Money. Some of us work hard to get it. Others marry into it. And some people just get a lucky break.
But what about the rest of us? Do you need a high-income job to get rich? And does becoming wealthy have to be risky and complex?
From cutting your costs to investing while you’re young, you’ll discover just how easy it is to increase your personal wealth.
Cut your spending if you want to grow rich
Picture a millionaire – someone who’s rich in assets and free of debt. What kind of job do you think this person has?
Probably a lucrative one, right? After all, most rich people are surgeons, investment bankers, and high-flying lawyers – not your average middle-income earners.
Well, if that’s your picture of prosperity, it needs to change. Why? Because wealth isn’t just about how much you earn. Instead, it’s more about how much you spend and how much you save.
Being smart with your investments is the key to becoming wealthy. But before you can invest, you need to save. After all, if you burn through your salary every month, there’s never going to be anything left over to invest.
So, if you want to become wealthier than the average person, you can’t spend like the average person. You have to spend less.
This is a trick that many rich people already follow. Don’t believe it? Then picture the car you think the average millionaire drives. Is it a Porsche? A Ferrari? A top-of-the-range Mercedes-Benz? If that’s your best guess, you’re miles off. The average American millionaire drives a Toyota.
And what about their houses? If they’re not blowing their money on cars, surely they’re splurging on their homes, right? Think again.
According to Thomas Stanley, an American wealth researcher, most million-dollar homes aren’t owned by millionaires. Instead, those houses usually belong to non-millionaires with high standards and even higher mortgage payments. In fact, only 10 percent of millionaires own homes worth more than a million dollars.
Simply put, wealthy people are generally frugal people, and their lifestyles are often nothing like the lavish ones we associate with the rich. Because they spend little, they can afford to invest a lot. That’s the real trick to growing your wealth.
To capitalize on compound interest, start investing as soon as you can
So, you’ve cut back on your expenses. You’ve stopped eating out every night and no longer go on expensive weekend breaks. Now your bank balance is starting to rise.
What should you do next? Let the money build up in your account? Hope the interest on your savings keeps up with inflation?
Spending less is only the first step to becoming wealthy. If you truly want to capitalize on your savings, you can’t just let them sit in the bank. You have to find somewhere for them to grow.
If you put your money into investments at the first opportunity, you’ll thank yourself in the years to come. That’s because compound interest will work in your favor.
You might already understand how compound interest works. If not, think of it like this. When you make an investment, you start with a certain amount of money – $1,000, say. If you’re earning 10 percent compound interest on that investment every year, it will grow to $1,100 after 12 months. After another year, you’ll gain 10 percent on that $1,100, bringing your balance to $1,210.
In other words, compound interest refers to the fact that every year, you earn interest not only on the original amount but also on whatever interest you gained since you first invested. Over time, the total can grow into far more than you ever imagined. For example, if you invested $100 at 10 percent compound interest and left it alone for 50 years, you’d have $12,000. And if you didn’t touch it for another 50 years, it would turn into almost $1.4 million.
Because compound interest leads to greater rewards over time, the best strategy is to start investing as soon as possible. In fact, you can invest half as much as your neighbor and still end up with more money if you start investing early. It’s no wonder billionaire Warren Buffet, who made his first investment when he was only 11 years old, likes to joke that he started too late!
So, if you’re a college student and you can save some money, start investing today. And if you’re in your sixties and you’ve never invested before, don’t wait either. As the ancient Chinese proverb says, the best time to plant a tree was 20 years ago. The second best time is now.
Avoid actively managed funds and opt for index funds instead
You’ve cut your spending, and you want to start investing right away. Luckily for you, there are plenty of financial advisers to help you put your savings in the best possible place. All you need to do is follow their advice, right?
Well, not quite.
It turns out that lots of financial advisers pay more attention to their own agendas than they do to yours. Too often, the advice they give you is tailored to make them money – not you.
They do this by recommending actively managed funds. Why? Because when you put your money into an actively managed fund, your financial adviser profits from what you pay.
When you invest in an actively managed fund, you give control of your money to a fund manager, who uses it to buy and sell stocks. On the face of it, this doesn’t sound like a bad deal. But when you compare actively managed funds to index funds, the shortcomings become clear.
An index fund isn’t “actively managed.” In other words, there’s no one buying and selling stocks on your behalf. Instead, when you invest in an index fund, you’re buying a single, stable product that contains thousands of stocks.
For example, if you buy a total stock-market index fund, you’re buying a product that bundles together stocks from the entire stock market. If the stock market goes up, the value of your investment goes up. And if the stock market goes down, the value of your investment goes down, too.
Actively managed funds take a different approach. Instead of matching the performance of the stock market like an index fund, they try to beat it. Unfortunately, once you take fees and taxes into account, about 96 percent of actively managed funds do worse than the stock market as a whole. And the 4 percent that do outperform the stock market are almost impossible to identify ahead of time.
Many actively managed funds soar for a couple of years, make staggering profits, and then crash for reasons nobody fully understands. That’s why a better and simpler strategy is to avoid actively managed funds altogether and stick to index funds instead.
