You may wonder what living below your means has to do with investing. Obviously, you need to live below your income in order to have money to invest. Did you know that living below your means has a big effect on your portfolio?
How does this affect your portfolio? Your spending level continues to impact your portfolio long after you have retired. The more money you are accustomed to spending pre-retirement the larger a portfolio you will need. This is because you need to have a reasonable withdrawal rate to avoid running out of money.
Here are some examples to explain in more detail. Let's say that you make $50,000 a year. You can comfortably live off this and manage to save 10% each year. You are living below your means which is very good. You estimate you will receive approx. $12,000 a year from Social Security. That leaves a shortfall of $38,000 a year that your portfolio needs to provide.
Keep in mind this is not counting taxes or inflation in the example. Traditionally, you could expect a withdrawal rate of 4%. This means you would need a portfolio of $1,000,000 to provide with a little extra leftover. The example assumes you will not be having additional income such as a part-time job.
So let's assume that you are on track. Now letís change the scenario slightly. Let's say that you receive a raise of $5,000 a year. You are ecstatic. After taxes, it leaves you with approximately $3,000 more each year. To celebrate you take a much anticipated vacation with your family. It is supposed to be a one-time event.
One-time would be fine. But a funny thing seems to happen to a lot of people. That one-time event becomes a once-a-year event. Or, you spend extra at your favorite restaurant. It seems small. After all, you have more money to spend now. The thing is that that extra money now becomes a regular occurrence. You are no longer spending $50,000 a year but $53,000 instead.
Consider how this changes the portfolio. You now need $53,000 a year in retirement. Subtracting Social Security of $12,000 (you may get a little more since you are being paid more, but for simplicity we'll leave the amount the same) leaves a shortfall of $41,000 a year. Oops, a $1,000,000 portfolio at 4% comes up short by $1,000.
You may assume that you will work after retiring or cut your expenses after you retire. Both will help your portfolio. Remember that inflation was not considered in this example. Inflation would have required you to have more money to maintain the same standard of living. Also, many people retire sooner than anticipated due to health reasons.
Plus, a 4% withdrawal rate may be too high. Today interest rates are historically low and portfolio returns are on the low end of average. You want a steady stream of income in retirement which means investing in lower-paying investments. They may not support a 4% withdrawal rate.
What does all this mean? The point is to be aware that spending that raise or extra money does have consequences for your future. There is nothing wrong with enjoying your money. Just be aware how it will impact you in the future.