Brad Wardell's views about technology, politics, religion, world affairs, and all sorts of politically incorrect topics.
Understanding money and investment
Published on March 4, 2007 By Draginol In Business

I haven't ever read one of those "get rich" books. But I suspect that any reputable one would have a graph or chart or something that looks something like the above.

The difference between wealthy people and non-wealthy people is the above. Wealthy people build assets, non-wealthy-people don't.  If you're not using your company's 401K plan or investing in your IRA, then you won't ever be wealthy.  If your excuse is "I can't afford to invest" then you are choosing to never be wealthy (or you don't have very strong math skills or both).

What inspired me to write this was that I saw people on suggesting that wealthy people are just the people who work really hard year after year missing out on a lifetime of experience "life".  I've seen this portrayed on television and in movies as well. "Wealthy people" are really just workaholics who waste their lives greedily trying to get money and missing out on the lives of their children, neglecting their spouses and ultimately regretting not "stopping and smelling the roses".  That is a description of a workaholic but has nothing to do with wealthy people other than the reality that workaholics are more likely to be wealthy.

In reality, wealthy people build assets and let the income from those assets compound year after year.  Let's say, for instance I save $20 a week. That's a pretty trivial amount. If 20 bucks is the difference between you eating or not then it's probably time to re-evaluate your spending priorities.  In 10 years you'll have amassed $16,000. At 20 years it'll be worth over $50,000.

How we normal people can be "wealthy"

So let's work this out in real life.  If you start at the age of 25 saving $20 each week, then by the time you hit 65 you will have $305,000. And that's assuming a return of only 8% each year.  And most investors expect at least a 10% return over long term. The average "diversified stock portfolio" has averaged a 12.9% in the past few decades. So an 8% return would be a pretty conservative return.

Now, imagine if you can manage to save on average $200 per week instead of $20. That's quite a bit for most people I concede. That's around $10,000 per year in investment.  But if you can manage to do that, now you have over $3 million saved up by the time you're 65. 

With the current tax code, you can put in up to $4,000 per year into an IRA and it's tax deductible. Your spouse can do the same thing. That's up to $8,000 per year -- pretty close to the multi-millionaire result (around $2.5 million by the time you retire).

Early retirement for "the rich"

But what if you want to retire "young". Say you want to retire at 45 or 55?  Look at the chart above. What you have to do is build up your assets so that they return as much as annual income as your job does.

For our example, let's say that Bob and Sally are 35 years old. Between the two of them, they have an annual income of $120,000 and decide they want to retire at 55. They've already saved $50,000 between the two of them in IRAs and 401Ks (which is actually not very impressive -- less than $5k per year since they were 21).

When they hit 55, they will have over $1.2 million assuming a decent return.

Some personal thoughts on investment

I've always been a statistics nut. My friends have seen me graph and measure all kinds of weird things. So it wouldn't surprise them that I always saved the maximum into any IRA or 401K.  While I have a successful company today, it wasn't that way for a long while. My average personal yearly income lagged behind that of my friends until a few years ago.  That is, from 1993 (when I incorporated my company) to nearly 2003, my accumulated personal income was less than that of most of my friends.  But despite that, I had always maxed my IRAs, invested as much as I could either in the company or in stocks.

But most people don't invest their income. They go to work, come home and after they've paid their house payment, car payment, grocery bill, etc. They then go out to eat or buy DVDs or some other consumable that they could have invested. And what they don't realize is that it takes a very small amount of investment to generate huge returns over time.

My investments have averaged around 11% since I started investing back in 1994 (not counting my company). Even had I invested just $5,000 per year back then and stayed at that level forever, I'd have millions when I hit 65. 

But most people won't do that. I've talked to friends and acquaintances and it never ceases to amaze me how much money people will piss away eating out (seriously, I've known people who make less than $35k per year who still spend $100 per week eating out each week).  The beauty with investments is that if you are willing to aggressively invest early on, your compounding returns will soon be so much more that you'll be able to "live it up" long before you retire.

Investment isn't about squirreling away your nuts as you toil in a job for the day of retirement. Investment is about building assets. And having those assets generating income in various forms that eventually far exceeds what your job could bring in.  That 21 year old saving $5,000 per year would have $76,000 10 year years. That's $26,000 back. They'd have $250,000 on their 41st birthday (despite only putting in $100,000 -- they'd have gotten more than twice as much back). You could throw one heck of a party or go on some pretty lavish vacations as you neared your 20 year reunion without putting a real dent into your retirement.

So don't squander your chance to be financially independent. Being "wealthy" is just a matter of having some sense of delayed gratification. Max out your IRAs and 401Ks and the rest will tend to itself.

Comments (Page 3)
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on Mar 07, 2007
That is a description of a workaholic but has nothing to do with wealthy people other than the reality that workaholics are more likely to be wealthy.

In reality, wealthy people build assets and let the income from those assets compound year after year.

You seem to be saying that wealthy people get most of their income from investment returns on their assets. This was the case in the 1920s, but it's no longer correct. If you look at the chart on page 51 of this PDF Link, it's hard to explain in words, but you'll see what I mean. In 1929, the richer you were, the more of your income came from capital gains and dividends -- up to 70% of the income of the top .001%. Wage income made up less than ten percent of the income for that highest group. In 1999, even that very richest group made only 15% of its income from investments. In America today, the income of the rich comes from wages (50%) or entrepreneurial income (30%). The bond-coupon-clipping, "ownership society" doesn't exist any more.

