How to build wealth? Whether your goal is to have enough for a retirement nest egg or millions to enjoy the fabulous lifestyle of the rich and famous, the process is always the same: 4 simple steps.
If you asked your grandparents about growing up in the mid to late 20th century, especially those who had experienced the tough times after World War 2, the most common advice you will hear is 1) work hard 2) spend less than you earn 3) save.
How right they were. But how do we make investing part of the process so that wealth building becomes more efficient and quicker? Timing and sequencing. The two are essential to creating wealth. First and foremost, the driving force behind multiplying your money is in making the best use of the capital available to you and systematically putting it to work.
As with anything in life, efficiency and success come from having a strategy. Thankfully the wealth building strategy is very simple, involving four simple steps: Save, Invest, Save, Reinvest.
Step 1 - Saving:
Just as your grandmother said: save. Wealth building starts with putting money aside. A regular amount on a regular basis, depositing unexpected financial windfalls in lieu of spending them will very quickly grow your stash and form the basis for the next step. The secret for accumulating enough to move on to step 2 is very simple: patience. Be patient until your stash is big enough to make it worthwhile investing your money. The costs and research prior to investing by far outweigh the benefits of investing small sums. In fact, it would be detrimental to not be patient and build up capital first.
Step 2 - Investing:
The second step is investing. While it may at first appear difficult to decide where to invest your money, it is rather simple once you have learned some of the strategies and techniques (if you are unfamiliar with investment strategies and techniques, you’ll find many articles all across Captain Finance). But all technicalities aside, don’t invest until you have a solid amount of savings. This is important for a number of reasons: Firstly, and very crucial for the successful investor: the bigger your stash to invest, the easier it will be to keep the associated investment costs to a minimum.
Take for example, the disciplined saver Maggie. Every month she puts away $/€/£ 250. In terms of savings, this is an above average amount, but as an investment sum it is too small. If Maggie was to invest the $/€/£ 250 in shares, the trading fees would eat up most, if not all, of her potential gains. Maggie’s brokerage firm charges $/€/£ 2.5 for investment amounts of up to $/€/£ 1,000. From $/€/£ 1,001 to 3,000, she will have to pay $/€/£ 5 to trade.
In order to keep the percentage of costs to a minimum, Maggie should wait 4 months to accumulate $/€/£ 1,000 to get the best deal. If she opts for investing more, she’d be better off waiting a full year and save $/€/£ 3,000 (12 months * $/€/£ 250). Now she can truly take advantage of the upper limit of the investment amount in the second $/€/£ 5 bracket in the brokerage’s fee structure and keep the investment-cost ratio to a minimum.
This is why patience is key before embarking on step 2. Trigger step 2 of your wealth building only once you have accumulated enough money. But be aware, if you are planning on spreading your money across multiple investments, do likewise and always keep the associated costs in mind.
Step 3 – Save, don’t reinvest:
This might sound very counterintuitive and polar opposite of what you frequently read and hear, but reinvesting can be detrimental to your wealth building.
I suppose that many of you are now shaking your heads in disbelief, but bear with me: Reinvesting is undoubtedly one of the most important elements of wealth building, but the how and when are crucial keys to its success.
Many companies, for instance, offer you the possibility to directly reinvest dividends. Instead of being paid a dividend in cash, you can opt to be rewarded in extra shares. What sounds like a wonderful idea might not always be beneficial to you:
Imagine you are earning $/€/£ 300 in dividends. The company’s share price currently stands at $/€/£ 50. Theoretically, you could thus take up the offer to be paid in 6 additional shares. And while it is always fantastic to see your portfolio grow in size, the brokerage firm will usually charge you a trading fee for the above transaction. This subsequently renders the dividend option too costly. Your brokerage firm will usually not charge you for receiving cash, however. You would be better off to take the cash as the trading cost-investment amount ratio is not in your favor. Remember: you will have to offset the costs by additional gains if want to earn money.
Instead of directly reinvesting your dividends, the better option is to save the cash in a savings account until your stash is big enough to benefit from an advantageous cost-investment ratio.
In addition: with more capital a greater variety of investment opportunities will be available to you. Certain bonds, for instance, can only be bought in increments of $/€/£ 10,000 or even 50,000.
Therefore, rather than directly reinvesting your money, stick to your strategy in Step 2 and save before reinvesting your returns.
Step 4 - Reinvest:
As you continue to save and reinvest, the intervals between the different steps become shorter. With every additional saving and investment return, the principal grows at an increasingly stronger pace. As your investment returns become bigger so do your savings. Eventually you will be able to skip Step 3 and move straight to Step 4 reducing the overall phases of wealth building to three: Save, Invest, Reinvest. When you have reached this point, you know that you are sticking to the right strategy.
Enjoy the journey and all the success in your wealth building. If there are other strategies that have worked for you, let others know about them below in the comments section. If you want us to talk about any other topics here on Captain Finance, let me know and drop me a line.