A Repeatable Path to Wealth

Published:  12/03/2023

I’ve heard many students say that they wish they had been taught how to manage their money in school, so this post is about personal finance. This is a pretty big topic. I am not sure I can do it justice in one post, but I will try to cover the most important parts. Obviously, I am not a financial advisor, but I can give you some ideas to think about. Also, I will end this post with a set of book recommendations.

Workers typically need to work for 45 years or more before they can retire, and tragically, around twenty percent of workers feel they will never be able to stop working. Of course, it is possible to love what you do for work so much that you will never feel the need to retire. Even under that ideal scenario, work is better when you do not have to do it for the money. If you learn to save and invest, you can amass enough wealth to be able to live off the interest your investments produce. That is financial independence (you would then be “independently” wealthy). Financial independence is freedom, security, and optionality.

Here is one path to financial independence that has worked for other people and is repeatable. It doesn’t require a bunch of luck or talent, but it does require the consistent application of some basic steps.

  1. Earn*
  2. Spend less than you earn (a significant amount less).
  3. Save the unused portion of your income in a savings account until you have at least 3 months of living expenses set aside for an emergency.
  4. Once your emergency fund is set up, all the additional unused income will be invested into one or more low-cost index fund(s).
  5. Automate this investing so you can effortlessly repeat it until you are financially independent.        

 

Step 0:

You cannot save and invest money if you cannot earn money, so invest in yourself first. This means you need to build your skillset so that you can be productive. That is why you are at school learning. This is investing. You are investing in your personal capital. Make yourself undeniably good at something (or many things) and you will be able to earn a living.   

Step 1:

The hardest step above is step one, spending less than you earn. Our culture and human nature work against us when it comes to saving money. We have unlimited desires, so there is never a shortage of things to buy. Advertisers compete for our dollars. Credit card companies entice us to spend more money than we have.

We also have an innate desire to be respected and to be admired. Everyone on social media is trying to present an image of success and high status. Too often, we feel like we need to spend money to demonstrate how successful we are. This is natural to humans. For example, economists asked people which of these worlds they would prefer to live in:

  1. A world where people either live in 1,000 square foot homes or 2,000 square foot homes, and you live in a 2,000 square foot home.
  2. A world where people either live in 3,000 square foot homes or 4,000 square foot homes, and you live in a 3,000 square foot home.

Something like 80% of respondents said they would prefer to live in world A because in world A they were in the top half of society. This is shocking because everyone in world B has larger homes than the people in world A. Objectively, people should prefer to live in world B even if they are in the bottom half of society, but that isn’t how most of us feel naturally. It takes some work to change that mindset.

This tendency to compare ourselves with others used to be called, “keeping up with the Joneses,” and that was before TV and the internet. Back then, if the neighbor bought a new car, you might feel envious and buy a new car too. Now with the web, we feel compelled to compete with everyone. I heard someone say, “we used to keep up with the Joneses; now, we keep up with the Kardashians.” This is bad for us. Competing with others will make you poor and unhappy.  Compete with yourself not others. There will always be someone who seems to have more, but if you compete with yourself, you will constantly grow and improve.

The best way to accomplish savings is to automate the process. Remember, you want to make good habits easy to do. Have your employer take out the money pretax if possible and send it to an investment you have picked, and/or when your check is deposited have a portion transferred over to a savings account (try to find a high yield savings account that gives you some interest on your money). By setting aside this money automatically, you will never know its missing from your take home pay. This will help you to spend less because you will not have easy access to the money you have set aside. Of course, you will also need to be careful when using credit cards. Force yourself to pay off the balance every month to avoid paying interest to the credit card company.

