (if ever).
This is especially true with interest rates where they are today. Most interest you get from a savings account is not enough to even cover inflation. That means in "real" terms, you are slowly, but surely, losing money if you keep it in a savings account.
To understand why this is true you need to understand the concept of nominal and real interest rates.
Nominal interest rates are the interest rates posted by the bank.
Real interest rates are nominal rates minus inflation.
For example, let's say you can get 1.5% interest on deposits in a savings account and inflation is 2%. The real interest rate on your savings is -0.5% (1.5%-2%). In this example, inflation is slowly eating away at the real value of your money.
Keeping all your money in a savings account is like filling a bucket up with water. Only the bucket has a hole in it so small, it's invisible to the naked eye. You put the bucket down and everything seems fine. But, If you leave the bucket for long enough, the water will slowly start draining from the bucket.
If I may extend the analogy a little further, let's say the goal is to fill the bucket up with water. Every two weeks you are able to pour a small cup of water in the bucket. Even without the hole, it's going to take a really long time to fill the bucket up. With the hole, you may never get the job done.
Your money is water.
The savings account is the bucket.
Once the bucket is full, you can retire.
The invisible hole in the bucket is inflation.
What if the bucket filled itself?
If the bucket did not have an invisible hole in the bottom, it would be much easier to fill up. It would still take a long time if you can only add one cup of water every two weeks, but at least you wouldn't lose any water.
Filling up a bucket with no hole would be equivalent to investing your money in something that was exactly equal to inflation. You're still doing all the work, but at least your not losing water over time.
But, what if the bucket started filling its self up? That would sure make the task of filling the bucket a lot easier.
That is exactly why you need to invest. Specifically, you need to invest in assets that will have a rate of return that is greater than inflation.
What you invest in is up to you, but the 3 most common asset classes are;
Pick whichever asset classes you feel comfortable with. The point is you need to start putting your money into assets that will increase in value and produce passive income over time.
Returning to our bucket analogy, investing will create a tiny trickle of water into the bucket. The bucket will slowly start filling it's self even when you are not around to pour water into it.
Overtime the self-sustaining trickle of water into the bucket will get bigger. Eventually, it will be adding more water to the bucket than you are. Then one day, the bucket is full and you find that you only had to fill less than half of it yourself.
Let's say you are saving $1,000 per month for retirement. You can choose between two savings options; putting the money in a savings account or investing it. How much would you have after 30 years if you chose the savings account and how much would you have if you invested?
I'll also assume the following:
Your stating with $0 currently saved.
Inflation is 2% per year.
The savings account interest rate is 2% per year.
Investment returns are 7% per year.
If you chose the savings account
You would have $360,000 after accounting for inflation.
Every single penny of that $360,000 have would come from your savings as inflation was exactly equal to the interest rate you received.
If you chose to invest
You would have $832,258 after accounting for inflation.
Your total contributions would be $360,000
Investment returns would make up the additional $472,258.
By choosing to invest rather than save, you would have accumulated an additional half a million in real wealth without doing any additional work.
This should make it clear why you need to stop saving and start investing if you want to build wealth and reach financial independence.
That being said
I'm not saying you shouldn't have any money sitting in a savings account. Priority one of any good financial plan should be building an emergency fund of cash savings. A savings account is a good place to hold your emergency fund.
Once you have a well-funded emergency fund established it's time to stop saving and start investing.
Investing is necessary if you want those buckets to start filling themselves up.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.