Why Reducing Expenses Counts Twice
When it comes to relative wealth and financial freedom, reducing expenses is king.
First, what do I mean by “relative wealth”? Usually, relative wealth is used to describe your wealth relative to others. Not in this post (you shouldn’t care what other people have anyway!). Today we’ll use the words “relative wealth” to describe your wealth relative to what you need.
You need shelter and a place to live. But how big and fancy it has to be differs. If you require a McMansion to feel happy, you need more wealth than someone happily living in a trailer park.
Your wealth, relative to your needs, is what matters if you want more financial freedom. When your wealth exceeds your needs, you are financially free. Your absolute wealth is much less important. Increasing it is nice, but the impact on your happiness and life satisfaction will be much lower if you already have your needs met.
So. Relative wealth is what we want. How do we build more of it?
We do that by either a) increasing our income or b) reducing our expenses. These are the only options we have for increasing our wealth.
Let’s say we need 100 “wealth” to satisfy our monthly needs. And let’s say we make 100. We build up no wealth and we’ll have to keep working forever in this scenario.
Now let’s say we increase our income to 150 and keep our monthly needs the same (a task harder than it sounds). We now save 50 a month. In three months we build up enough wealth to live for a month.
What if we decreased our needs instead? We go from 100 to 50. Again, we save 50 a month. But something magic happened: we now save enough to live an entire month, each month.
Three months down the line in the first scenario, we have enough financial freedom to live for a month. In the second, we have enough for three months.
Both scenarios have a 50 “wealth” change, one in income earned, the other in expenses burned. However, the financial freedom outcome is significantly different. In a year, the income strategy yields 4 months of financial freedom - the expenses strategy yields 12!
Interestingly, the two scenarios will save the same amount of wealth in absolute terms. But in relative terms they are 1 to 3 in this example. (Now imagine combining the two…)1
The overall takeaway here is that increasing income will help you once. It will increase what you take home each month. You can spend that or save it. But it only helps you once. Reducing expenses helps twice. First, you save more each month by reducing expenses. Second, you need to build up less savings in the first place.
Another way of looking at this is with your savings rate. Your savings rate determines how quickly you become financially independent. The higher your savings rate, the better. At 66%+ you can retire in 10 years. At 33% it takes 26 years. At the more traditional 10% range you are looking at something like 50 years.
Savings rate = (income - expenses) / income
As you can see, increasing your income will increase both the numerator and denominator in the equation above, whereas reducing your expenses will increase just the numerator. So to increase your savings rate it is more effective to reduce your expenses by 50 than it is to increase your income by 50, just as we have seen in the example above.
0% = (100 - 100) / 100
Reducing expenses by 50:
50% = (100 - 50) / 100
Increasing income by 50:
33% = (150 - 100) / 150
You may argue that the scenarios here are too artificial and that reducing your expenses from 100 to 50 means cutting down spending in half, whereas increasing income from 100 to 150 is not doubling your income so it may be easier to achieve. But:
All else being equal, reducing your monthly expenses by $100 will help you reach financial freedom earlier than increasing your income by $100 will.
Wether increasing income or reducing expenses are easier for you depends on your situation. Both are helpful.
Understanding that spending matters more than income has been one of the key lessons I have learned on my journey towards more financial freedom. It’s why I aspire to be an elite saver and why I keep tracking my spending habits. Cutting down excess spending is not just more effective than increasing income, it is also easier. As a worker I have much less direct control over my income than I have over my expenses. Promotions, raises, etc., are nice but they are also impacted by factors out of my control.
So take a look at your balance sheet and consider a round of trimming. You’ll be amazed a how much better your situation can look if you cut down a bit. Income is exciting but expenses are where the real change happens.2
As the two strategies save the same you could also create a strategy where you first increase your income while building up financial freedom and then only reducing your expenses once you have enough. There is some validity to this idea as e.g, maybe you need a car for your current job but you could live without one if you quit. That may be a valid edge case but many expenses can be reduced even if you are still working. Which means you could reduce the expenses upfront and become financially free that much earlier. Also, reducing expenses is a process so you better start working on it now rather than later. ↩