Get the big purchasing decisions right to avoid financial ruin. The biggest expenses for most people are their homes and cars. Find a way to keep these costs down to save a lot. I personally don’t care about cars, so I buy used, fuel efficient, reliable vehicles. I also pay cash for my cars to avoid finance charges. This is not easy to do, but if you get in the habit of setting aside a “car payment” for yourself every month. You will be able to buy yourself a new (used) car every five to ten years in cash. I did this by paying off a car I had a payment on and then drove the car for an additional five years. I kept making the payments after I paid off the car; except, I sent the “payment” to my savings account. After five years, I was able to pay cash for my next car. I still pay myself a payment every month for my next car.

At the time of this writing (2023), the housing market is insane, so I don’t have great advice on how to save money on your housing, but I can tell you that you want to be doubly cautious about buying a home. Homes are way more expensive than people think because they usually only look at the mortgage payment. The mortgage is only the start of the costs associated with owning a home. Don’t equate rent to a mortgage. When renting, the rent is what you pay to live there. When you own, your mortgage is only a part of what it costs to live there. If your toilet backs up in your apartment, you call the landlord. If a toilet backs up in a house you own, you call a plumber (and then the bank to see if you can afford the plumber.)

Aside from considerable maintenance costs, there are property taxes, closing costs when making the purchase, and insurance. Money fools will say things like your house rises in value and makes you money over time. The truth is much more complicated. As a future investor, you need to learn to ignore this sort of advice. You have options where you put your money, so while your residence might rise in value over time (emphasis on might), you need to ask what that money could have done in another investment. Don’t view your personal residence as an investment. It is your home, not a piggy bank. Don’t buy a home until you find something you love and until you know you’ll likely be able to stay in the home for a decade or more.    

There is too much to say on spending money wisely, so I will leave off here by saying that mathematically your savings rate is practically the only thing that matters when striving to be financially independent. Cut your expenses and increase your earnings, and you will be wealthy quickly. As a rule of thumb, once you have saved and invested 25 times the amount of money you need to live off, you are objectively financially independent. For example, if all my expenses and needs can be met with an income of 50k per year, I would need at least $1,250,000 invested to be financially independent. If I could reduce my expenses to 35k per year, I would need 25x35,000 which is only $875,000.     

Here is some inspiration provided by a colorful character Pete Adeney aka Mr. Money Moustache. He’s a bit extreme in his approach, but there is a lot truth/value in what he says here:

How Pete Adeney retired at 30 yrs old
 

Step 2:

Save a large portion of your earnings. I think this number should be close to 30% of your earnings before taxes (typically, the recommendation is to save 15 to 20 percent). For example, if you are earning 100k per year, saving 30% of your pretax salary would require you to save $2,500 per month. This is a lot of your take home pay.

Why save so much of your pay? After twenty-five years of saving and investing this much money, you would likely earn enough return on your invested money to maintain the same living standard without having to earn money from a traditional job. That’s financial independence.

I am not advocating early retirement even if it would be financially possible at that point. I don’t recommend that anyone fully quits working because work is about more than a paycheck. Work is a way to socialize. It is a way to express yourself. Work can be fulfilling, and it can provide you with purpose. If your work doesn’t give you these things, financial independence will give you the freedom to find work that does.

By saving and investing this amount of money, you will create a personal safety net, but gradually, it will grow into a vehicle of freedom and independence. By forcing yourself to live off only a little more than half of your take-home pay, you are habituating yourself to spending a modest amount of money each year to live and be happy. This means you do not need a huge fortune to retire on to maintain your current standard of living (remember the simple math above, 25 times your expenses…). Most retirees will need a huge sum of money saved or they will have to severely lower their standard of living in retirement. The money you are saving will grow and compound (if you invest it) to give you the money you need to quit working if you want.  

Remember, I am not recommending you retire early. You do not need to retire just because you are rich, but working is best when you really don’t need the money. When you're financially independent, you might decide to work part time, learn to paint, write, or play music. You might go to law school and advocate for clients that are too poor to afford good legal representation. Any type of work is possible when you are financially free.

