Building wealth is a topic that can spark heated debate, promote quirky get-rich-quick schemes, or drive people to pursue transactions that they might otherwise never consider. But is “three simple steps to building wealth” a misleading concept? The simple answer is no.
Basically, to accumulate wealth over time, you need to do just three things: (1) Make money, (2) save money, and (3) invest money. This article looks at each step in turn.
KEY TAKEAWAYS
- Building wealth over time is a matter of following three basic steps and sticking to them.
- The first step is to earn enough money to cover your basic needs, with some left over for saving.
- The second step is to manage your spending so that you can maximize your savings.
- The third step is to invest your money in a variety of different assets so that it’s properly diversified for the long haul.
Step 1: Make Money
Step 1: Make MoneyThis step may seem elementary but is the most fundamental one for those who are just starting out. You’ve probably seen charts showing that a small amount of money regularly saved and allowed tocompoundover time eventually can grow into a substantial sum. But those charts never answer this basic question: How do you get money to save in the first place?
There are two basic ways of making money: through earned incomeorpassive income. Earned income comes from what you do for a living, while passive income is derived from investments. You may not have any passive income until you’ve earned enough money to begin investing.
If you are either about to start a career or contemplating a career change, these questions may help you decide on what you want to do—and where your earned income is going to come from:
- What do you enjoy?You will perform better, build a longer-lasting career, and be more likely to succeed financially by doing something that you enjoy and find meaningful. In fact, one study found that more than nine out of 10 workers said they would trade a percentage of their lifetime earnings for greater meaning at work.1
- What are you good at?Look at what you do well and how you can use those talents to earn a living.
- What will pay well?Look at careers using what you enjoy and do well that will meet your financial expectations. One good source of salary information, as well as the growth prospects for various fields, is the annual Occupational Outlook Handbook published by the U.S. Bureau of Labor Statistics.2
- How do you get there?Learn about the education, training, and experience requirements needed to pursue your chosen career options. The Occupational Outlook Handbook has information on this, too.
Taking these considerations into account can help put you on the right path if you don’t already know exactly what you want to do. Once you’ve landed a job, you should also evaluate your income situation periodically—say, at least once a year. Ask yourself: Is your current income adequate for your needs, including saving? Do you believe that if you stay with your present company or in your current line of work, your income will increase at a reasonable pace in the future?
Step 2: Save Money
Simply making money won’t help you build wealth if you end up spending it all. To set more money aside for building wealth, consider these four moves:
- Track your spending for at least a month.You might want to use a financial software package to help you do this, but a small, pocket-size notebook could also suffice. Record your every expenditure, no matter how small; many people are surprised to see where all their money goes.
- Find the fat and trim it.Break down your expenditures into needs and wants. Food, shelter, and clothing are obvious needs. Add health insurance premiums to that list, along with auto insurance if you own a car and life insurance if other people are dependent on your income. Many other expenditures will merely be wants. But take a hard look at both categories. While you can probably eliminate some wants altogether, you may be spending more than you really should on some needs, such as clothing.
- Set a savings goal.Once you have a reasonable idea of how much money you can set aside each month, try to stick to it. This doesn’t mean that you have to live like a miser or be frugal all the time. If you’re meeting your savings goals, feel free to reward yourself and splurge (an appropriate amount) once in a while. You’ll feel better and be motivated to stay on course.
- Put saving on automatic.One easy way to save a set amount each month is to arrange with your employer or bank to automatically transfer a certain portion of every paycheck into a separate savings or investment account. Similarly, you can save for retirement by having money automatically withdrawn from your pay and put into your employer’s 401(k) or similar plan. Financial planners usually advise contributing at least enough to get your employer’s full matching contribution.
Keep this in mind, too: You can only cut so much in costs. If your costs are already down to the bone, then you should look into ways to increase your income.
Step 3: Invest Money
Once you’ve managed to set aside some money, the next step is investing it so that it will grow.
(Before you start investing, however, make sure you have some money set aside to handle any unexpected financial emergencies. A common recommendation is to build up enough to cover at least three to six months’ worth of expenses in a liquid account, such as a bank savings account or a money market fund.)
Investments vary in terms of risk and potential return. As a general rule, the safer they are, the lower their potential return, and vice versa.
If you aren’t already familiar with the various types of investments, it’s worth spending a little time reading up on them. While there are all kinds of exotic investments, most people will want to start with the basics: stocks, bonds, and mutual funds.
- Stocksare shares of ownership in a corporation. When you buy stock, you own a tiny slice of that company and will benefit from any rise in its share price, as well as any dividends that it pays out. Stocks are generally seen as riskier than bonds, but stocks can also vary widely in risk from one corporation to another.
- Bondsare like IOUs from a company or government. When you buy a bond, the issuer promises to pay your money back, with interest, after a certain period. As a very general rule, bonds are considered less risky than stocks, but with less potential upside. At the same time, some bonds are riskier than others; bond-rating agencies assign them letter grades to reflect that.
- Mutual fundsare pools of securities—often stocks, bonds, or a combination of the two. When you buy mutual fund shares, you get a slice of the entire pool. Mutual funds also vary in risk, depending on what they invest in.
Perhaps the most important investing concept for beginners (or any investor, for that matter) is diversification. Simply put, your goal should be to spread your money among different types of investments. That’s because investments perform differently at different times. For example, if the stock market is on a losing streak, bonds may be providing good returns. Or if Stock A is in a slump, Stock B may be on a tear.
Mutual funds provide some built-in diversification because they invest in many different securities. And you’ll achieve greater diversification if you invest in both a stock fund and a bond fund (or several stock funds and several bond funds), for example, rather than in just one or the other.
A concept closely related to diversification is asset allocation. It involves deciding what percentage of your portfolio you want to invest in each particular asset category, or type of security, based on risk and other factors. As another general rule, the younger you are, the more risk you can afford to take because you’ll have more years to make up for any losses.
Should I pay off debt or invest?
If you have high-interest debt, such as many credit card charges, it usually makes sense to pay it off before you invest. Few investments ever pay as much as credit cards charge. Once you’ve paid off your debt, redirect that extra money to savings and investments. And try to pay your credit card balance in full each month, whenever possible, to avoid owing interest in the future.
How much money do I need to buy a mutual fund?
Mutual fund companies have different minimum initial investment requirements to get started, often beginning at about $500. After that, you can usually invest less. Some mutual funds will waive their initial minimums if you commit to investing a regular sum each month. You can also buy mutual fund and exchange-traded fund (ETF) shares through a brokerage firm, some of which charge nothing for opening an account.
What is an exchange-traded fund (ETF)?
Exchange-traded funds (ETFs) are investment pools much like mutual funds. A key difference is that their shares are traded on stock exchanges (rather than bought and sold through a particular fund company). They sometimes charge lower fees as well. You can also buy them, along with stocks and bonds, through a brokerage firm.
The Bottom Line
While get-rich-quick schemes sometimes may be enticing, the tried-and-true way to build wealth is through regular saving and investing—and patiently allowing that money to grow over time. It’s fine to start small. The important thing is to start.
Article Sources:
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- Harvard Business Review. “9 Out of 10 People Are Willing to Earn Less Money to Do More-Meaningful Work.”
- U.S. Bureau of Labor Statistics. “Occupational Outlook Handbook.”
This article was reprinted with permission by Infopedia. (Post date June 27, 2022) The views expressed herein are those The Investopedia Team and do not necessarily reflect the views of The H Group. This article was legally licensed through AdvisorStream.
