Feel Wealthy or Be Wealthy?

November 29, 2014 — Leave a comment

Did your income jump significantly at any point in your life?  If you are fortunate enough to experience that, you may face a tradeoff between feeling wealthy and being wealthy.

If you feel wealthy, you are likely to increase your spending significantly, which can make you less wealthy very quickly.  If this doesn’t make sense to you, Sports Illustrated estimated in 2009 that 78% of National Football League (NFL) players are either bankrupt or in serious financial trouble within two years of retirement.  This is a group of people who typically make several millions each year.  While this is an extreme example, you can get in trouble even without feeling adventurous or being irresponsible.

Say your income jumped from $100,000/year to $300,000/year.  You make the following adjustments to your annual expenses:  $1.5M house, with $72,000/year mortgage payments (30-year fixed loan with 4.5% interest), $18,000 property taxes, $15,000 repairs & improvements, $10,000 utilities + cleaning + gardening, $40,000 private schools for 2 children, $5,000 classes for the children, $20,000 food, $10,000 car payments, maintenance, gas & insurance, $10,000 travel & vacations, $10,000 various types of insurance, including medical & dental & medical bills for the family, $10,000 clothes, toys, household items, etc..  If you don’t have children, you may spend more on nice clothing, eating out, jewelry, hobbies, etc.

I didn’t include all categories of spending, and already consumed your entire net income of $220,000, with nothing left to save.  If you lose your job, you are left with high expenses and low savings.  Furthermore, you have no money left to help your children with higher education, or to fund your own retirement.  By feeling wealthy, and spending accordingly, your financial security dropped lower than before the big raise.

Instead, you can decide to not feel wealthy.  You increase your spending to $120,000 – a significant jump, but low enough to leave $100,000 to save.  Within a few years, you accumulate meaningful savings.  If you lose your job, your savings can carry you for a much longer period of unemployment.  In addition, finding a job to cover your $120,000 in spending will be much easier than replacing the $300,000 salary.  Here are some key ideas for making this work:

  1. Keep your focus on spending-to-assets, and strive to reach a sustainable ratio of 3%-4% per year.  While it would be impossible for most people to reach this rate for a long time (even with $300,000 or $600,000 in annual earnings), use any big jump in earnings to increase your spending modestly and your saving rate significantly.
  2. Never feel wealthy thanks to high income.  No matter how much you earn, you can end up with no financial security, and no wealth.  It can start with nicer cars, expensive jewelry, a nicer home, vacation home, full-time staff in each of your houses, yacht, private jet, private island, or private jumbo jet.
  3. Once you approach sustainable finances, you can increase your spending along with your assets, and enjoy the continued increase in standard of living without losing your peace of mind.
Disclosures Including Backtested Performance Data

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Gil Hanoch

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