By Alan Goldfarb, CFP®, AIF®
If you have a serious desire to accumulate wealth and are tired of all those get-rich schemes, that are designed to separate you from your money, then this articles' for you. The real secret to getting rich is making the money you make, make money. In order to do this you have to have a plan. In view of this, let me offer a few items you must be aware of if you are earnest about making money.
COMPOUNDING
You absolutely must have a knowledge of compounding. Compounding is the royal road to riches. Compounding is the safe road, it is the sure road, and anybody can do it. To compound you need discipline, perseverance, intelligence and time. You need discipline in order to save. You need perseverance to keep you on the saving path. You need intelligence in order to understand what you are doing and why -- and in order to comprehend the amazing rewards that compounding will bring you. And you need time to allow the power of compounding to work for you. Remember, compounding only works through time.
But there's one catch in the compounding process. The catch is that it's boring -- b-o-r-i-n-g. Or I should say it's boring until (after seven or eight years) the money starts to pour in. Then, believe me, compounding becomes very interesting -- in fact, it becomes downright fascinating!
AN EXAMPLE
In order to emphasize the power of compounding, assume that one investor opens an IRA at age 19. For seven successive years he puts $2,000 into his IRA at an average growth rate of 10%. After seven years this fellow makes no more contributions -- he's finished. A second investor makes no contributions until age 26 (this the age when the first fellow finished his contributions). Then he continues faithfully to contribute $2,000 every year until he's 65 (all at the same 10% rate).
Let's look at the incredible results. The one who made his contributions earlier and made only seven contributions, ends up with MORE money than the other, who made 40 consecutive contributions but at a LATER TIME. The difference in the two is that the first had seven more early years of compounding than the second. Those seven early years were worth more than all of the second's additional contributions. The second investors' $80,000 would have grown to $893,704 (an 11 fold increase) -- not bad at all. However it's pale compared to the firsts 66 fold increase. His $14,000 has grown to $930,641.
DON'T LOSE MONEY
The next rule is don't lose money. This might sound like a silly rule, but believe me it isn't. If you want to be wealthy you must not lose money. Absurd rule, obvious rule, silly rule? Maybe, but most people lose money in disastrous investments, gambling, rotten business deals, poor timing, etc. After 25 years of experience as an investment advisor I can tell you that most people very definitely do lose money -- in the stock market, the commodity market, in the option market and everywhere else.
RICH MAN
Here's another thesis that I've written about before, and for want of a better name I call it rich man, poor man. In the investment world the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader. The advantage that the wealthy investor enjoys is that he doesn't need the markets. I can't begin to tell you what a big difference that makes, both in one's mental attitude and in the actual handling of one's money.
The wealthy investor doesn't need the markets because he already has all the income he needs. He has money coming in via earnings and investments. In other words, the wealthy investor never feels pressured to "make money" in the market. The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. In other words, the wealthy investor puts his money where the values are.
If no outstanding values are available, the wealthy investor waits. He can afford to wait. The wealthy investor knows what he's looking for, and he doesn't mind waiting months or even years for it if he has to (they call that patience).
POOR MAN
What about the little guy? This fellow always feels pressured to "make money," to force the market to "do something" for him. When the little guy isn't buying penny stocks with 2% or 1% yields, he's spending 10 bucks a week on lottery tickets or he's "investing" in some crackpot scheme that his buddy told him about .
The little guy is in hock up to his ears, and as a result he's always sweating -- sweating to make payments on his house, his car or his lawn mower. He's impatient and he feels perpetually pressured. He tells himself that he has to make money -- fast. In the end, the little guy wastes his money, or he loses his money gambling, or he dribbles it away on senseless schemes. In short, he spends his life dashing up the financial down-escalator.
But here's the sad part of it, the ironic part of it. If, from the beginning, the little guy had adopted a strict policy of never spending more than he made, if he had taken the extra income and compounded it in safe, income-producing investments, then in due time he'd have money coming in just like the rich guy. The little guy would have to become a financial winner instead of a pitiful loser.
DON'T TRADE
Today's tax system militates against trading in taxable accounts. If you make a short term profit you pay the tax on that profit at the highest regular income rates. But if you sustain losses, you can only write off $3,000 a year against those losses. So the system weighs heavily against the trader. If you must trade, make sure it's in a tax deferred account.
MATHEMATICS
For some reason, few people understand the mathematics of investing. It's simple. If you buy a stock at $20, and the stock drops to $10 you have lost 50 % or half of your money (actually more because of commissions). To recoup your original investment, you have to find a stock that will double or rise 100%. And that isn't easy.
THE REAL PROBLEM
The real problem investor's face is greed (or envy). If your neighbor or your best buddy is making money in bonds or stocks and you are sitting in a money market fund, you may find yourself losing sleep and asking, "What am I doing? I'm playing it safe while that idiot, is making a fortune." So you pull out your money, jump into a few stocks and presto, within six months -- you're showing a loss of 25% for your greed.
CONCLUSION
The only time the average investor should go outside the basic compounding system is when a given market offers outstanding value. I judge an investment to be a great value when it offers (a) safety, (b) an attractive return, and (c) a good chance that the given investment will appreciate in price (in other words, when the item is undervalued). At all other times, for reasons cited above, the compounding route is safer and probably a lot more profitable over the long run.
So just do it. Stick to your own system. One of the criteria for building wealth is you must not lose money. Jumping in on the stock or bond market when they do not represent real value is the perfect formula for losing money. By allocating your assets properly you can, over time, get rich safely.