A Simple Formula for Long-term Financial Success (Visualized)
Manage your income, expenses, savings and investments
Why don't people put effort into managing their household finances?
That's a question I've been thinking a lot about recently. I've asked a number of people that question and the answers I get cluster around "difficult" and "complicated". So I'm writing today's post to dispel one misconception - managing your finances is not that complicated.
I'm going to share some visuals that highlight the simplicity of the ideas at the core of managing one's finances. Now, I don't want to oversimplify. As you dive deeper into each of the elements I'll show below, you can get much more complicated. However, I want to demonstrate how simple it is at the core - so simple that I hope it convinces people who don't manage their finances because they are intimidated to start doing so.
Three key elements to managing your finances
When you boil things down to their absolute simplest level, there are three key elements to managing your finances
- Income: The sum of all the money that you bring into your household
- Expenses: The expenditures you make in your household
- Excess income = Savings and Investments: The gap between income and expenses, which you should save and invest
To have sound household financials, you should have a positive and, ideally, growing gap between your income and expenses. This excess income (which is your savings) should be invested to build longer term wealth and passive, unearned income.
Here is a chart which lays out the typical path that most people follow on these three elements across different lifestages:
- College: You are still building your education and skills with very limited income, but you do have ongoing expenses. The negative gap between your expenses and income is filled with scholarships, student loans or contributions from your family
- Single, no responsibilities: You have graduated and have started working with entry-level income. Your expenses are focused on what you need for your day-to-day life. The portion of this lifestage titled "no responsibilities" refers to the fact that you don't yet have a family
- Family: You've gotten married and are having kids. As you move further into your career or business, your income increases. However, your expenses also increase as you have to support your growing family and responsibilities
- Empty Nester: Your children have moved out of the house. You're at peak earnings, and your expenses have started decreasing as your children have moved out
- Retired: Your income decreases as you are no longer working. A subset of your expenses come down as you don't have the costs tied to your job or business. However, other expenses increase such as medical care or increased spending on activities in retirement
Through each of these lifestages, your goals should be the same: increase income, ensure any growth in expenses is at a lower rate than increases in your income and successfully invest excess income. While each of these items can get more complicated, the overall idea is still very simple.
Income is a combination of earned income from your job or business earnings and unearned investment income such as interest, dividends or capital gains.
The ideal path you should see for your income is one that grows over time with an increasing amount of unearned, investment income:
In this ideal path, your:
- Earned income should grow as you move further into your career or business. You can also supplement that income with a side job or business. Now, there will be a natural point such as retirement where your earned income will start winding down
- Unearned income consistently grows as you invest your excess earnings over time. Ideally, your unearned income grows to reach the point of financial security where your unearned income is at least or above your expenses.
It is natural to see expenses grow over time. Your responsibilities increase and expenses grow to meet those. In addition, life is meant to be lived and you want to enjoy the fruits of your growing income. So, realistically, the goal here is to keep the growth of those expenses at a lower rate than the growth in your income.
The ideal place to start with managing your expenses is to have a budget that helps you understand where you spend your money and can develop a plan to limit or even reverse the growth in your expenses. A good starting point can be to read my article titled Budgeting Is a Foundational Requirement for Financial Success and use that iteratively as I described to manage your expenses.
Excess income = savings and investment
If your income grows and and your expenses grow at a slower rate than income, the excess income within your household finances should grow. Rather than just have this money sit in cash, you should invest it in a diversified mix of investments which grow in value and provide you passive, unearned income.
How to invest can become more complicated - a number of the articles I'm writing are focused on helping you learn how to do that better. However, the core concept that you should invest your excess savings is a pretty simple idea.
This completes today's post on the simple formula for long-term financial success. The practical steps you can start taking from today's post are:
- Start actively managing your finances: If you haven't started managing your finances yet, start. It's not as complicated as people make it out to be. Focus on the three key elements that are described in this article
- Find ways to increase your earned income: Think about ways you can grow your income - can you push for more responsibilities at your current job? Should you look for a higher-paying job? Can you add a second job? Add a side hustle?
- Keep any growth in expenses to lower than the growth in your income: Establish a budget if you don't have one (read my article titled Budgeting Is a Foundational Requirement for Financial Success) and use that iteratively as I described in my article to manage your expenses over time
- Invest the gap (excess income) between your income and expenses: The idea is to have your investments provide sufficient unearned income to cover all your expenses for your financial security
Thank you again for joining me on my journey to build financial literacy for young adults and their families. Please share any comments or questions that you have in the comments section. If you are interested in reading more of my posts, please access my author page (https://vocal.media/authors/sudhir-sahay) where you can see all the posts I’ve published. Also, if there are any topics you’re interested in my broaching in future posts, please let me know. In addition to the comments section, I can be reached at [email protected]
About the Creator
Sudhir Sahay is a Sales and Marketing executive and a father of two young men. Sudhir hopes to share his journey building basic financial literacy for his children and providing savings and investing advice to their friends and peers.
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