Invest in bonds to make your portfolio more stable
Managing your investments is like maintaining a healthy diet. That’s because when it comes to nutrition and when it comes to your investment portfolio, diversity and balance are key.
For example, even though you know that green vegetables are good for you, eating nothing but brussels sprouts for the rest of your life would be a bad idea. You also need to eat protein, other carbohydrates, and healthy fats.
In the same way, your portfolio can’t just contain index funds. You have to balance it out with bonds.
When you buy a bond, you’re essentially loaning money to an organization – normally a government or a company. In return, they promise to give you interest every year and to pay you back when the loan expires.
Because the return you get from a bond is predictable, it’s not going to be very high. Sure, you’ll get interest, but often it’s just enough to keep up with inflation. So, why are bonds so useful? Because they’re not volatile.
Whereas a bad year for the stock market can drastically change the value of your index fund investments, bonds don’t fluctuate nearly as much. And because of their resilience in the face of market changes, bonds can stabilize your investment portfolio.
You can even purchase bonds in the form of a collected index, just like you can with stocks. And just like a stock-market index fund can match the performance of the whole stock market, a government bond index fund matches the more stable market of government bonds.
Because bonds are so reliable, they can be quite useful if you’re approaching retirement. After all, no one wants to discover that their nest egg has been cut in half just because of the chaos on Wall Street.
One rule of thumb says to take your age and then subtract ten. Whatever you’re left with is the percentage of your total investments that should be in bonds. So, if you’re 22, that means 12 percent of your portfolio should consist of bonds. If you’re 60, it should be 50 percent.
Whatever your age, though, the ability of bonds to add stability and variety to your investments is something you shouldn’t overlook.
Fight the temptation to “time the market
Jeremy Siegel, a professor of finance at the Wharton School of the University of Pennsylvania in Philadelphia, set himself an interesting task. He wanted to see if he could explain some of the biggest stock-market movements since 1885. So he sat down with the data and began to comb through the history books.
Unfortunately, even with all the records in front of him, he couldn’t account for most of the puzzling fluctuations or explain what caused the market to rise on some days and fall on others. And if a professor of finance can’t explain market changes with the benefit of data, historical reports, and years of hindsight, your chances of predicting future trends are practically zero.
As humans, we like to think well of ourselves – whether it’s by overestimating our driving skills or thinking that we can beat the market like nobody else. Sure, we might admit that there’s a lot of risk in trying to make a quick buck from buying and selling stocks, but we also convince ourselves that we won’t get burned. We believe that we’ll be smarter and that this time will be different.
This was the attitude in the late 1990s when technology stocks soared during the dot-com bubble. With share values skyrocketing, everyone wanted a piece of newfangled digital companies like Nortel Networks and Priceline.com. But the bubble burst, as bubbles always do, and investors lost millions. Many people thought they could get out in time if the market turned around, but very few of them came out of the crisis better than they were before.
In the end, the message here is the same one professor Siegel discovered – trying to time the market is a fool’s game. In fact, John Bogle, whom Fortune magazine called one of the top investors of the twentieth century, expressed the same feeling about timing the market when he said that: “After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently.”
The bottom line is that gambling with your savings isn’t wise. So do yourself a favor and learn from other people’s mistakes by staying clear of trying to beat the market.
If you can’t resist buying specific stocks, be sure to select them very carefully
When it comes to investing your money, the best option is to choose index funds and bonds. It’s really that simple – but for some people, it’s a hard program to follow.
For them, the temptation to invest in specific stocks is just too great. And while this isn’t the smartest move, statistically speaking, that doesn’t mean all approaches are equally risky.
So, if you’re an investor who can’t resist the urge to buy specific stocks, set aside 10 percent of your portfolio for that purpose. But don’t just buy at random. Instead, keep a few pointers in mind to help you avoid costly mistakes.
First of all, try not to buy and sell too often. Every time you trade, you incur taxes and fees. So although trading stocks can seem like a great way to make money, if you do it too frequently, it can actually wind up being quite expensive.
A better strategy is to only buy stocks that you’re happy to own for a long time. This means choosing companies whose business operations you can understand. For example, if you don’t know much about technology, and have no idea what makes a particular tech company successful, then don’t invest in their stocks. Instead, focus on companies with relatively straightforward products and simple business strategies.
Another thing to watch out for is a company’s level of debt. If it has sizable loans to repay, it’s going to struggle in an economic slump. When sales drop and creditors come knocking, it might even have to close down. Instead, look for companies with little or no debt. This gives them added stability, which makes it less risky to buy their stocks.
On the whole, you’ll probably find that your index fund investments perform better than the stocks you picked yourself. That’s to be expected. But buying a few select stocks will hopefully keep you from taking any larger and more damaging financial gambles. That’s how you’ll grow your wealth.
Cut your expenses and start investing your savings as soon as possible – the magic of compound interest rewards you over time. To start investing, put your money into index funds and bonds. And if you must pick specific stocks, make sure you carefully study and fully understand the companies in which you’re interested.