It’s a common misconception that a higher paycheck means greater financial security. As countless professional athletes, high-paid actors and lottery winners have taught us, it’s possible to earn a huge income—in the tens of millions of dollars, even—and still end up broke or in debt.
It’s referred to as lifestyle inflation, and it can happen to the best of us. Whether you’re “keeping up with the Joneses” by using your raise at work to get a nicer car or spending your tax refund on upgrading some other aspect of your life, it can be tempting to spend more money when you have more money to spend.
Who’s better off financially—a CEO with a $150,000 annual salary or a receptionist earning $60,000 per year? The answer is, it depends how much they spend. A CEO with a $150,000 annual salary is no better off than a receptionist earning $60,000 per year if the CEO spends everything she earns. If she has a big mortgage, car payments, takes fancy vacations, eats at expensive restaurants and regularly buys new clothes, she could easily be living paycheck to paycheck despite her high income.
By contrast, consider if the receptionist drives a paid-off car, lives in an affordable neighborhood, brings lunch to work and saves and invests 20 percent of every paycheck. Extrapolate that scenario over a 25-year career and the lower-paid receptionist could very well retire with greater wealth than the high-earning executive.
Here’s the three-step formula I offer my clients to encourage them to invest early, save consistently and resist the temptation to spend more than they earn.
Start early
The more time you’re invested in the market, the longer compound interest can work its magic. Put time on your side and start investing regularly. The market is unpredictable and not a reliable means to get rich quick. It’s not about timing the market—it’s about time in the market.
Pay yourself first.
Treat saving and investing like an expense in the sense that you have to do it every month, just like you pay your bills. The easiest way to do this is to have a percentage of your income automatically deducted from your paycheck every month and put into an investment vehicle, like a 401K, an IRA or an index fund. Automatic contributions make it so you don’t have to think about it every month—only instead of paying other people, you’re routinely investing in your own future.
Live within your means.
If you spend everything (or more than) you earn, you’ll always be a slave to your paycheck. Keep lifestyle inflation in check by always saving a portion of your paycheck and investing any raises, bonuses, cash rebates or tax refunds you receive.
You don’t need an elaborate plan to set yourself up for financial freedom. It can be simple. The more you save and invest, the closer you’ll be to affording the lifestyle you want, now and in the future.