This jibes with my personal experience. I am that guy you talk about who saves $200 a week. In fact, I save about $14,000 a year out of an income of $24-$30,000. It's been paying off great, too, since I started investing just in the middle of the 2000-2002 bear market and have seen about $25,000 in investment returns since then, leaving me with a net worth of just about $100,000. But that still doesn't put me in the top 10% for people age 20-29.

The difference between being rich and merely wealthy is that being rich lets you have your cake and eat it too. You can blow $200 a week eating out and still beat the nonwealthy in accumulating a 401(k). Not that I'm complaining. Stocking my 401(k) might not make me really wealthy, but it's still a lot better than subsistence farming or living paycheck to paycheck.
on Mar 07, 2007
On the investment advice: if your goal is to live off your investment returns, financial planners have a rule of thumb based on running simulations in historical market returns. Even if you start at the worst possible time, you should be able to withdraw 4% of your portfolio's value a year and never run out. So you can multiply the income you want by 25 and that's how much you'd have to save to be truly independent. That's not really necessary, though. There's nothing wrong with spending down your principal and "dying broke."

You're pushing IRAs and 401(k)s here. Given the general income bracket I see in JoeUser's audience, Roth IRAs would be a better idea. Traditional IRAs can actually increase your lifetime taxes if you start in a low enough income bracket, according to a study Link. Basically you end up not able to take the full value of the mortgage deduction or child tax credits, and you pay more in social security. So IRAs save money mostly just for the higher income brackets, but Roth IRAs work for everybody. (401(k)s with no match have the same problem, but 401(k)s with a match are absolutely the best investment out there.)
on Mar 14, 2007
I agree that investing at an early age is a key to financial stability. I started with E-Bonds in 1964 and continued most of my working life. I also looked at the retirement benefits provided by the companies that offered me employment over my career.

The reality today is that employers are reducing their retirement benefits and in many cases eliminating it altogether. Also working families in the bottom 20% simply do not have the income to save anything that will make a difference in their net worth. Tax deductions, tax free investments are of no help to the low income families since they do not pay Federal Income Taxes. That is the problem with the most recent proposal to help people acquire health Insurance. The proposed $7,500 deduction for health insurance for people in the bottom 20%, which are the people that do not have coverage, is of no benefit!

We need to provide more education to every student in High School as to why it is so important to begin saving in their early 20's and continue that savings their entire life until retirement. We however have not found an answer for the bottom 20% who simply do not make enough money to live much less save any amount that will make as difference in their financial condition! Some believe the answer is to start their own business. Some believe it is training. Both these will help some become financially self sufficient. However there are many jobs that simply do not pay enough to support a family and these jobs will never go away. We will need people to pick up the trash, cut the grass etc. For the workers that perform those jobs, training and self employment are not the answer. If we could snap our fingers and give everyone a B.S. degree we would have people working at Berger King and collecting the trash with college educations making $15,000- $25,000 per year!
on Mar 24, 2007

The reality today is that employers are reducing their retirement benefits and in many cases eliminating it altogether. Also working families in the bottom 20% simply do not have the income to save anything that will make a difference in their net worth.

That isn't reality. That's speculation.

My mother bought a house after years of saving around 20 bucks a week when we were most definitely in the bottom 20% of the income level.

Similarly, pensions have been replaced by 401Ks which have steadily been improving as companies compete for employees.

on Mar 20, 2008
It's been about a year since the last comment in this thread. How are people doing? Those that mentioned their savings plans, have you continued to save and invest? For those fearful of investing, have you made any changes?

For what it is worth, here is the plan my family has followed for the last several years:
1) Document the current financial picture. If you don't know where every dollar is going, it's hard to make good decisions.

2) Put every available dollar into a savings or money market account until you build up $1000. If you have to reach for a credit card anytime there is an emergency, you'll never get anywhere.

3) Take your smallest total debt and put whatever you can against it every month. Once you get this debt knocked out, take the total amount you were applying to the first one, and put it on the next one (in addition to the minimal payment you were making on the second one previously). Repeat. This is called the debt snowball.

4) If your company offers a 401K match, put as much as you need to into it to max out the matching portion. It's free money!

5) If your company doesn't have a 401K match, put your money into an IRA (Roth for most folks). You have total control over your investment choices this way, unlike your 401k which will have a limited selection of choices.

6) If you have kids and wish to help pay for their education, find a good college savings plan and start contributing.

7) Get your emergency fund built up to six months of expenses.

8) Max out your 401k or SEP or whatever is available to you.

9) Get your emergency fund built up to six months of income.

The timing between steps 3 and 4 is debatable. If you have a hard time with money, I would say stick with step 3 until you get a couple debts paid off. This builds positive money management principles into your life. If you have little debt, then maybe you can start investing sooner.

Happy Investing!
on Apr 29, 2009

Dr Guy
I put $50 away every week into an internet account

Internet Account?

Yup, an internet bank usually has better rates than local banks. Check out ING or HSBC.

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