Building Wealth: Simplified
Building Wealth:
Simplified
When you take the time to think about it, there are actually only three steps to building wealth: make more money, save more money and invest more money. Building wealth is one of those topics that has become quite taboo recently. With all those online “get rich” quick schemes, it has become quite tough to convince people that the best and only way to build wealth is through self-control over a long period. There is simply no get rich quick scheme although people will always try to sell you on something that will make them rich quickly! The truth is that there are actually only three simple steps to building wealth that are very easy to understand but a bit tougher to follow.
To be able to accumulate wealth over time, you need to do the following three things:
- Make Money. Before you can even start thinking about saving or investing, you need to make sure that you have a steady source of income that allows you to pay off your debts and your necessities / living expenses.
- Save Money. Once you have a steady income (or a sporadic income that provides enough money to pay your living expenses), you can begin saving money and avoiding any unnecessary spending.
- Invest Money. Once you have decided how much money you are willing to save every month / year, you will have a small war chest of funds that you can invest to make more money without having to work for it.
The
equation of building wealth is as follows: Savings = Income – Spending
Understanding
These Steps
Step
1: Making Money
Although
this might seem straightforward - find a job and get paid - this is actually
the most fundamental step as it allows you to reap the largest benefit from the
next two steps. Although we all know about compounding interest – making
interest from your principal by allowing your money (rather than your time)
make more money through interest – can definitely add up over time to a
substantial amount of money. But nobody really talks about the important
question – are you actually making enough money to be able to save?
Keep
in mind that making money is not simply about how much you make but more about
how much you do not spend. Imagine two people: John and Bob. John makes
$100,000 a year and spends $80,000 on his lifestyle as he enjoys having two cars
and a nice house. He saves $20,000 a year. Bob makes $50,000 a year and is a
bit more frugal as he uses public transportation and only spends $30,000 on his
lifestyle. Bob is also able to save $20,000 a year. Although John and Bob both
save the same amount of money, $20,000, they make very different salaries. So it’s
a lot less about making a lot of money and more about making sure that you do
not spend all of it. This is important because many people imagine that if they
made more money at work than they would be wealthier and have a better
lifestyle and be able to afford all the luxuries that people want to have. But
this is simply not true, they would be benefit from this better lifestyle if
they were able to save more of their money and not spend all of it on
non-essentials. This is because of something called lifestyle creep where
people tend to spend more of their income as they start making more money. If
you are currently spending 90% of your income and you received a salary
increase of $10,000, it is easy to feel like you deserve to treat yourself and
you end up spending all of the $10,000. What you should do with any salary
increases or any windfalls (think tax refund or inheritance), is to save all of
that money by pretending it doesn’t count in your income and putting it away in
your savings account so that you don’t feel the need to spend it all. The basic
formula for building wealth is to simply make more money than you spend and
save the rest.
There
are two types of income – earned and passive. Earned income comes from putting
in time to make money. This tends to come from a regular 9-5 job where you put
in X amount of hours a week and you get paid a fixed salary that increases with
inflation every year. Passive income comes from a non-traditional job or from
your investments where you make money that is not tied to the amount of time or
effort you put. This is money that is made when you are sleeping or not
currently working. An example of this would be creating a YouTube video.
Although you put in time to create the video, once it is posted online, you are
able to continuously make a profit over the coming weeks and years as people
watch it. You are making money from this video even when you are working on
other projects or videos.
Overall, to make the most money, you should find a job that fits these four criteria:
- You enjoy what you do; you always perform better when you enjoy your job.
- Find something that you have a skill in so that you can use your talents to make money.
- Look for a career that has high growth and a competitive salary.
- Determine what steps you need to take in terms of education and experience to be able to pursue these potential job options.
You
need to take all of these considerations into account to help you make more
money that will allow you to save and invest more.
Step
2: Saving Enough Money
Even
if you are making a ton of money every month, if you are not saving your money,
you will not move very far financially. The issue is that if your wants exceed
what you can actually afford, you will not be able to move forward. The first
step to resolving this issue is to distinguish your wants and your needs. As an
example, if you want a car you should first figure out what you need it for. Do
you need it to get to work? Do you have young kids that live too far from
school and you need to drive them in the morning and pick them up? By
determining what you need the car for, you can figure out if you really need it
or not. So let’s say that you really need a car to get to work as there are no
buses or public transportation close to where you live. Now the next step would
be to determine what you can afford to pay for a car and to pick a car that is
used only for transportation rather than as a symbol of wealth. What I mean to
say is that you do not need an expensive car to get you from point A to point B;
you simply need a reliable car to help you travel to and from work without
paying a premium. By only purchasing what you need, in this case a cheap and
reliable car that can get you where you need to go, you can avoid paying a
premium for something that will not add value to your life and will help you
save some extra money that would have been spent for no real gain.
I
think it is interesting to note that the average American saves approximately
8% of their after-tax money every year. Now you might be thinking, “Wow that’s really
not a lot, I save a lot more” but you have to take into consideration that most
people love spending money especially when they have some disposable income in
their pocket. Imagine that you have just received your paycheck, now most of it,
approximately 35-50% goes to paying your rent and living costs, another 15-20%
goes to food, clothing and necessities and the rest, 30-50% is left for either
discretionary spending or saving. Now most Americans will take this extra money
and spend it on restaurants, vacations and other activities that are enjoyed
but are short-lived. Now, with the world being in a recession, the US personal
savings rate has actually increased to 20% as people are unable to travel, go
to restaurants and are a bit more careful with spending money as they are
worried about job security and their futures. This has benefitted many people
as now they are forced to save money and are able to pay down their debts at a
faster rate to help prevent insolvency.
Now
before we move onto the next section, I think its also important to reward good
behavior, if you are able to set a savings goal, which will be different for
everyone, and are able to successfully achieve it, you should be willing to
reward yourself with something that you enjoy that is an appropriate amount
every now and then to help keep you motivated and to appreciate the hard work
you are putting in. My reward tends to be Chipotle as I try to avoid eating out
and this is a special treat to myself when I am able to achieve and surpass my
savings goal.
Step
3: Investing Your Money
Now
that you are making and saving money, we have officially reached the third
step: investing your money. So now you need to put all of your money in a savings
account at 2%! That’s fine, right? Wrong! Actually, if you want to build wealth
and make money, you need to take on some risk, which means you need to invest
in securities which on average provide a 5-7% yearly return. So how do you know
what is the right move for your current situation? You need to take into
account your financial life, your household income, your time horizon and any
other factors that are important to you. For me, I needed to take into account
that I wanted to rent a larger apartment in the next year or so because my
current apartment was not big enough so I needed to make sure I had enough
money in my chequing account to pay for a higher rent in the near future. If
you only have 2 years to invest before you need to use that money to pay for
school, you should definitely stick with safer investments such as bonds so
that you can make a little bit of money without worrying about the market
crashing before you need to take the money out to pay for school.
What
I believe is the best way to invest for beginners, is to follow the great words
of Warren Buffett and to invest in Index funds by taking a chunk of the whole
market rather than trying to pick individual stocks that you hope will do
better than the entire stock market. If you do not know, what an index fund is,
look at my other blog here where I explain investing and give advice from
Warren Buffett himself!
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