The first law of personal finance: Spend less than you earn

“Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness.

Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”

– Wilkins Micawber (David Copperfield, by Charles Dickens)

Were you to stick to just one New Year’s Resolution – and assuming “I will not kill again” is surplus to your personal requirements – then you could do a lot worse than vowing to spend less than you earn.

Living within your means is about the least sexy concept in personal finance, I know.

The magic of compound interest, the principle of risk versus reward – heck, even the Dr Who-ish sounding Time Value of Money – they all have a certain frisson.

But none of them adds up to a bean if more money goes out the door than you have coming in.

And that’s true regardless of your net worth, or the size of your monthly wodge.

One rule for everyone

Some think that watching the pennies is only a concern for people on the poverty line, Dickensian characters, or natural born tightwads.

They’re wrong. Spending less than you earn is as important when you’re rich as it is when you’re trying to get there – assuming you want to stay that way.

Just think of all the sports stars who’ve gone bankrupt, or the lottery winners who end up with nothing.

There are many ways to go broke, but persistently living beyond your means is the one that never fails. Anyone who’s seen Brewster’s Millions knows that even reckless investments occasionally pay off. But outgoings exceeding income is guaranteed to leave you with nothing.

You might be thinking those sports stars were retired, and hence their days of earning mega-bucks were behind them. Surely they had a licence to hoover up designer goods to ferry across town in the supercar that best fitted their mood?

As for the lottery winners: who wants to win a million to be freed from wage slavery, only to keep their spending to a few measly tens of thousands a year?

But that isn’t the right way to look at it. Not if somebody wants to stay wealthy.

Sports stars and lottery winners who give up work are no longer earning, but their capital can still earn for them. A sensible approach would be to figure out what inflation-adjusted annual income your loot can give you, and then live with those means, just like a wage earner.

Result, happiness!

How to start growing your fortune

The joy of spending less than you earn is it always leaves you with something.

An acorn. A spark. A bit of grit that you can grow into a pearl.

And that leftover money you have every month holds the key to your future financial freedom.

By saving and investing this surplus – by never spending more than you earn and so continually saving and adding a little more, and then a little more again – the daunting task of securing your financial security becomes nothing more onerous than a habit.

Yet the results can really add up. This is the bit where any decent financial writer busts out a compound interest calculator, and I’m not about to let the side down!

  • Invest just £100 a month from age 21 into the stock market and you might retire at 67 with a pot of over £400,000, in today’s money.1
  • Start late but put away your full ISA allocation of £960 a month from age 40 into a mix of shares and bonds, and you might end up with around £500,000 in today’s money.2

Or ignore me and choose instead to spend more than you earn. Then you will have £0 to save. And you will have £0 to invest.

Which whether you leave it for 21 years or 46 years or 100 years will still see you end up with a big fat £0.

Become an automatic millionaire next door

A great book to read to discover the power of this simple strategy is The Millionaire Next Door. It’s the result of a lot of research that shows that ordinary people often become rich over their lifetimes by spending less than they earn, and saving the difference.

What’s a good target? Up to you. Perhaps 10% of your earnings. If that seems impossible right now then maybe start with 5%, and try to save most of your pay rises from here.

Of course there’ll be a bit more to learn. For instance:

  • You’ll want to invest in very cheap passive funds to capture as much of the market’s return as you can.
  • You’ll want to decide whether an ISA or a pension – or both – is the best tax-sheltered way for you to save.
  • You’ll want to subscribe to Monevator to get occasional nagging reminders like this one to keep you on the straight and narrow.

Too boring? Want to start a business to make your millions? Invest some of your money in fast-growing companies? Build your own property empire?

Go for it! More power to you.

But whatever you do, spend less than you earn. Attempts to sidestep this simple rule (such as by borrowing to invest) have a poor track record of short-term success, and a guarantee of eventual failure.

That said, there’s one group who are allowed to splash the cash.

You’re over 75? Feel free to figure out how to sensibly spend the lot before you discover you can’t take it with you.

The rest of us? That’s what we’re aiming for!

  1. I’m assuming a 5% real return here. A real return is an inflation-adjusted return, so you can think of it in today’s money. This assumed rate of return is a smidgeon less than the average from UK shares over the very long-term.
  2. I’m assuming a 3% real return here, a lower rate than in the previous example, to allow for the lower return potential of the bonds.

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