Updated May 15, 2019
Building wealth is a hot topic that
sparks heated debate, promotes quirky "get rich quick" schemes, and
drives people to pursue transactions they might otherwise never consider.
"Three Simple Steps to Building Wealth" may seem like a misleading
title, but it isn't. While these steps are simple to understand, they're not
easy to follow.
The
Steps
Basically, building wealth boils
down to this: To accumulate wealth over time, you need to do three things:
- You need to make it.
This means that before you can begin to save or invest, you need to have a
long-term source of income that's sufficient to have some left over after
you've covered your necessities.
- You need to save it. Once
you have an income that's enough to cover your basics, you need to develop
a proactive savings plan.
- You need to invest it. Once you've set aside a monthly savings goal, you
need to invest it prudently.
This makes a simple equation:
Savings=Income−Spending\text{Savings}
= \text{Income} - \text{Spending}Savings=Income−Spending
Step 1:
Making Enough Money
This step may seem elementary, but
for those who are just starting out, or are in transition, this is the most
fundamental step. Most of us have seen tables showing that a small amount
regularly saved and compounded over time can eventually add up
to substantial wealth. But those tables never cover the other sides of the
story – that is, are you making enough to save in the first place? Keep in mind
that there's only so much you can cut in costs. If your costs are already cut
down to the bone, you should look into ways to increase your income. Also, are
you good enough at what you do and do you enjoy it enough that you can do it
for 40 or 50 years in order to save that money?
There are two types of income
– earned and passive. Earned income comes from what you
"do for a living," while passive income is derived from investments.
This section deals with earned income.
Those beginning their careers or in
the midst of a career change can think about the following four considerations
to decide how to derive their "earned income":
- Consider what you enjoy. You will perform better and be
more likely to succeed financially doing something you enjoy.
- Consider what you're good at. Look at what you do well
and how you can use those talents to earn a living.
- Consider what will pay well. Look at careers using what
you enjoy and do well that will meet your financial expectations.
- Consider how to get there. Determine the education
requirements, etc., needed to pursue your options.
Taking these considerations into
account will put you on the right path. The key is to be open-minded and
proactive. You should also evaluate your income situation annually.
Step
2: Saving Enough of It
You make enough money, you live
pretty well, but you're not saving enough. What's wrong? There's only one
reason why this occurs: Your wants exceed your budget. To develop a budget or
to get your existing budget on track, try these steps:
- Track your spending for at least a month. You may want
to use a financial software package to help you do this. Make sure you
categorize your expenditures. Sometimes just being aware of how much you
are spending will help you control your spending habits.
- Trim the fat. Break down your wants and needs. The need
for food, shelter, and clothing are obvious, but you also need to address
less obvious needs. For instance, you may realize you're eating lunch at a
restaurant every day. Bringing your own lunch to work two or more days a
week will help you save money.
- Adjust according to your changing needs. As you go
along, you probably will find that you've over- or under-budgeted a
particular item and need to adjust your budget accordingly.
- Build your cushion – you never really know what's
around the corner. You should aim to save around three to six months'
worth of living expenses. This prepares you for financial setbacks, such
as job loss or health problems. If saving this cushion seems daunting,
start small.
- Get matched! Contribute to your employer's 401(k) or 403(b), and try to get the maximum your
employer is matching.
The most important step is to
distinguish between what you really need and what you merely want. Finding
simple ways to save a few extra bucks here and there could include programming
your thermostat to turn itself down when you're not at home, using regular
unleaded gasoline instead of premium, keeping your tires fully inflated, buying
furniture from a quality thrift shop, and learning how to cook. This doesn't
mean that you have to be thrifty all the time. If you're meeting savings goals,
you should be willing to reward yourself and splurge (an appropriate amount)
once in a while! You'll feel better and be motivated to make more money.
Step
3: Investing It Appropriately
You're making enough money and
you're saving enough, but you're putting it all in conservative investments.
That's fine, right? Wrong! If you want to build a sizable portfolio, you have
to take on risk, which means you'll have to invest in equities.
So how do you determine what's the right level of exposure for you?
Begin with an assessment of your
situation. The CFA Institute advises investors to build
an investment policy statement. To begin, determine
your return and risk objectives. Quantify all of the elements affecting your
financial life including household income, your time horizon, tax
considerations, cash flow/liquidity needs, and any other factors that are
unique to you.
Next, determine the
appropriate asset allocation for you. Most likely you
will need to meet with a financial advisor unless you know enough to
do this on your own. This allocation will be based on the investment policy
statement you have devised. Your allocation will most likely include a mixture
of cash, fixed income, equities, and alternative investments.
Risk-averse investors should keep in mind
that portfolios need at least some equity exposure to protect against inflation. Also, younger investors can afford to
allocate more of their portfolios to equities than older investors, as they
have time on their side.
Finally, diversify. Invest your equity and fixed-income
exposures over a range of classes and styles. Do not try to time the market.
When one style (e.g., large-cap growth) is underperforming the S&P 500, it is quite
possible that another is outperforming. Diversification takes the timing
element out of the game. A qualified investment advisor can help you develop a
prudent diversification strategy.
To get started investing, you will
need a brokerage account. With the sheer amount of brokers to choose from,
picking one can be a troublesome process. To help ease that confusion and
frustration, we have created tools to help out. Check out our guide on how to open a brokerage account and also our list
of the best stock brokers to get an idea on how to move
forward with investing your money.
