3 Simple Steps to Building Wealth

Building wealth is a topic that can spark heated debate, promote quirky get-rich-quick schemes, or drive people to pursue transactions they might otherwise never consider. But is “three simple steps to building wealth” a misleading concept? The simple answer is no. Basically, to accumulate wealth over time, you need to do just three things: (1) Make money, (2) Save money, and (3) Invest money. This article looks at each step, in turn.

Understanding 3 Simple Steps to Building Wealth

Step 1: Make Money 

This step may seem elementary, but for those who are just starting out, it’s the most fundamental one. You’ve probably seen charts showing that a small amount of money regularly saved and allowed to compound over time can eventually grow into a substantial sum. But those charts never answer this basic question: How do you get money to save in the first place? 

There are two basic ways of making money— through earned income or passive income. Earned income comes from what you do for a living, while passive income is derived from investments. You may not have any passive income until you’ve earned enough money to begin investing.

If you’re about to start a career, or contemplating a career change, these questions may help you decide on what you want to do—and where your earned income is going to come from:

1. What do you enjoy? You will perform better, build a longer-lasting career, and be more likely to succeed financially by doing something you enjoy and find meaningful. In fact, one study found that more than nine out of 10 workers said they’d trade a percentage of their lifetime earnings for greater meaning at work.
2. What are you good at? Look at what you do well and how you can use those talents to earn a living.
3. What will pay well? Look at careers using what you enjoy and do well that will meet your financial expectations. One good source of salary information, as well as the growth prospects for various fields, is the annual Occupational Outlook Handbook published by the U.S. Bureau of Labor Statistics.
4. How do you get there? Learn about the education, training, and experience requirements needed to pursue your chosen career options. The Occupational Outlook Handbook has information on this, too.

Taking these considerations into account can help put you on the right path if you don’t already know exactly what you want to do. Once you’ve landed a job, you should also evaluate your income situation periodically—say, at least once a year. Ask yourself: Is your current income adequate for your needs, including saving? Do you believe that if you stay with your present company or in your current line of work, your income will increase at a reasonable pace in the future?

Step 2: Save Money

Simply making money won’t help you build wealth if you end up spending it all. To set more money aside for wealth-building, consider these four moves:

1. Track your spending for at least a month. You might want to use a financial software package to help you do this, but a small, pocket-size notebook could also suffice. Record your every expenditure, no matter how small; many people are surprised to see where all their money goes.
2. Find the fat and trim it. Break down your expenditures into needs and wants. Food, shelter, and clothing are obvious needs. Add health insurance premiums to that list, along with auto insurance if you own a car and life insurance if other people are dependent on your income. Many other expenditures will merely be wants. But take a hard look at both categories. While you can probably eliminate some wants altogether, you may be spending more than you really should on some needs, such as clothing.
3. Set a savings goal. Once you have a reasonable idea of how much money you can set aside each month, try to stick to it. This doesn’t mean you have to live like a miser or be frugal all the time. If you’re meeting your savings goals, you should feel free to reward yourself and splurge (an appropriate amount) once in a while. You’ll feel better and be motivated to stay on course.
4. Put saving on automatic. One easy way to save a set amount each month is to arrange with your employer or bank to automatically transfer a certain portion of every paycheck into a separate savings or investment account. Similarly, you can save for retirement by having money automatically withdrawn from your pay and put into your employer’s 401(k) or similar plan. Financial planners usually advise contributing at least enough to get your employer’s full matching contribution.

Keep in mind, too, that there’s only so much you can cut in costs. If your costs are already down to the bone, you should look into ways to increase your income.

Step 3: Invest Money

Once you’ve managed to set some money aside, the next step is investing it so that it will grow.

(Before you start investing, however, make sure you have some money set aside to handle any unexpected financial emergencies. A common recommendation is to build up enough to cover at least three to six months’ worth of expenses in a liquid account, such as a bank savings account or a money market fund.)

Investments vary in terms of risk and potential return. As a general rule, the safer they are, the lower their potential return, and vice versa.

If you aren’t already familiar with the various types of investments, it’s worth spending a little time reading up on them. While there are all kinds of exotic investments out there, most people will want to start with the basics: bonds, stocks, and mutual funds.

• Bonds are like IOUs from a company or government. When you buy a bond, the issuer promises to pay your money back, with interest, after a certain period. As a very general rule, bonds are considered less risky than stocks, but with less potential upside. At the same time, some bonds are riskier than others; bond-rating agencies assign them letter grades to reflect that.
• Stocks are shares of ownership in a corporation. When you buy stock, you own a tiny slice of that company and will benefit from any rise in its share price as well as any dividends it pays out. Stocks are generally seen as more risky than bonds, but stocks can also vary widely in risk from one corporation to another.
• Mutual funds are pools of securities—often stocks, bonds, or a combination if the two. When you buy mutual fund shares you get a slice of the entire pool. Mutual funds also vary in risk, depending on what they invest it.

Perhaps the most important investing concept for beginners (or any investor, for that matter) is diversification. Simply put, your goal should be to spread your money among different types of investments. That’s because investments perform differently at different times. For example, if the stock market is on a losing streak, bonds may be providing good returns. Or if Stock A is in a slump, Stock B may be on a tear.

Mutual funds provide some built-in diversification because they invest in many different securities. And you’ll achieve greater diversification if you invest in both a stock fund and a bond fund (or several stock funds and several bonds funds), for example, rather than just one or the other.

A concept that’s closely related to diversification is asset allocation. It involves deciding what percentage of your portfolio you want to invest in each particular asset category, or type of security, based on risk and other factors. As another general rule, the younger you are, the more risk you can afford to take because you’ll have more years to make up for any losses.

The Bottom Line

While get-rich-quick schemes may sometimes be enticing, the tried-and-true way to build wealth is through regular saving and investing—and patiently allowing that money to grow over time. It’s fine to start small. The important thing is to start.

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