This Equation Is All Of Personal Finance — Literally
Don’t make it harder than it has to be.
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
You could read a thousand books on personal finance and still barely scratch the surface.
Whether that’s worth it is another question.
Regardless, it’s easy to go down a million monetary rabbit holes, each with potential to change your life for the better.
But what if you don’t have the time or desire to do that? Are you going to miss out on essential knowledge and wind up poorer for it?
No, and here’s why.
From this month’s groceries to your big fat retirement account, all of personal finances boils down to exactly four things.
- Money earned
- Money spent
- Rate of return
- Time
That’s all. Seriously, that’s it.
After earning an MBA, and spending years analyzing large corporations’ data, and trading and investing personally, I can attest that there really is nothing else.
To be fair, these factors hold more nuance than meets the eye, and you can’t control all of them all the time.
But if you wrap your head around them, and think through their implications, then you’re 100% mentally equipped to build a solid financial foundation.
As you’ll see, it’s already plenty to think about, so don’t complicate it any further!
Financial symbiosis in one line
If you’re among the algebraically inclined, then here’s wealth in one line:
(Earned — Spent) * (1 + rate of return) ^ Time
Or, in plain English:
Wealth is what you have when you earn more than you spend, and the difference keeps on compounding.
It may sound simplistic, but remember that these pieces do affect each other. All four factors are interrelated. Perhaps you can increase earned but only for some time before you burn out. Perhaps you can boost the rate of return…but it takes more money spent to do so.
The variables are few, but they do not exist alone.
Factor one: money earned
Spoiler alert: earning more money is really helpful.
Shocker, I know, but try to contain your astonishment.
All else being equal, more income increases the amount available to compound. The difference to future-you will feel a lot like free money.
Let’s say you have a $1,000 lump sum that earns 10%/year for the next 5 years. It grows into $1610.51.
But if you started with $1100, the result is $1771.56. In other words, an additional $100 now becomes an additional $161.05 later.
Remember, this interacts with the other three variables. If we scale this out to larger sums over longer periods of time, we’re talking serious future benefits from even temporarily bringing more money in.
The point: Positive returns and the passage of time are on your side. That means more money earned now is disproportionately more valuable in the future.
There are plenty of resources on how to earn more. I suspect that’s about half of the entire internet’s content these days. But suffice to say that any increase in cash flow today is worth disproportionately more down the road.
Factor two: money spent
Life isn’t free. Some degree of spending is unconditionally necessary. But if you’re got room to reduce spending, then do it. Period.
Remember, what compounds over time is the difference between money in and money out.
By spending less, you boost that difference and therefore boost how much is available to compound. This is true up until some threshold of basic costs for an acceptable standard of living.
But until you hit that threshold, basic arithmetic tells us that spending less is exactly as good as earning more.
There’s usually more room to boost earnings than to cut spending, and that’s where the infamous stop-buying-coffee trope comes in.
But filling a bucket with a hole in the bottom is unnecessarily hard. You can do it with a big enough hose, but why waste water?
Your financial path is no different.
That’s why — within reason — a penny saved is truly a penny earned.
The point: Controlling spending is the other half of the income equation. It can only drop so much, but those wins are quick, direct, and certain.
Don’t be silly and forsake earning two bucks just to save one, but don’t spend that one mindlessly, either.
Factor three: rate of return
Whatever the difference between earnings and spend, it’s going to grow at some rate.
Perhaps it goes into investments that accrue positive returns. Perhaps it pays down loans that are accruing negative returns. Perhaps it just sits in the bank as inflation inflicts its own negative return.
All the above are at least sometimes within your control.
That’s important to remember, since returns are a double-edged sword. Compounding accomplishes marvelous things when it’s in your favor, like with steady dividend increases on stocks you hold. It can also wreck your financial future when you’re the one paying out that rate of return as loan interest, credit card balances, or insidious lifestyle inflation.
Either way, there are two key things to understand.
First, compounding results build on themselves in both directions. Second, what matters most is net returns across everything you touch.
That’s why it’s impossible to exaggerate the importance of paying off high-interest personal debt. It’s nice to put $5,000 into your IRA averaging 8% growth each year, but that’s a big problem if you’re also holding $5,000 in 19% credit-card debt.
Watching that IRA balance grow may feel good, but all it does is subsidize part of your interest payments. Your overall “life portfolio” is returning -11% per year. Yes, that’s a negative sign, as in the difference between 8% received and an alarming 19% paid.
Carrying this hypothetical balance frees up cash to invest, but it’s a net loss that will only compound against you.
You’re effectively borrowing at a higher rate to earn at a lower one. Last time I checked, that’s bad business.
The point: It’s critical to think of returns holistically and not to get hung up on the rates of any one part of your financial picture. Debt directly undermines investment returns, so it’s a disservice to think of either one in a vacuum.
Factor four: time
As long as income regularly exceeds expenses, and returns are regularly more than inflation, building wealth is a waiting game.
Obviously, a wider earning-spending gap and a higher rate of return makes a massive difference. And with good stewardship, a cash windfall can expedite everything by years.
But holding all those things constant, it’s a waiting game.
Of course, it’s tempting to try to shortcut time. We fall prey to get-rich-quick hacks, or we eagerly buy things today that our future selves can’t pay for. (Ironically, the former usually involves the latter, but that’s another story.)
The point: Long-term consistency is the secret ingredient that lets positive compounding work its magic. It’s within your power to save and to boost rates of return, but patience also goes a long way without adding stress).
There’s a powerful and sort of mind-bending twist to all this:
This wealth equation feeds into itself over and over and over ad infinitum.
Each year’s equation is made of each month’s equation. Each month’s of each week’s, of each day’s, of each action’s.
Of course, nobody who actually runs the numbers on every single action in life is much fun at a party. After all, the point of A Christmas Carol is that Ebenezer Scrooge stopped doing that.
But when you take to heart the four variables of personal finance, and you focus on reasonable and low-stress ways to shift each one in your favor, it’s almost impossible to go wrong.
Here’s where to begin
The best way to get started is with what I call a minimalist budget. I use that term for a clear but simplified money plan that supports what matters without wasting energy on what doesn’t.
Here are two guides I’ve written to help you harness this personal finance equation to your benefit.
Simple isn’t easy, but in my experience, simple always works in the end.
