September 20, 2011 8:52 PM EDT
Basically, building wealth boils down to this: To accumulate wealth over time, you need to do three things:
1.You need to make it. This means that before you can begin to save or invest, you need to have a long-term source of income that's sufficient enough to have some left over after you've covered your necessities.
- You need to save it. Once you have an income that's enough to cover your basics, you need to develop a proactive savings plan.
- You need to invest it. Once you've set aside a monthly savings goal, you need to invest it prudently.
Getting on Track
Step1: Making Enough Money
This step may seem elementary, but for those who are just starting out, or are in transition, this is the most fundamental step. Most of us have seen tables showing that a small amount regularly saved and compounded over time can eventually add up to substantial wealth. But those tables never cover the other sides of the story - that is, are you making enough to save in the first place? And are you good enough at what you do and do you enjoy it enough that you can do it for 40 or 50 years in order to save that money?)
To begin, there are two types of income - earned and passive. Earned income comes from what you "do for a living," while passive income is derived from investments. This section deals with earned income.
Those beginning their careers or in the midst of a career change can think about the following four 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 you enjoy.
- Consider what you're good at. 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 (educational requirements, etc.). Determine the education requirements, if any, needed to pursue your options.
Taking these considerations into account will put you on the right path. The key is to be open-minded and proactive. You should also evaluate your income situation annually.
Step 2: Saving Enough of It
You make enough money, you live pretty well, but you're not saving enough. What's wrong? There's only one reason why this occurs: your wants exceed your budget. To develop a budget or to get your existing budget on track, try these steps:
- Track your spending for at least a month. You may want to use a financial software package to help you do this. If not, your checkbook is the best place to start. Either way, make sure you categorize your expenditures. Sometimes just being aware of how much you are spending will help you control your spending habits.
- Trim the fat. Break down your wants and needs. The need for food, shelter and clothing are obvious, but you also need to address less obvious needs. For instance, you may realize you're eating lunch at a restaurant every day. Bringing your own lunch to work two or more days a week will help you save money.
- Adjust according to your changing needs. As you go along, you probably will find that you've over- or under-budgeted a particular item and need to adjust your budget accordingly.
- Build your cushion - you never really know what's around the corner. You should aim to save around three to six months' worth of living expenses. This savings prepares you for financial setbacks, such as job loss or health problems. If saving this cushion seems daunting, start small.
- Get matched! Contribute to your employer's 401(k) or 403(b) and try to get the maximum your employer is matching. Some employers match 100% of the participant's contribution, and this can be a big incentive to add even a few dollars 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 bucks here there could include programming your thermostat to turn itself down when you're not at home, using plain unleaded gasoline instead of premium, keeping your tires fully inflated, buying furniture from a quality thrift shop and learning how to cook. This doesn't mean that you have to be thrifty all the time: if you're meeting savings goals, you should be willing to reward yourself and splurge (an appropriate amount) once in a while! You'll feel better and be motivated to make more money.
Step 3: Investing It Appropriately
You're making enough money and you're saving enough, but you're putting it all in conservative investments. That's fine, right? Wrong! If you want to build a sizable portfolio, you have to take on risk, which means you'll have to invest in equities. So how do you determine what's the right exposure for you?
Begin with an assessment of your situation. The CFA Institute advises investors to build an Investment Policy Statement. To begin, determine your return and risk objectives. Quantify 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.
Next, determine the appropriate asset allocation for you. Most likely, you will need to meet with a financial advisor unless you know enough to do this on your own. This allocation will be based on the Investment Policy Statement you have devised. Your allocation will most likely include a mixture of cash, fixed income, equities and alternative investments.
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