Wait. Isn’t this supposed to be about investing? So why am I telling you about savings? At the very least, shouldn’t I be telling you about concepts like Time Value of Money (TVM) or Compound Interest? Well, all of those might be important but let me explain why I think savings, at least in the beginning, is the most important step of all.

Compounding will turbo-charge the returns you get on your capital. C the difference between simple interest and compound interest. A simple interest of 10% per annum (p.a.) on a sum of $1,000 brings your total to $2,000 after 10 years while the same $1,000 compounded at 10% p.a. for 10 years gets you $2,593.74. That’s almost 60% returns ($1,593 vs. $1,000) just by letting your returns compound.

So why is savings so important?

### Zero compounded by anything is still zero

For starters, no matter how powerful compounding is, if there isn’t anything to compound, your returns are still zero.

That’s just it. You can’t escape the mathematics of the situation.

Naturally, the higher the savings rate also means that compounding has a much bigger number to compound on.

### Without savings, it’s going to take a long, long time

In the beginning, you aren’t likely to have much capital to start with. Even if you can produce god-like returns in the realm of 20-30% p.a., the absolute sum is not going to be life-changing.

For example, let’s say you have a financial independence target of $1 million and you expect to compound $1,000 to your financial freedom. Assuming you can achieve the above-mentioned godlike returns of 25% p.a., it will still take you roughly 31 years to reach your target.

But what happens if you start saving an additional $1,000 a year? Then it only takes you about 24 years.

And remember, the above example assumes you are going to some sort of investment genius. I can assure you that more likely than not, you will be as average as I have been.

Let’s try to apply some more realistic numbers and see what that takes us. This example is going to be in the context of someone working in Singapore that has a Central Provident Fund (CPF) account. As of writing and I think (fingers crossed!) for the foreseeable future, the Special Account (SA) pays roughly 4% p.a.

If a Singaporean worker starts working at 25 years old can somehow contribute get $5,000 per year in their SA and it continues to compound at 4% p.a. until he/she reaches 55 years ago where CPF allows that lump-sum withdrawal, this person would have $280,424.69. Assuming that the 4% p.a. is a real rate of return, I think more than a few people would be quite happy with having $280K in their bank.

### Savings forces us to live with less

Living with less means that it’s much easier to be financially independent.

Most people don’t realise this but there isn’t a magic number to financial independence. Financial independence depends a whole lot on whether you have enough income to meet your expenses.

A person with an income of $100,000 and expenses of $100,001 per year will never experience financial independence and in fact will be forced to dissave.

Naturally, achieving financial independence means being able to generate the income necessary to cover your expenses at will. There is no dependence on an employer for this income.

How does this relate to savings?

Well, if your savings rate was high, then your expenses would naturally be low. Let’s consider two people, both with an income of $100,000 p.a. Let’s say that A only saves $10,000 while B saves $90,000. The corollary must be that A spends $90,000 while B spend $10,000 per year. This means that each year, A would have saved 1/9 of a year of his expenses while B would save 9 years of expenses.

I also think there’s something to say about how people buy too much crap that they don’t need due to excessive advertising or how we end up spending on things that won’t mean much some years down the road and the environment is paying a price for that.

### Less is more

If we were to apply the pareto principle of how 80% of all outcomes are determined 20% of actions, I would say being able to save and having a high savings rate is the 80/20 rule of personal finance.

I don’t think I’ve ever read or heard of anyone who has gone broke by saving too much. On the other hand, there are numerous examples of those who have made millions and lost it all and more because they simply couldn’t control their spending.

In short, save more, spend less.