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Easiest way to build wealth

The most important key to wealth is often mentioned only in passing. Every day, you can see, hear and read long discussions of what to invest in - stocks, bonds, real estate, gold, etc. Yet the choice of investment vehicle is almost irrelevant if you have the greatest ingredient of wealth - time.

It is often said that compound interest - adding accumulated interest to the principal so that interest is earned on interest as well - is the key to wealth. True, but compound interest is impotent without time - it needs time to do the compounding. Time is the key.The more time you have to attain wealth, the lesser rate of return is necessary. If you start with $1000, and wish to be a millionaire in 5 years, you have to reinvest all earnings and your rate of return has to be around 325% per year - such rates of return are achievable by doing something like starting a business and taking it public during those 5 years - a most difficult task.

On the other hand, if you have 45 years to reach a million dollars ( if you are just graduating from college, you have exactly 45 years before the official retirement age of 67), then reaching a million dollars, if you start with $1000 and reinvest earnings, requires a rate of return of 17% - not easy, but within a realm of possibility.

Problem with time is that it passes almost unnoticed. It's easy to spend years going to school, working for a new company, all with vague expectations of some large payoff that will set us free. Job after job, decade after decade... Every stock market rally brings us closer to freedom, only to be set back by a sudden fall in stock prices. A new promotion, or a job offer from a competitor, gives us wings - only to find out that it is the same grind as in the previous company - just different faces of executives, demanding customers, and immediate supervisors who expect we will work 100hr weeks. Before long, we are 30, 40, 50 years old, often with very little to show for it.

There is a better way. Long term investments of small amounts. We can think of it as an insurance policy - in case the IPO does not happen, or the great American novel you write does not sell, or the investment banking job you counted on does not work out. The time to start investing is NOW. Even if you have no clue about investing, start putting money away in a savings or money market account. Do not worry about the rate of return at first - just get some capital. You can spend a year studying stock market, or real estate, or commodities - in the meantime, accumulate capital. Once you are confident that you know something about investing, you can create a strategy, a wealth plan, and start implementing it with the capital you saved.

Here are some numbers to consider: To reach a goal of 1 million dollars, you need following:

Starting capital:         $1000         $2000         $3000         $4000

Years to reach $1 million:   45            45            45            45          

Required rate of return:    17%           15%           14%           13%   

However, these are still pretty high rates of return - stock market may, or may not provide such rates of return over the next 45 years. Government tax liens may or may not provide such rates of return over the next 45 years. Bonds will certainly not provide such rates of return over the next 45 years. Maybe we can then improve the strategy - notice that we start with a set amount of capital, and never add more capital - we rely entirely on earnings from the original investment to bring us to $ 1 million.

What if each year we added some fixed amount of money - it will require some planning, and perhaps foregoing some consumption, but maybe a million dollars is worth a few sacrifices...
Here is the same table, but with addition of capital each year:

To reach a goal of 1 million dollars, you need following:

Starting capital:             $1000         $2000         $3000         $4000

Amount to add each year:      $1000         $2000         $3000         $4000

Years to reach $1 million:       45            45            45            45

Required rate of return:        11%          8.6%           7.25%         6.3% 

Notice that required rate of return plummets when you start adding money every year. 11% per year is actually about what stock market has historically returned over extended periods of time. If you can scrounge up $4000 per year, required rate of return drops to 6.3% - this is bond territory. You could simply buy bonds, without putting your principal at risk in the stock market.

So why isn't everyone a millionaire? Because most people do not invest early in their life. The longer you wait, the more capital you will need, and higher rates of return. If you start when you are 30 years old, in order to reach 1 million at 67, assuming 8% rate or return, you will need to start with $ 5000 in capital, and will need to add $5000 every year.
If you start when you are 40 years old, at 8% rate of return, you will need starting capital of $ 10,500 and will need to add $ 10,500 every year.
Look at the table above - if you start at 22 years old, assuming a rate of return around 8%, you only need to start with $2000 and contribute $2000 per year to reach the same result as a 40 year old starting with $10,500 and contributing 10,500 each year.

So is it really this easy? Well, there are 2 problems that can lessen the amount you make.
Problem #1 - Taxes.
Fortunately, in the United States, if you have earned income, you can put up to $4000 per year in an IRA (Individual Retirement Account) or up to $15500 in an 401K - you get a tax deduction in the year of contribution, and money in an IRA or 401K grows tax free until you take it out at retirement - then you pay regular taxes. If you use Roth IRA or Roth 401k - you do not get a tax deduction when you contribute, but your money also grows tax free, and when you take it out at retirement - there is no income tax to pay. So if you start early, taxes are not a problem (many countries outside of the United States have similar plans allowing their citizens to save for retirement tax free; some countries do not tax long term capital gains at all, other do not tax stock market gains).

Problem # 2 - Inflation.
None of us has control over how fast our governments will inflate the currency - thus making it worth-less - resulting in higher cost of everything we buy. There is no easy way around it - that's why governments throughout history have been using inflation to steal wealth from their citizens. However, this problem can be at least partially handled through judicious choice of investments. Worst case scenario, you may end up with a million dollars that's worth a lot less than a million - but this is still preferable to not having that million at all.

BOTTOM LINE: Start saving capital right now. Put it in an interest bearing savings account or a money market account. In the meantime, study various investments, then decide what your investment strategy should be. Once you decide on a strategy, start employing your capital. And remember - you do not have to stick to the same strategy. If over time, say 5 years from now, you come up with a better strategy, you can simply shift the capital to this new strategy. But the most important step is to start NOW.
300 years ago, Baltasar Gracian, in his superb book "The Art of Worldly Wisdom" said:
"Time and I against any other two" - so start now, get Time on your side.

 

 


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