Building wealth boils down to three main things:
Step 1: Making Enough Money
This step may seem like common sense, but for those who are just starting out, or are in transition, this is the most fundamental step. If you have ever looked at saving tips on the Internet, you have probably seen tables that show a small amount of money saved regularly and compounded over time eventually adding up to a substantial amount of wealth. Those tables look great online, but they do not take into account all of the factors of your life. Are you making enough money in the first place to be able to save a small amount regularly? Are you good enough at what you do, and do you enjoy your job enough to do it over a few decades in order to save that money?
That being said, there are two types of income to consider: earned and passive. Earned income, as it sounds, is what you make form your job. Passive income is derived from investments. We’ll discuss those in a later step, so for now let’s focus on earned income.
For those beginning their careers, or those in the midst of a career change, can think about following four important 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 that you truly enjoy.
- Consider what you are good at doing. 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, if any, needed to pursue your options.
Taking these four considerations into account will put you on the right starting path. The key here is to be open-minded and proactive. You should also evaluate your income situation annually.
Step 2: Saving Enough of It
- Track your spending for at least one month. Make sure you categorize expenditures. Sometimes just being aware of how much you’re spending will help you control your spending habits.
- Trim the fat. Break down your wants and needs. Obviously, the need for food, shelter, and clothing are at the top of your list, but you also need to address less obvious needs. For example, you may realize you’re eating lunch from a restaurant every day. You can save big bucks by just bringing your lunch with you to work two or more days a week.
- Adjust according to your changing needs. As you get an idea of your finances, you may find that you are over- or under-budgeted on particular items and need to adjust accordingly.
- Build your nest egg. You never really know what tomorrow will bring, and as such it’s smart to plan ahead. You should aim to save around three to six months’ worth of living expenses. This will prepare you for financial setbacks, such as health problems or the sudden loss of a job. Start small, and build.
- Get matched! If you are lucky enough to have an employer that offers a 401(k) or 403(b) retirement plan, try to get the maximum that your employer is matching. Some employers match 100%, and this can be a huge incentive to even add a few dollars from each paycheck.
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 dollars here and there could include things like programming your thermostat to turn itself down a few degrees when you’re not home, using regular unleaded gasoline instead of premium (unless your car calls for premium), keeping your tires fully inflated to achieve better gas mileage, buying furniture from a resale store, and even just learning how to cook so you can prepare meals at home and to take with you to work. Does this mean you have to be thrifty all of the time? No, if you are meeting your savings goals, you should be willing to reward yourself and splurge an appropriate amount once in a while. You’ll feel better and be more motivated to make more money.
Step 3: Investing Money Appropriately
Making enough money and putting your savings into conservative investments isn’t enough. If you want to build a sizable portfolio, you are going to have to take on risk, which means you will have to invest in equities. How do you determine what is the correct exposure for you?
- Assess your situation. The CFA Institute advises investors to build an Investment Policy Statement (IPS), an agreement between your portfolio manager and you that outlines general investment goals and objectives. Determine your return and risk objectives by quantifying 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.
- Determine the appropriate asset allocation for you. You’re probably going to want to meet with a financial advisor for this step, unless you know enough to do this on your own. This allocation will be based on the IPS you have created. Your allocation will most likely include a mixture of things, like cash, fixed income, equities, and alternative investments.
- Consider your protections. 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 more time on their side.
- 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 is underperforming 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.