Learn to live on less and save up the fruits of your productive work, so that you can use them to liberate yourself as soon as possible. Your first savings goal is to create a safety net for yourself. Determine what you need to live each month, and then save up at least 3 months of living expenses. This money should be saved in a high yield savings account that you can access easily. A high yield saving account is just a savings account that pays you a top rate of interest. At the time of this post, you can find online savings accounts that will pay you close to 5% interest on your money. This money is not supposed to be invested. It is there to give you peace of mind and to protect you from financial ruin. I keep close to a year’s worth of living expenses in mine, but that is probably the maximum anyone should keep in a regular savings account.       

Step 3:

You need to invest your savings so that it grows. If not, inflation will eat away at it. If you don’t know what inflation is, just think of it as a slow diminishment in the value of our money. Imagine a pile of cash saved is like a hill of sand. Inflation is the wind and weather that erodes the sand slowly over time. After a time, the hill (our pile of cash) will erode to nothing. Inflation is a result of too much money chasing after too few things in the economy, but all you need to realize is that you want to grow your money to counter this erosion of value.

If you don’t invest, you are guaranteeing a loss that is equal to whatever the rate of inflation is. Nominally, your accounts will have the same amount of money in them, but every price around you will be rising. This will destroy the purchasing power or value of the money in those accounts that do not earn enough interest to keep up with inflation.

Therefore, you need to invest your savings after (and only after) you have saved up a cash reserve that can be used in an emergency. This cash reserve is called an emergency fund, and it should hold anywhere from 3 months to a year of living expenses (depending on your ability to quickly find enough income to pay your bills in the event of a job loss). Once this emergency safety net is funded, you need to invest all future savings someplace to avoid the ruinous erosion of value that is inflation. The easiest place to stick this savings is an index fund that has very low fees.

In the past, an investor would buy stock in a company. The investor would then hope the stock would rise in value over a long period of time. One day, the investor would sell the stock to cash out and collect/harvest their gains. There was no guarantee of success of course. You could buy a company’s stock, and it could drop in value over time causing you to lose money on the investment. The company could even go out of business, which would bring the value of your investment down to zero. As a result, you would have to monitor your investments to ensure that you could sell in time to avoid losing everything. However, stock prices rise and fall daily, so it isn’t easy to know if a current dip or series of bad days is a mere blip or the start of a downward spiral of the company’s stock from which it will never recover.

One way to avoid this sort of failure was to invest in the safest most sturdy companies. Companies that were unlikely to fail or fall. These companies are called “blue-chip companies.” The stocks of blue-chip companies are supposed to be safe-ish places to invest your money. However, any historical look at the list of fortune 500 (the largest 500) companies from previous eras will reveal that even the bluest of blue-chip companies is not safe from extinction. In fact, it is very rare for a company to stay on the list of 500 largest companies for the length of time you will be required to invest for. Additionally, something like 75% of all the gains in the stock market are derived from just 25% of the companies in any given period.

These gains are usually not coming from blue-chip companies. They are usually from companies that are on their way to becoming blue chips. Once an upstart rises to the level of a blue-chip company, most of the growth in its stock price has already been achieved. Buying that company’s stock at that point is not likely to provide large gains to you. You would have missed the boat as they say.

This means you will have to gamble on companies that have yet to achieve breakout success if you want big gains. Some of the smaller companies you invest with might experience spectacular growth, but it is more likely that they will not make it to the top and you will lose money on most of those investments. In summary, investing in blue-chip companies only will likely produce below market returns, and investing in small companies with future growth potential will have much greater risk.

Hopefully, you have by now realized that picking individual companies to invest in is not an easy task. It’s also perilous for investors that don’t watch over their investments carefully. Luckily, a firm called Vanguard developed a special investment option called an index fund in the 1970s. Index funds allow individuals to buy small amounts stock from a representative sample of companies making up the stock market or specific index (like the S&P 500). This investment is not like other mutual funds, which are actively managed by people attempting to beat the stock market. Those traditional mutual funds are bad investments on average.

