How to save a million dollars

Make me a millionaire

A reader asked me the other day, how to save $1,000,000 before they retired. At first, I thought that quite an arbitrary figure to aim for. Would they be happy with $800k? Maybe they were aiming for it, just because it sounded like a ‘magic number’ and they wanted to call themselves a ‘millionaire’. So I asked for a few more details about their situation.

Let’s call him Mr. A. Here’s a few facts about him.

He lives in the UAE and earns a take-home pay of $4,200 p.m.

There is no income tax paid in the UAE. 

He is currently 32 years old and wants to retire to his home country when he hits 50. 

He currently has $5,000 cash saved up.

At first sight, this sounds like a pretty tall order, but I wanted to see if this was possible, and how to go about it.

I ran the numbers and I’m going to lay out a few possible ways to hit (or not) his goal. I won’t pull any punches here. This isn’t going to be east, but Mr. A; here are some possible ways to hit your goal.

Is a million dollars enough?

If we are to assume the fairly well accepted ‘safe withdrawal rate’ of 4% from his pot of savings and investments over time, a $1,000,000 pot would fund an annual income of $40,000. (This $40k would then be increased by inflation annually.)

At the moment he is earning 12 x $4,200 = $50,400 annual salary. So $40k is about 80% of his current salary.

Retiring on a salary of about 80% of your salary when you were working is actually pretty reasonable. Maybe this $1,000,000 retirement ‘pot’ actually isn’t such a crazy idea.

How much of my salary should I save?

Looking at his annual salary – $50,400. If hypothetically he was to save all of it for 18 years and not spend a penny, he’ll have $907,200. Not far off the goal, but also highly implausible unless he was somehow living for free.

So, he will need to save some of his income and also earn some kind of return on those savings. Mathematically, that’s quite simple to work out and in order to save your calculator, I’ve done the sums here:

Initial Investment 5,000
Annual growth rate 10%
Compounding periods per year 1
Years 18
Savings rate 45%
Annual contributions 22,680
Final Balance 1,061,989
Initial Investment 5,000
Annual growth rate 7%
Compounding periods per year 1
Years 18
Savings rate 60%
Annual contributions 30,240
Final Balance 1,045,030
Initial Investment 5,000
Annual growth rate 5%
Compounding periods per year 1
Years 18
Savings rate 70%
Annual contributions 35,280
Final Balance 1,004,543

(If you want the compound interest calculator formula – It’s (1+r)n where r is the expected rate of return and n is the number of years to compound by. You also have to add in the annual contributions annually. The FV (future value) function in google sheets does all this for you.)

The two variables in these sums are the annual growth rate, and the savings rate. Everything else remains the same

Now, Mr A must take a long hard look at his situation and decide a couple of things. He must decide what savings rate he is willing to afford. Can he reasonably expect to save 45% of his salary. That’s a big shift in living standards for anyone to swallow. 

It may be that Mr A has just recently started working and hasn’t yet adjusted to his new, big salary. Or he’s married and his spouse is earning enough for their living expenses, in either case, he could be fortunate enough to be able to save the majority of his salary.

But those savings rates are ridiculously high!

Maybe they are, maybe not. J.L.Collins who wrote ‘The Simple Path to Wealth’ famously stuck to a 50% savings rate. Whether or not that’s for you, only you can tell. But what if you really think you can’t hit these kinds of figures; let’s look at what to do with a lower savings rate. Let’s go for 30%. It’s still significant, and much more than most people will put aside. Would this be enough for Mr. A to hit his million-dollar goal?

Initial Investment 5,000
Annual growth rate 7%
Compounding periods per year 1
Years 18
Savings rate 30%
Annual contributions 15,120
Final Balance 530,965

$530,965. No. This is quite a long way short of his desired goal. It’s still a nice sum of money, but it only gets him halfway to where he wants to be. So there seem to be only two different options now, without increasing the level of risk that Mr A takes.

(This scenario was assuming a middle-of-the-road figure of 7% annual returns on his money. Some years will be much more than that, and others much less, but we’re just using that as a reasonable average. Remember, with potentially higher returns, there is potentially higher risk. Be that in volatility, currency fluctuations, interest rates or just solvency. Nothing comes for free and everything is a tradeoff.) 

