Why do so many people believe it is difficult to build your net worth?
My Corporate Finance professor used to state that finance was “very easy”. He even went a step further and joked that the financial industry had invented all these complicated terms and concepts in order for finance professionals to have a jobs If people found out how simple finance really was, the industry would suffer major job losses. Needless to say I did not always agree with his views as I plowed many late nights the more complex business cases we had to solve. But in essence…he was right. Finance is easy. And building your net worth only requires pulling 3 simple levers.
As my financial literacy improves I sometimes get lost in the urge to compare and optimize every little financial decision. Often delaying the decision to make.It is in those times that I remind myself that building wealth is at its core extremely simple. There are only 3 decisions you have to make to build financial wealth. It is really that simple.
Financial wealth is built by investing your money over time.
Let me repeat that phrase as it contains everything you ever need to know about building wealth: “financial wealth is built by investing your money over time”.
- investing = choosing activities that will generate a return on your money.
- money = the amount you choose to invest
- time = the period over which you choose to invest
Let’s break things down:
As you choose an investment, some will return more money than others. Interest rates are measured as a percentage on your initial investment. Example: You lend 100€ on 1/1/2017 to a friend. On 1/1/2018 your friend returns the 100€ he lent and gives you an additional 10€ for your investment. This means the rate of return of this investment was 10%.
As you build wealth and invest money, you will have to evaluate your investment options and select those that yield a high enough interest rate for the risk the investment represents. Typically, you should assume that the higher the expected rate of return, the higher the risk associated with the investment. If you are risk averse and want to play it super safe , you currently have to settle for a rate of return near 0%. On the other hand, if you become greedy and want to go for a “too beautiful to be true opportunity”, well… you’ll have to feel comfortable with the associated risk.
This one is obviously self-explanatory. The less you spend and the more you save and invest, the faster your wealth builds. Note that this lever is dictated by two variables: how much income you generate and how much you save of your income.
Investing your money over time kicks in the magic of compound interest. As you reinvest the returns from your investments, these sums will than again generate a return. As this happens year after year your investments compound and form an unstoppable wealth snowball. Einstein coined the phrase:” Cumulative interest was the eight wonder of the world. He who understands it… earns it. He who doesn’t… pays it.”
Building your wealth is simple
Building wealth is really that simple. Knowing that there are only three simple levers to build your newt worth, makes planning for it a lot easier. If your ambition is to become immensely wealthy, you better start yanking really hard on each of these 3 levers. If your income is rather limited and your ability to save not that high you should not despair. You will become wealthy, but it will take you a little longer and you’ll might want to look for higher yielding investments (and thus taking on some added risk). I personally have a horizon of only 12 years before I want to reach my goal of 1,5 million € in net worth (=1,6 million USD). This simply means that my main focal point should be directed to the amounts i can invest and allowing for riskier options in my investment portfolio.
Building wealth is definitely simple, but it sure is far from easy.
What are the levers you are choosing to pull on? Let us know in the comment section!