I recently had a discussion with a friend of mine on whether or not it’s possible to save your way to a million dollars or if it’s only possible to earn it. We talked about it from many angles, and yes it’s possible, but it’s very unlikely. You’ll have to live very cheaply for a long time, at least more much more cheaply than I care to.

So how did we come up with this finding? Like most of the other articles on this blog, I worked out the numbers. Today’s article is all about the numbers we worked out during that discussion. We’ll start from one angle and then work the what-if’s, how-to’s, and what-about’s after.

Ok, let’s start with a basic premise, let’s start with a salary. Where do we start here? To make things simple, let’s take the median Californian’s household salary of about $54k. Let’s assume a 25% tax rate straight off the top (which is probably lower than the actual rate, therefore working in our favor), leaving us with $40.5k in net income. Now, according to “The Wealthy Barber”, we should invest 10% of our income. Again to pad it in our favor, let’s make that 10% of gross (pre-tax income) rather than the net income. This means we will put away $5.400 a year into an investment instead of $4,050. As for the interest rate, let’s take an easy to measure interest rate, the current 30-year fixed US Treasuries rate of 5.375%/year. After 30 years, you would have $391,792.50 in your account. You’d be short about 61% of your goal of a million dollars!

Alright, now that we have a baseline, let’s start looking at these numbers in more detail, let’s change them, and let’s work with different assumptions. Ok, first, what if instead of 10% we saved 20%? What difference would that make? $783,585.05. Much closer but still over 21% short of our one million dollar goal. To make our goal of one million dollars we would need to put away $13,782.81 each year! Assuming a median income of $54k, that represents over 25% of gross income, or over 34% of net income! In other words, for ever dollar you take home after taxes, you need to put 34 cents into your investments, you need to live off of just under $27k a year. In California, assuming the rent is at least $1k a month (which is low), that means you need to live on $15k a year for everything (car, food, health, kids, entertainment, travel, etc.) for 30 years! That’s not very much, not much at all.

Ok, let’s look at it from another angle. What if we increased the interest rate to a more aggressive interest rate? Let’s take the average compound rate of return on stocks from 1802 through 1991, 7.7% per year. Assuming this rate of return with our original 10% of gross, would we make our one million dollars in 30 years? Unfortunately no, we would have made only $609,226.29, still shy over 39% of our targeted one million dollars. At that rate of return, we would need to invest $8,863.71/year, over 16% of our gross or almost 22% of our net. Although possible, I personally think that consistently investing 20% or more of the net income of the median family is probably asking for too much for the ordinary person. Investing 20% of 100k net in revenue is possible, but not for the median income family, it’s just too much.

Ok, so let’s look at it this way, assuming we want to save only 10% of our net income, the smaller of the two numbers, at the higher rate of 7.7%, then how much income would we need to produce? $88,637.11 in net income. Assuming a tax bracket of 25% again (it’s probably higher as taxes get progressively higher with additional income), then we would need to make $118,182.81 in gross yearly revenue!

The next question that comes to my mind is what interest rate would you need to earn on the median salary to have 1 million dollars after 30 years, assuming you’re putting away 10% of the net income of the median household income of $54k? You would need to earn consistently over 30 years 10.139% compounded interest a year. This is very doable, however it tells me that I most likely need to be a smart equity investor, a smart real estate investor, or start my own business. Chances are that I won’t attain my 1 million dollar mark (in today’s dollars) otherwise.

Now I can already see some of you saying that with inflation, one million dollars isn’t going to be anything in 30 years. Very true, but remember these calculations are in today’s dollars. That is, what you have in the bank (or in investments) then will buy the same amount of stuff then as it does today if you had a million dollars today. In actually, if you add inflation into the calculations, these numbers look even worse because you now have to reduce your real interest rate by 3.5% (today’s inflation rate). So if you make 7.7%, you’re actually only making 4.2%!

