What does it take to acquire wealth? It’s not getting an MBA or a degree in economics. It’s not getting hot stock tips. Building wealth doesn’t even require having an above average income. The most important factor in building wealth is the right behavior.
There are 3 simple rules for building wealth, and if you follow them you’ll have success. So here they are: Live below your means, save, and invest smart.
All the financial knowledge in the world won’t matter if you don’t stick to these principles. But sticking to them has shown that over time, you will build wealth.
Rule #1 for Building Wealth: Live Below Your Means
When you’re looking at how to build wealth, living below your means is the most important thing. The concept itself is simple: just spend less than you earn. Most importantly, stay out of debt — especially credit card debt. Living below your means is not always easy. Many people live paycheck-to-paycheck and find that there’s no money left after the bills are paid.
And it can get worse.
If there is not enough to even pay the bills each month, that’s when the credit card comes out. If you rely on credit to get through each month you start digging a hole that gets more and more difficult to get out of. Trust me, I know from experience.
The key to reducing expenses is to choose less — especially when it comes to big costs:
1. Live in a smaller house. When my wife and I bought our home together, for example, our mortgage company approved us for an amount that was quite generous given our income at the time. Had we bought a house for the entire amount offered, half our income would have gone to the mortgage. We would have been “house poor.”
2. If you’re renting, you may need to have a roommate for longer than you’d like, but think of the extra money you’ll have if your rent is split in half.
3. Hold off on buying that new car for as long as possible. When you do need to get a new car, get a smaller, more economical one or consider buying used.
When making financial decisions, emotions and desires can obscure things. But math does not lie. Run the numbers and actually see what you can afford. The sooner you get control of your expenses, the better. You can’t save until you create a cash surplus.
Rule #2 for Building Wealth: Save
Wealth is measured by the amount of money you’ve retained, not by the amount of money you’ve earned. A high income does not automatically translate into a high net worth. You can be a top earner but still be broke and living paycheck-to-paycheck. If you make a lot, but spend all your discretionary funds on expensive cars, vacations, fancy dinners, and other non-essentials, you will not accumulate wealth. On the flip side, if you have a modest income, you can still accumulate wealth by saving a fixed amount from each paycheck.
Here are some tips for saving money:
1. Build an emergency fund. You should save up enough money to cover three to six months of living expenses. No one knows what the future brings, but building up this buffer first will prepare you for the unexpected and help you stay out of financial trouble.
2. Participate in a 401(k) plan if your employer offers one. A 401(k) is a great way to save because money is taken directly out of your paycheck — before your taxes are calculated. You end up paying yourself first before anyone else. Also, many companies provide 401(k) matching dollars up to a certain percent, which is free money for you.
3. When you get a raise, maintain the same lifestyle and save the extra money.
What if money is tight? What if there’s nothing left after paying your bills?
Don’t get discouraged. Save what you can.
Even if what you can put away now is minimal, it is important to start the habit of saving. There are almost always ways to find a little money that can be put away.
For example, how often do you eat lunch out? Today, an inexpensive lunch with a drink can still cost over $10. That adds up to over $50 a week, which is $2,600 a year! Obviously not everyone living paycheck-to-paycheck is eating lunch out five days a week, but many of us have small habits like this that add up over time.
You can also look to refinance or consolidate your current debt obligations. You might even be able to negotiate a lower interest rate so that the amount you ultimately pay off is lower.
All this is moot if you don’t know what you’re saving for, however. Are you saving for retirement? Kids’ education? A vacation home? What you’re saving for will determine how you invest your money.
Rule #3 for Building Wealth: Invest Smart
Once you’ve built up savings, you don’t want it just sitting there, collecting minimal interest in a checking account. You want it to grow. Therefore, building wealth requires investing.
But be careful whom you take investment advice from. Friends and coworkers love to talk about the stock market and give their opinions. But do they really know what they are doing? Stick to getting your financial advice from a professional such as CPA, CFP, or a Registered Investment Advisor. If your plumber is offering an opinion, make sure it’s about plumbing.
Beware of manias. History is loaded with them. Recently, we had the tech bubble. Everyone bought stock in any company that had a dot-com at the end of its name just to see the market tumble in 2000. We had the real-estate craze that lead to the crash of 2008. People were going into debt buying homes they couldn’t afford thinking housing prices would go up forever. Bitcoin is another very recent example. The price went from $900 to $20,000 in less than a year — and as of this writing, it’s back down around $6500.
In a mania, emotions can take over, and it’s easy to get caught up in the hype and excitement of a new investment. A fear of missing out on the Next Big Thing dominates. But acting on emotions can lead you to make poor decisions with your money.
Smart investing involves simple principles: take into account your time horizon, diversify your investments, and understand your risk tolerance.
1. Know your time horizon. Before you invest, make sure you know when you’ll need the money you’re putting away. The more time you have, the more risk you can take. If you are planning to use the money within the next three years, don’t put your money in the stock market. Put it in a safe investment like a savings account, CD, or a money market. For your longer-term goals, like retirement, stocks are appropriate. If the stock market takes a turn for the worst, you have time for your investment to recover.
2. Diversify your investments. As the old saying goes, don’t put all your eggs in one basket. Many people have put all their money into one company only to see their investment disappear overnight due to negative news. Invest in a variety of companies. Better yet, invest in mutual funds or exchange-traded funds that hold a diversified portfolio. You should also diversify your investments into different industries, sectors, and regions of the world. This way if one sector is failing, you have exposure to others.
3. Understand your risk. To be a smart investor, you need to understand the risk characteristics of each of your investments and how much risk you are willing to take. The markets are volatile. You can see your investment’s value rise and fall in real time. If you invest your money in stocks just to sell them in a panic when the price falls, you will not have success. If your risk tolerance is low, only put a small portion of your money in stocks.
The principles I’m discussing here are not novel. They’ve been said many times before in many different ways, but that’s because they work. They may be basic, but the wisdom behind these rules for building wealth will lead to financial success.