Here are two different scenarios that he may want to consider:

  1. Work for longer
  2. Increase those savings over time

Longer? How much longer?

8 years to be precise. 

Initial Investment 5,000
Annual growth rate 7%
Compounding periods per year 1
Years 26
Savings rate 30%
Annual contributions 15,120
Final Balance 1,067,425

By keeping the same sized contributions, and with the same growth rate, it will take Mr A 26 years, instead of his desired 18 to hit his goal. Could he stomach retiring at 58 instead of 50? Maybe. I don’t know. That is for him to decide. Perhaps he won’t even know himself till he reaches his goal. A lot can change in the next 2 decades. But it just shows that if you can’t get a better return, and you can’t save more, your only option is to work longer.

What if Mr. A increases his savings over time? Let’s say he increases them by inflation. If he is able to increase his pay by inflation also, then hopefully this isn’t too much to ask. We have assumed that inflation averages about 4% in the example below. Let’s see how long it takes to hit his goal.

Initial Investment 5,000
Annual growth rate 7%
Compounding periods per year 1
Years 22
Savings rate 30%
Initial annual contribution, increasing by 4% annually 15,120
(Final contribution, for your reference) 34,455
Final Balance 1,060,635

22 years. 4 whole years faster than just keeping the contribution fixed. This would come down even more if over time, his job changes and he receives pay rises above inflation. He could put a proportion of those pay increases into his savings and accelerate his wealth growth. 

If every 5 years he was able to get a 10% pay rise with a promotion, for instance, his savings might look something like this.

Year Total Savings Annual contribution
0 5,000
1 20,470 15,120 + 4% every year
2 37,628 15,725
3 56,615 16,354
4 77,586 17,008
5 102,407 19,389 10% pay rise
6 129,740 20,165
7 159,793 20,971
8 192,788 21,810
9 228,966 22,682
10 270,851 25,858 10% pay rise
11 316,703 26,892
12 366,841 27,968
13 421,606 29,087
14 481,369 30,250
15 549,550 34,485 10% pay rise
16 623,883 35,865
17 704,854 37,299
18 792,985 38,791
19 888,837 40,343
20 993,012 41,957

How we’re down to just 20 years, saving 30% of his salary and increasing those savings over time with inflation and with potential salary increases.

How to earn 7% per year

Well that really is the million-dollar question. There are many ways to achieve a target figure like this, some better than others. There’s really no right or wrong answer, as anything that achieves the goal is obviously good enough. There are several different ways I would approach it. I would probably avoid going all-in on any one of them, but using them all to my advantage over time. 

The three I would consider would be:

  1. Investing in stocks and bonds
  2. Investing in property
  3. Building a business

Investing in stocks and bonds

Investing in stocks and bonds would be my preferred solution. A quick run on with 3 very simple portfolios split between a stock market index and a bond market index – 60/40, 80/20 and 50/50, using the two funds; VTSMX (Vanguard Total Stock Mkt Index) and VBMFX (Vanguard Total Bond Market Index) gave the following results.

3 portfolio assets allocations
Portfolio returns
Portfolio growth graph

They all hit or got very close to the $1,000,000 goal in the 21 years, from 1997 to 2018, which included the two big bear markets in 2001/2 and 2008. This was assuming the same conditions as mentioned above, saving 30% of his salary, and increasing that for inflation every year. (Inflation has actually been lower than 4% recently.)

If an investor had just kept his head down and kept contributing to his investments month in and month out, he would have hit his goal.

(Please bear in mind these are just using data for the US markets, and it is historical data. There is no guarantee that this will be repeated going forward. But it does show that a 7% return is possible. Look at the TWRR column – that shows the average annual returns.)

Investing in property

Investing in property can be very lucrative. It is possible to build significant wealth through it. But it can also be dangerous. I’ve put more thoughts on this particular asset class here, but the pros and cons can be summarised as follows.

