The Valor Blog.
Investment News and Views, Direct from Our Team.

Its not what you earn, but how much you save and return on your passive income

Unfortunately there is a common misconception that high income earners are wealthy. This belief is often far from the truth.

Why is this?

The main reason is because high income earners are also often high spenders.

Many of my clients are like me, airline pilots. Airline pilots earn above average, but they also spend above average. The amount the typical airline pilot saves is close to nothing as they buy bigger houses, spend more on holidays and send their children to better schools.

The belief that they are wealthier than they actually are is common and hence they save little.

This paradigm is also common for doctors, lawyers and many high paying executives.

Over 10 years ago, a good friend of mine gave me a brilliant book called “The Millionaire Next Door” by Thomas Stanley and William Danko. This book changed by life and made me realise the basic concept:

Its not what you earn but what you save that leads to truly independent wealth.

High income earners who are also high spenders are usually not wealthy. They drive fancy european cars, but the cars are on lease. They have beautiful houses, but the houses are mostly owned by the bank.

My wealthiest clients are those that spend the least. Some of my clients save over half their income and have become truly wealthy. When I go to their houses, they have modest furniture, they live in modest neighbor hoods, and they drive second hand cars. Once they get past the first 15 to 20 years of spending less than they earn, they get to a point of margin expansion on their savings income versus their expenses. This is where their savings income begin to grow rapidly when compared to their expenditure and they often cant spend all of the excess income from their savings.

There is one point I would like to add. If you save significant amounts of money, earning high returns on your savings can make you spectacularly wealthy over the long term.

The problem is that many high income earners don’t save any money. The typical strategy is to build up some equity in their house and then use this equity to buy loss making (negatively geared) property speculating that it will go up in value.

This speculation of capital gains has been a good bet over the last 15 years, but I am not certain that it will work in the same fashion going forward over the next 15 years.

The latest ABS statistics show that “investors” are growing in the home loan market. I strongly recommend the ABS to review their term “investors” as most of these investors are speculators. Speculators who are prepared to lose money on an asset in the hope that it will go up in value to cover those losses and then also hope the assets goes up further in value to actually make money. According to this article, 63% of property owners lose money. If you aim lose money on an investment in the hope it will go up in value one day, you are a speculator not an investor.

A far superior strategy over the long term is to spend significantly less than what you earn and slowly add to a growing portfolio of wonderful businesses (and property if it doesn’t lose you money every year). This strategy requires a concept called “patience” which most Australians have forgotten about. The “need it now” strategy has put most Australians on the back foot when it comes to saving and investing.

Debt can be wonderful when asset prices are rising (the last 15 years), but when asset prices fall and if you are no longer able to make repayments, you can wipe away significant chunks of your paper wealth. If you dont have much equity, you can get to a situation of negative equity. Speak to property owners on the Gold Coast for a lesson in this phenomenon. Apart from the Gold Coast, this de-leveraging effect has not happened in Australia for a very long time, but it has happened many times throughout history and around the world. With Aussies geared to the hilt, just be a bit more cautious than usual.