I can also suspect some of you will comment about increasing your income, and hence contributions, over time. Yes, that’s all true and all, and I completely agree. The thinking is that although you might not make over $100k today, you will tomorow so you should be able to play catch up by putting away bigger and bigger amounts. Yes, this is true, sort of except that there’s a catch! This is where the power of compound interest becomes very very interesting! Again, nothing speaks as well as working out the numbers, so let’s do just that.

Say I invest 10k in year 1 and do nothing for 10 years at 7.7%. I will end up with $100,003.52 after 30 years. Now, what if I invest $1k every year for 30 years (i.e. I invest for a total of $30k)? I will end up with only $112,819.69, a difference of about 10%! Wow! I invested 3 times as much money only to make 10% more! Catching up really didn’t help much.

Of course, in the example above we spread it out over 30 years. What if we do the same numbers, but over 10 years now? Get ready for a shock! For the initial $10k investment in the first year and nothing after I end up with $21,544.60. If I do the second scenario, investing $1.5k a year for 10 years, I end up with $21,706.79. I actually have to invest 50% more money to get the same final balance.

Let’s look at the effects of compound with one last example. Let’s say I have no money initially, so I invest nothing for 10 years. Then for the next 10 years I invest $2k a year, then for next 10 years after that I invest $3k a year, what will I end up with? $105,768.77! Wow! I end up with almost the exact same as if I invested $10k the first year. I have to invest a total of $50k to catch up to my initial $10k investment. 5 times as much money to end up with about the same final amount! That’s the power of compound interest!

You can play with the numbers, but you’ll find that as interest rates climb, the differences become even more staggering. Basically the idea is that you should let time be your friend. The longer you can compound a number the higher the return. Remember, compound interest is an exponential formula, so use its power to your advantage. Put as much as you can early on, it’ll make a world of difference tomorrow because its very costly to catch up later. Therefore using the argument that you’ll be making more money later and hence bigger investments is probably not a good one.

All in all, it’s possible to save a million dollars but the odds need to be in your favor. The math above assumes historical averages with median salaries. The math here does not deal with factors such as unemployment losses (you’ll probably have some bad months in your life, etc. The numbers also doesn’t deal with inflation which could substantially affect the results. Also, since these calculations don’t consider inflation, they assume that you’re gaining the full stock return which is completely untrue! For example, if you’re stocks went up say 10% this year, then you only really made 6.5% after adjustments for inflation. That’s right, you need to remove 3.5% for inflation. So for example if you had $100 invested and you made $10 for a total of $110, then you’re $110 can only buy $107 of equivalent goods as compared to your $100. As a more concrete example, if you could buy gold at $1/lbs, then in year one you could buy 100 lbs of gold. In year two gold would have gone up to $1.035/lbs because of inflation (assuming a 3.5% inflation rate), allowing you to buy only 107 lbs and not 110 lbs. This means that in reality our calculations are better than reality because we didn’t take this inflation into consideration.

Also, these calculations assume you never pay taxes on your investments. If you do pay capital appreciation taxes then the numbers change drastically. Therefore, a quick tip for this type of investing, try to pick investment vehicles that you can stay with for a longer term to avoid taxes because they can have drastic differences in these calculations as seen in my previous article on the affect of taxes on the real estate investment returns.

Now that you know most of the math what do you think? I personally don’t think it’s feasible to assume most people will be able to save and invest $1,000,000 dollars in 30 years. Not that it’s impossible, people have done it, but I don’t know that I want to live that type of financially squeezed lifestyle. Rather I think you’ll have to look at other avenues to increase your revenues (or rate of return) rather than just try to save your way to $1,000,000. You should probably look into investing wisely in equities, real estate, or building your own business. Basically, you need to look at something other than just putting money away in your mattress, because the honest truth is that in 30 years you’ll likely not have the $1,000,000 you worked so hard to save for, you’ll only have a fraction of that. I’m not saying don’t invest, I would never say that, actually I’m a very strong proponent of investing. All I’m saying is that you probably need more than just plain saving in your financial plan to get your $1,000,000.

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