  • You could buy a house and live in it. Potentially pay less than the cost of rent and over time slowly pay down your mortgage to leave you a chunk of equity. How much that will be in the future, no-one knows.
  • The real value of that mortgage in real (after inflation) terms usually decreases over time, as inflation works in your favour.
  • You can leverage your savings, by using someone else’s money to buy the house for you. This is usually the bank providing you a mortgage meaning you only have to put down a small percentage of the purchase price.
  • If the property increases in value, the value of your part of the property grows fast, as the size of the mortgage is fixed. Any upside growth works in your favour.
  • If the property decreases in value, you may lose all of your equity or even more, if the value of the property falls by more than you put in as your deposit.
  • Leverage is a double-edged sword.
  • If you buy 1 or 2 investment properties, you are probably making one or two big bets on the direction of their prices.
  • Property ownership and management can be a pain in the backside.
  • If you are going to invest in property – buy something that will provide you a regular positive cashflow. Something that has a limited downside in terms of the price, provides rental payments well in excess of your monthly costs and is always likely to rent. 
  • If you approach it like this, you are thinking like a business owner. You are better protected in terms of the downsides than someone who buys an expensive property hoping for the price to rise, and whose income from the property only just, or even doesn’t quite cover their costs.

Building a business

Building a business sounds to me like a plausible third option. Real estate investing is actually just running a little business, and many people forget to treat it as such. But there are many other ways to earn money. 

It might even be possible to rise to a position in the next couple of decades, within your current business where you reach a senior position and possibly even become an owner.

If Mr. A was so inclined and had an entrepreneurial spirit, perhaps he could look at setting up a side business. Either in the country that he is working in or even back home. If he has particular skills from his profession, perhaps he could do some freelancing or consulting. Or if he could follow his passions and interests and set up something completely different. 

I know someone who is making a substantial side income running a food stall business and another who is building a small hotel back in their home country. Several friends have turned their hobbies into profitable businesses making everything from dresses to tables, windows to jewelry. One does tax returns and another, music classes for kids. The options really are limitless.

Potentially the financial upsides to these ventures could be much higher than conventional investing, and if they are approached in a way that limits the costs and risks to Mr. A, there’s not much harm in trying. Businesses can be set up for a very small upfront cost and could potentially return well in excess of 10%.

A great book for looking at low-cost business startups would be the $100 Startup by Chris Guillebeau.

What’s the best way to reach this goal?

Perhaps the best approach would be to consider one main direction, such as low-cost investing in shares and bonds, with one or more smaller side ventures to try and maximise his earnings. Once he gets a feel for investing, he will decide what he is comfortable with and follow that strategy.

He will need to stick to a regular investing plan, and in the last few years before his retirement, starting to de-risk the portfolio as it approaches his goal. He should increase his savings contributions over time, in line with inflation and also any pay rises he receives. The cash generated by running a side business or property venture can be compounded on top of his normal savings to hopefully reach his target even sooner.

There’s also a whole heap of other variables in this equation. Is he married? Is there another income in the family? What about kids? Any other big outgoings coming up? Can he count on the end of service benefit from his current employer? Too many to consider really, and only you know what your own personal situation is. I just want to lay out some frameworks to help guide your thinking, and I hope you can take it from there.

A quick note about inflation

We have talked in this example about increasing savings amounts in line with inflation over time. I think that’s an excellent idea. But inflation is also your nemesis as well. It destroys your wealth over time. 

With inflation averaging, let’s say 4% p.a., then the equivalent of $1,000,000 in today’s money will be about $2,000,000 in 18 years’ time. Or in other words, if you ‘just’ save up $1,000,000, it will only buy you half, 18 years in the future, of what it will today. Inflation will have destroyed your purchasing power by half by then, if inflation is around 4% p.a.

Ignore it at your peril.

How to account for inflation

The simplest way to calculate investment returns, taking into account inflation is either to simply subtract the expected inflation rate from your expected rate of return and calculate everything in today’s’ values. (E.g. 7% expected returns – 4% inflation = 3% real (after inflation) returns.)

If you wanted to, you could instead work out what your target figure is, taking into account inflation. (Use that (1+r)n formula again.) Then you don’t have to adjust your expected return figure. The only advantage to using this method is that it helps you keep a track over the years of where you are in relation to your goal, in ‘nominal’ terms. You will know how much you expect to have saved up by any given point, and you can compare your account statements to that figure.

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