Wealth is measured by your net worth, which is a key metric in tracking your overall financial fitness. As a reminder, net worth is calculated by taking the total of everything you own (your assets) and subtracting the total of everything you owe (your liabilities).
When you have a cash flow plan (a budget) and follow it, with a purposeful allocation of money each month into either savings or investments, the assets side of the equation grows over time. If you are investing in a diversified stock portfolio, this asset number can grow tremendously as you consistently add to it into the future.
Okay, back on topic
Hopefully, you already understand dollar-cost averaging (DCA), or you read the post above about the magic math of consistent investing (which is what DCA is all about). If you do understand it then it is clear that “excess cash” – after you’ve covered both required and lifestyle expenses – from your spending each month is so important. Putting that money to work is the key to building wealth.
There are really only two ways to increase your net worth – minimizing liabilities (debt) and increasing assets. When I say increasing assets I specifically mean appreciating assets like investments, savings, and real estate. If you increase assets by purchasing things like boats, cars, high-def TVs, you are actually working against yourself. It isn’t a problem to enjoy your money and have those things, but don’t acquire them at the expense of being able to also save and invest in your financial future.
So growing assets or …
So you can build wealth by growing your assets or you can tackle the other side of the equation and lower (or eliminate) liabilities. That’s just a fancier way of saying your net worth increases as you pay down debt.
Paying off debt is actually a key part of becoming wealthy so don’t neglect this part of the equation. If you read any studies about truly wealthy people – like the case studies in the book the Millionaire Next Door – you’ll notice that almost all of them state that removing and avoiding debt is a key part of their financial success. Yes, even paying off your mortgage early.
Do you have a savings account?
Savings accounts are a GREAT place to stash your emergency fund. You should most certainly have a goal to hold between three and six months of living expenses (here’s how to tell which end of the scale is best for you) – and once you are in retirement you should hold eighteen to twenty-four months worth of living expenses in a savings account.
Beyond that, you are actually working against yourself. Savings account over the past few years have been paying only a fraction of a percent of interest. The stock market has been averaging almost 10% per year over extended periods, and inflation has been averaging around 2% historically. So the money that you have in a savings account actually loses value. By that, I mean the purchasing power of those dollars goes down over time because inflation is growing faster than the interest is accumulating.
What’s the one thing to stop?
An unfortunately large percentage of people aren’t comfortable with investing – largely because they don’t understand (by their own admission according to many different surveys). Because they don’t understand the power of investing, how it all works, and how to get started, they more often than not just put their extra cash into a savings account. And this needs to stop for someone who wants to build wealth.
As mentioned already, money in a savings account tends to lose value over time. So it is actually destroying wealth and working against you. Keep a reasonable amount of money in a savings account for an emergency fund – or if you have a large impending purchase coming up within the next few years. But any long-term money… retirement savings, college savings, down payment for a home in five or more years… those types of situations are going to be better off invested in the stock market so the balances have a chance to grow faster than inflation.
The longer away from the goal (for most people this means retirement for sure) the more likely that the return on the investments will be closer to the 10% historical average. Markets go up, but they also go down, but then they also go back up. Sure, in theory, this cycle could stop, but so far it hasn’t and there is no reason to think it will change in the future. That’s why short-term goals are sometimes better in cash, but long-term goals are almost always better placed into stocks.
Read some of our other posts if you are worried about market fluctuations and think it is too risky for you; or if you don’t understand how diversification can help protect your investments. If you really want to start building wealth though, you really do need to get comfortable with the idea of investing in the stock market for the long-haul. It’s much easier than most people think to get started.
Get started with investing without the hassle
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