How wealth is built

Introduction to Investing: Article #1

 

If you are interested in increasing your wealth to improve your quality of life, then the logical place to start is “How do you create wealth?”

Turns out that creating wealth is quite simple;

Step 1: Be happy with what you have.

Step 2: Spend less money than you bring in.

Step 3: Invest the excess you are not spending.

Step 4: Let time do the work.

We certainly didn’t come up with the above, but find it to be sound advice. Let’s begin:

Step 1: Be happy with what you have

This might seem like a strange topic to cover in an article about creating wealth however we believe it is necessary.  An important step to creating wealth is by being frugal and therefore being happy with what you have is certainly going to help you achieve frugality.  to skip a step. So what are the main drivers of happiness;

Money isn’t everything

Money is not the key determinant of living a content life thought.  A signifacnt piece of research suggests that 50% of your happiness is genetic and is the base level for YOUR happiness. There is nothing you can do to change this unless somehow you can go back and select better parents. Amazingly only 10% of your happiness relates to your position in life be it your job, the car you drive, the house you live in, the clothes you wear etc. while the remaining 40%, the only part you can fully control, is simply your attitude and outlook. Unfortunately, we cannot help when it comes to your outlook on life but Mihaly Csikszentmihaly can.

 

Money is important

Although our outlook on life is the main controllable drive of our happiness, money does correlate with life satisfaction or well-being. A study on money and well-being by one of our heroes, Daniel Kahneman,  found that money increases well-being up to a certain point and after that, the ratio between well-being vs each dollar earned diminished. However, a recent study by Matthew Killingsworth refutes that stating that money and well-being are linearly related, i.e. the more money you have the more positive you feel. We are not going to debate the correctness of either research but it appears that having money is important. Fortunately, this is a topic we can help you with!

 

Step 2: Spend less money than you bring in

As mentioned previously, this is a vital component of wealth creation but not always what people want to hear. Frugality is key to creating long-term wealth and being careless with your money is an easy way to go broke.

Spending less money than you earn is a simple enough idea but often the execution is a lot easier said than done. There are so many expenses in our daily lives, expected and unexpected, that often it is hard to make ends meet let alone save money.

Due to the involvedness of the subject, we are not even going to attempt to offer our advice, many experts in this field can help. We recommend Dave Ramsey, or Suzy Orman , but there are many to choose from so pick someone who suits your character.

 

Step 3: Invest the excess you are not spending

So here is where we are experts and what our “Introduction to Investing” series will focus on,  so let’s start by first setting a strong foundation.

 

Compounding: “The 8th wonder of the world”

Most of you are familiar with the concept of compound interest but it is worth repeating because of its importance.

There are two ways to grow your money;

  1. In a linear, straight-line by earning simple interest or,

  2. In a geometric fashion known as compounding.

Let us assume we want to make $1,000,000 by investing the $200,000 we have saved up over our lifetime. We can choose between two investments, both earn 10% per year but one earns 10% per year based on the initial $100,000 we invested (Linear/Simple Interest) and the other earns 10% per year on the balance of our account at beginning of each year (Geometric/Compound interest). In the race to $1 million which one wins?


 When you see it in the graph above it’s rather straightforward. By earning 10% interest on our initial investment each year we can only earn $20,000 of interest per year regardless of the balance at the beginning of each year meaning that by Year 10 we are not even halfway to our goal. If on the other hand, we earn 10% per year on the balance at the beginning of each year then we are effectively earning interest on the interest we earned the previous year. The amount of interest we earn each year therefore grows and by year 17 we have reached our target.

So whatever you invest in make sure it is compounding!

 

Rate of return: The higher the interest rate the better

We have established that we want to invest only if we can earn compounding returns. But let us go back to our example where we have $200,000 and want to earn $1,000,000. We again have two options, both now offer compound earnings but this time at different rates. One offers a 5% annual return while another offers a 10% return. Which one wins the race?


That one was obvious! The higher rate will reach the target first.

One thing you might not have picked up on immediately is the impact of inflation. Unfortunately, Inflation also has a compounding effect and it is of utmost importance that your investments earn more than the rate of inflation or you are getting poorer as each day goes by not wealthier.

Invest in the highest possible return on investment.

 

Step 4: Let time do the work

Due to the nature of compounding, the longer you leave your money in your investment, the quicker your wealth grows. When it comes to investing, time is your friend.


Consider our example where we were able to earn 10% per annum at a compounding rate of return. It took us roughly 17 years to turn our $200,000 into $1,000,000 but if we leave our money to do its work then our next million is earned in just over 7 years while the third million will take less than an additional 5 years, and so on. That is the nature of geometric returns or compounding. And who said maths isn’t beautiful!

Hopefully, now it is clear how Warren Buffet has accumulated the money he has by compounding his wealth at over 20% per year for 56 years!

Once you have found you optimum investment, let time work in your favour.

 

Conclusion

So let us establish a few important rules, as we begin our journey;

  1. Invest where you can earn a compounding return, i.e. invest where you earn “interest” on your “interest”.

  2. Invest in the instrument that offers the highest rate of return. This rate must be higher than long-term inflation.

  3. Let time be your friend – when you have found the right investment for you, leave it so that compounding can work its magic.

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