An index fund is designed differently from a traditional mutual fund. It is set up to match the market and its returns. If you invest into a Vanguard Total Stock Market index fund for example, you would be investing into a fund that is trying to give you a little piece of all the companies in the market overall. It doesn’t have to invest in every company to do this, but if it is set up properly, an investment in that type of fund will grow at around the same rate as the market overall.

When you invest into an index fund and the market goes up, you will know your investment has gone up. If the market goes down, your investment will have gone down. You won’t beat the market this way, but you will receive a return that is very near to the return of the market over your investment period. This may sound mediocre until you realize that the typical investor only gets 75% of the return the market achieves over a given period. Your index investment is therefore likely to have grown more than the investments of those trying to beat the market.

Also, your investment will not go down to zero unless the entire stock market goes to zero (a doomsday scenario that would make the fact that you lost all your money a footnote). If there is a company that has a meteoric rise that you didn’t see coming, your total market index fund investment will benefit from that rise. You won’t need to follow the day-to-day details of dozens of companies because their individual success or failure will not dramatically help or hurt your investment. For this reason, index fund investing is the primary place you should be investing your money. The only thing to watch out for is fees.

Make sure that whichever index fund you choose, it has very, very low fees. If an investment has a 1% annual fee attached to it, that could reduce your lifetime earnings by as much as 30%. https://www.sec.gov/investor/alerts/ib_fees_expenses.pdf

Therefore, try to find investments that are good quality and have very low fees (no more than say 0.15%). The specifics of this sort of thing are going to depend on what is available at the time you invest. I can’t tell you what will be out there when you start investing, but hopefully I have given you enough to go on. Use index funds or their equivalents to invest your savings.  

Lastly, I must mention that buying and selling stocks or crypto or whatever is not investing. That is trading. People are mostly terrible at trading. Wells Fargo did a study to determine why some of their customer’s investment accounts had outperformed the rest of their investing customers. What they discovered should tell you a lot about trading vs investing for the long haul. The best performing customers were dead. In other words, they died, no one closed their accounts, and as a result, no one tried to buy and sell stocks. Whatever these dead customers had invested in just sat there growing. Those customers had the best returns for the study period because they didn’t lose money attempting to trade their way to riches. Once you buy an investment, ignore it. Buy and hold is the way to go. If you have a diversified set of investments, you will likely do well given enough time.         

Step 4:

The final step is to automate the investing process. You want to have the money transfered from your bank to the investment automatically each month. This ensures you do not need to think about your investment(s). They will run silently in the background of your life. You can review them once or twice a year to track the growth, but you shouldn't need to work harder than that. Investing your money is the act of putting your money to work for you. Give your money a job, not yourself. The simpler the better when it comes to investing. At some point, when you have a lot of money invested and you are closer to actual retirement, you will want to meet with an advisor, but find one that is paid an hourly fee for consultation. Do not let an advisor take a percentage of the value of your investments. That will eat into your returns too much. Advisors will not return enough value to the justify the costs when they take 1% to 1.5% of your account value every year in fees.   

Obviously, there are many other things to learn, so use this list of books below to educate yourself. I have read all of them, and they are all great.

Recommended reading list:

The Psychology of Money by Morgan Housel (most closely matches my point of view on money)

Quit Like a Millionaire by Kristy Shen (describes a woman’s journey to financial independence)

A Random Walk Down Wall Street by Burton Malkiel (read this to learn why you should skip trying to beat the market)

The Millionaire Next Door: The Surprising Secrets of America's Wealthy by Thomas J. Stanley (this dispels the myths most of us have about the typical millionaire)

Naked Money by Charles Wheelan (great book for understanding what money is)

Your Money or Your Life by Vicki Robin (old school classic)

Die with Zero by Bill Perkins (great book, but should be read after you have down the basics)

Insurance for Dummies by Jack Hungelmann (insurance protects your money, learn about it.)