The person who asked the question wanted to know the answer specifically in terms of education/knowledge.
Here is how I answered:
There are 3 basic rules to money that most people know about, but fail to apply in their life.
ONE: Income – Expenses = Savings
Savings is the difference between your Income and your Expenses.
Many people focus on increasing Income, but they do not pay attention to reducing Expenses. In Quora and almost everywhere else, you see people asking questions such as ‘How to make more money’. But you do not see people asking, ‘How to live on $100 a month’.
When Income increases, Expenses tend to increase proportionately. Sometimes disproportionately. This is called ‘lifestyle creep’. This is the greatest threat to becoming financially independent.
The net result is that Savings does not increase.
The way to increase Savings is by both increasing Income and reducing Expenses. The reason why many people prefer not to focus on reducing Expenses is because they think that there is a limit to how much you can reduce Expenses to.
They are not wrong.
The limit you can reduce your Expenses to is zero, but most people don’t realise that you can live very happily on zero Expenses and still fulfil all your wants in life.
But this is a topic for another time. Let me focus on your question.
A person who earns $10K and spends $9K a month saves as much as a person who earns $2K and spends $1K a month. However, the $1K spender is in a much better financial position than the $9K spender. To understand why, you have to look at the next two rules.
TWO: Savings → Investments → Passive Income
Savings have various uses. It is used to pay off debt, which reduces Expenses. It is use to invest, which increases Income. Both these actions in turn go back to increasing Savings. The eventual goal of Savings is to convert it into low-risk investments that produce regular Passive Income.
Some people prefer to use high yield investments. I prefer not to, because high risk investments increase the chances of losing capital or income, which in turn threaten freedom and increase stress.
My goal is stress-free financial independence. Besides, Saving money is both low-risk and high yield.
THREE: Passive Income > Expenses = Financial Independence
The goal of investing is to increase Passive Income to the point where it exceeds Expenses. This is financial independence. This is the true measure of being financially wealthy.
A wealthy person is not someone with $1 million in his bank account. A wealthy person is someone who will never finish spending his money. The longer your money can last, the wealthier you really are.
Therefore, a person who has $100K in the bank and spends $100 a month is wealthier than a person who has $1 million in the bank and spends $10K a month. The first person can last 80 years, but the second person can last only 8 years.
Time, not money, is the true measure of wealth.
This is why a $9K spender will find it 9 times harder than a $1K spender to reach financial independence — because his passive income needs to be 9 times higher. Unfortunately, his savings is the same as the $1K spender.
To sum up:
- Focus not on increasing Income or reducing Expenses, but on increasing Savings.
- Use your Savings to further increase income and reduce Expenses, and to generate Passive Income.
- Do this until your Passive Income exceeds your Expenses.
This article was taken from Lumina Planners, the fee-based financial planning arm of Elpis Financial.