Personal savings rate size
Individuals interested in improving their financial state, often come to the question of how large their savings rate should be. The personal savings rate is composed of closely interconnected relationships of size, influences, and assets.
The typical range for a savings rate is 1-3%. The average from this range is 2%.
However, each individual person has different financial influences to cope with, and assets from which they derive income. That’s why “How much should my savings rate be?” is better asked as “How much and what factors affect my personal savings rate?”. Only then a framework for determining the savings rate for each individual can be constructed.
The personal savings rate is calculated as follows:
This formula, as a percentage of disposable income, can be adjusted for certain time periods:
(12 month savings/12 month income)*100%
Read tips for personal savings rate from Money Bear Club, and find out about a paradox with negative implications to budget keepers.
When to pull back and when to push ahead
Personal savings rate should be any number in the range of 5% to 24%. It’s normal for the personal savings rate to be in flux month after month, yet radical changes (+-10 percentage points) should be avoided. Remembering when to pull back, and when to push ahead with the savings rate, will help to manage personal finances with a higher degree of rationality.
Increasing the savings rate is essential at least 3-5 years before major life events. Weddings, child births, and similar events tend to cost more than people expect. Saving up for just one or two years is often not enough. Hence, increasing the savings rate in preparation for major life events will help to cope with them more easily, and afford better services.
Savings rate increases are also advantageous after receiving raises. A salary increase often prompts budget keepers to loosen the hold on wallets, and spend more money on liabilities. A savings rate increase just after receiving a raise will help a budget keeper to build their wealth. It will also create a goal which prevents disadvantageous spending.
Pulling back on the savings rate should be done when the individual can not cope financially with their current savings rate. It is useless to cut corners on essential purchases, just to meet the savings rate goal. An unfortunate financial situation will end eventually. However, the individual’s efforts at a difficult time should be directed at solving the situation, rather than increasing the personal savings rate.
Another instance when the personal savings rate should be decreased is during economic downturns. Many assets can be acquired on a bargain price during economic downturns. If wealth building is a goal, then the personal savings rate should decrease during downturns, and the investment rate should increase.
This way, it will be possible to buy a higher quantity of assets because of their decreased price. As the economy takes off, the asset price likely will increase. The asset price increase then should make up for the temporary decrease in the personal savings rate.
What percent of my salary should I save?
A few important factors should be taken into account when determining the percentage of salary that a person should save.
Monthly payments for basic living expenses (rent, utilities), and the income range of a budget keeper, are the most important factors when determining the percent of a salary that should be saved.
The framework of determining the percent of a salary that should be saved every month is easy to understand:
This infographic is based on the assumption that living expenses of an individual are greater than any outstanding financial commitments. If any outstanding financial commitments are larger than the living expenses, the savings rate can be under 5%.
There are instances when a personal savings rate will be lower than 5%. It can even be negative. A negative personal savings rate occurs when either the spending of a budget keeper exceeds savings (a), or their financial commitments are larger than their income (b).
If a personal savings rate is in the negative range, it can mean that an individual is irresponsible with their financial outflows. In this case, focusing on budgeting and saving money should help to rectify the negative savings number.
If a personal savings rate is negative, it often means that an individual has difficult financial commitments. To simplify, the monthly payments are larger than the individual’s income. In this case, negotiating better terms of financial commitments or increasing personal income should help to rectify the negative savings number.
A low personal savings rate isn’t always indicative of a bigger personal finance problem.
In some cities, residents aren’t able to save as much money as they would like. That happens because the opportunities a city offers create a very large demand for real estate. This leads to rising housing costs.
Paradox of personal savings rate
The logic behind the perceived personal savings rate looks sound at a first glance. The more a person will earn, the more will he/she be able to save. It is inevitable that at some point, the earnings or the assets an individual owns will allow to decrease the savings rate, and to increase money outflows indefinitely.
Personal savings rate, even with few possible decreases, tends to always increase over time. This paradox, which contradicts the usual assumption, can be easily explained by low variation in discretionary spending and the acquisition of assets over a lifetime.
People, even with higher salaries or more income from assets, will still live more or less the same lifestyle they are accustomed to. This factor leads to people’s spending only increasing slightly over their life.
The older people get, the more assets they will own. Since many assets provide a constant stream of income, budget keepers over time increase their income through assets, and can achieve a higher personal savings rate because of this factor.
What are the implications of this paradox to people saving money? The negative implications of the personal savings rate paradox include missed compound growth opportunities and less strict financial discipline in the later years of life.
Less strict financial discipline in the later years of life is often the cause of overspending, and insufficient preparation for retirement. Since people tend to believe that their savings rate will decrease over time, they are more comfortable with their financial discipline also declining over time.
Compound growth is a powerful generator of savings and wealth in youth. Yet, the bigger the amount invested, the more gains the investment is likely to create. Hence, compound growth kicks into high gear in the later years of life (because investment size tends to increase over time).
If a budget keeper operates on the assumption that their savings rate declines over time, they will be more likely to liquidate some of their investments, instead of letting them grow.
What is the implication of this paradox to wealth creation? The main implication of the paradox of personal savings rate is the possible decline in wealth of people who believe in it.
Thoughts tend to influence people’s actions (Ideomotor theory). More so, if the thoughts are directed at money. People who do not know about the savings rate increase over time, could have to deal with a harder path to wealth creation, and a longer time to reach their savings goals.
Savings from assets
Income from assets, like dividends from shares, and their management, is a topic that is rarely tied to the concept of personal savings rate. The neglect of this important topic can harm investors and budget keepers.
After receiving dividends, many will continue to reinvest instead of holding in cash. This may not always be the best idea. The scales should not always tip in favour of gains from re-invested money, especially during certain economic conditions.
It may be tempting to always re-invest the income from assets, by following the conventional, and otherwise rational advice. Instead of putting away a share of income from investments, many will choose to use it to increase the size of their investment portfolio.
Depending on the current state of the economy, a better move can be to save the income.
If the income from assets is received at the early stages of a bull market, or during a bear market, it wouldn’t be rational to not take advantage of the asset appreciation opportunities these economic conditions offer. Yet, if the income from assets is received during the later stage of a bull market, putting it away into savings would be a smart move.
This move would contribute to a larger fund that can be used to maximize gains after a bull market ends, and a bear market starts. A larger fund for investing during a downturn, likely will create larger gains after the market picks up.
Rate and raise
The final goal of a person saving money is creating wealth for their own specific reasons. Saving money enables people to live a more financially secure life, and to fulfil personal goals.
Raising the personal savings rate will help to create wealth. Yet, not all wealth creation opportunities are tied to savings or investments.
Many are entirely about being at the right spot in the right time, or having successful timing. Accidentally meeting a potential co-founder, or seeing a tweet about a new startup, can create far more wealth than any savings strategy or an investment.
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