Compounding is one of the most important concepts to understand. Everyone knows about inflation and outpacing inflation is the only real way to increase your net-worth (passively). The problem is that most people give up before the game works in their favor. It seems like you’re climbing up a hill with no end in sight. Oddly, once you get to the top of the hill, the momentum or snowball effect takes place quite rapidly. For fun we’re going to try and calculate exactly when that happens. This post is entirely made for entertainment purposes.
Rough Benchmark $3-5 Million?
The Only Rule: You will continue to earn money. The amount of money you earn will be able to cover your living expenses. This is an important point. Notice we said “living expenses”. This means your active income (working for money) will not touch *any* investment gains. It is also a moving target. If you’re living in Thailand earning $3,000 a month and spending $3,000 a month this is enough. Similarly, if you’re living in NYC earning $10,000 a month and spending $10,000 a month, this is considered equivalent. It is considered equivalent since we’re focusing on your investments creating a snowball effect for you. Also. We assume you’re under age 45 or so otherwise you’d probably want to work less.
Is $500,000 Enough? Unsurprisingly, we’ll go with “absolutely not” here. If we assume you earn $25,000 a year from this (5% returns), it would actually be a lot lower due to taxes. Even if the tax rate came in at 20%, this is $20,000/year or $1,666/month. Think about it like this, unemployment income is approximately the same at the “high end” and no one would get wealthy saving 100% of an unemployment check.
The key here is figuring out the second leg of reinvestment. If you re-invest $20,000 in after tax money at 5%… That is only $1,000. Compounding isn’t really helping you much unless your active income is contributing quite a bit more.
Okay How about a Million? Still not there based on the math. You’re definitely closer but it still doesn’t move the needle. Now you’re looking at $50,000/year or $40,000 or so after taxes. $40,000 would lead to $2,000 in extra income in Year Two. This is still quite small ($166/month). Yes you’re able to put away an average income (just on investment gains) but this doesn’t snowball the year after. The second year out you’re only up an extra $2,000.
How about $3 million! Quite close to the snowball effect. At $3 million you can now generate $150,000 a year or around $110,000 per year. This is getting very interesting since the incremental $110,000 per year now gets you $5,500 in year two as well. To keep the math simple, it means in Year 2 your ability to spend just went up by close to $500/month. This is almost equivalent to having another rental property. It’s not quite there but it is close.
How About $5 million? We’d say you’re there at this point. At $5 million you’re generating $250,000 a year without lifting a finger (ideally). This is around $200,000 in after tax income if structured correctly. Now you’re looking at an additional $10,000 a year built off of the passive income alone. This is close to the after-tax cash flow of a basic home (average rent in the USA is around $1,000 a month – without expenses accounted for). We’ll go ahead and call this the “snowball point”. Somewhere between $3-5 million is when the game is officially over and your passive income surpasses four working families. An insane amount of momentum. Essentially, if your passive income is enough to buy a median home, it’s pretty difficult to not have momentum since saving for a home is difficult for most working families.
Working Backwards
To make the math simple, we’re going to use $4 million dollars. Assuming we’re in agreement that this is enough to have the “snowball effect” take place, we can now take the age of 41 and solve backward to figure out how much needs to be saved. It’s much more likely to be non-linear (since real gains are not made by 5-10% increases in a salary) but we’ll outline two different paths for fun.
In the linear world someone would need to save $112,000 every single year for 21 years. Think about that for a second, with 5% returns (no correction ever) you’re barely at $4,000,000 by the time you’re 41 assuming you put away six figures immediately. This seems impossible. It seems impossible because there is practically no “career” in the world that we can think of where you would *save* $112,000 in your first year (emphasis on post-tax). Even high paying technology jobs cap out at around $250,000 after undergraduate education is complete (possible to save low 6-figures if you had no living expenses).
Now that we see the “save slowly” math doesn’t work we can conclude that the vast majority of multi-millionaires either 1) use leverage or 2) own their own businesses. Anyone who has followed this blog for a decent amount of time will say this is redundant (true) but it’s always good to see how illogical the masses can be. There is just no way to get to $4 million if you were to go to higher education by the way, you’d need to save around $225,000 per year (every year) to do this in just over 13 years.
Three Ways to Get There
Since we have gone full circle and can conclude “working and saving” is not going to get you to the *Promised Land* there are really only 3 alternative options. None of these are mutually exclusive. You can try to do all three, a combination of the three, or master just one of the three.
Option 1 – Leverage: This is the most common method to accelerating wealth and the answer is the same boring investment: Real estate. It’s the most obvious and the most boring because it is the easiest one to calculate. With leverage of 4-5x or so a 5% return suddenly turns into a 20% return (yes we are doing napkin math). Want to know how much this moves the needle? Well instead of saving $112,000 per year for 21 years, you’d only need to save $18,000 per year to reach $4M in 21 years.
Of course the elephant in the room is that 20% returns are insanely high and secondly that leverage is diminished over time (can only have four loans out at the same time). But. The point remains. Levering up and being correct early accelerates your returns in a big way. Even a move from 5% to 10% would be a huge change in compounding ($62,000 required per year over 21 years at 10%).
Option 2 – Any Business: Well… any business that actually works. A business can always be sold which accelerates your ability to jump a gap. For example, using the same $112,000 a year example… at age 30 you should have about a million dollars. But. If you had an asset and sold it for $1 million, you’d have $2 million dollars, a number that wouldn’t have been hit until age 35, compounding alone if an asset is sold would get you to $3.5M (very close by age 40 without saving for 10 years). More importantly, the more successful you are the more likely the exit value goes up. If you’ve been around for twenty years and already made it to $4 million (without a sale!) you’d always have the optionality to hit the exit button pushing you into a new realm of wealth.
Option 3 – Multiple Income Streams: Out blog focuses on this option and option number two the most. We focus on option three here because 1) we don’t see many websites talk about it and 2) we think it’s the lowest risk for the highest reward. If you’re already earning a six figure income the chances you work inside of an office is particularly high. We don’t know what the percentage is, but we’d wager that most high earning professions are “white collar” in nature which means you have access to the Internet. With the internet you can now double down on income being earned which accelerates your earnings. If you could cover just 30% of the needed capital per year, it suddenly becomes a lot more feasible. Alternatively, if the second source covers living expenses only (they’ll also feel rich). It’s essentially a win win. We do nothing but laugh when people say this isn’t possible since we’ve already had multiple individuals succeed with our blue print while the negative nay-sayers can’t even earn $10/hr extra during their free time in front a computer (hint: if you’re extremely desperate for cash you can always do freelance work online… if you can’t even find freelance work we doubt the person even has a basic white collar position!).
