Building wealth - it's a topic that sparks heated debate, promotes quirky "get rich quick" schemes and drives people to pursue transactions they might otherwise never consider. "Three Simple Steps To Building Wealth" may seem like a misleading title, but it isn't. While these steps are simple to understand, they're not easy to follow.

The Steps
Basically, building wealth boils down to this: To accumulate wealth over time, you need to do three things:

  1. You need to make it. This means that before you can begin to save or invest, you need to have a long-term source of income that's sufficient enough to have some left over after you've covered your necessities.
  2. You need to save it. Once you have an income that's enough to cover your basics, you need to develop a proactive savings plan.
  3. You need to invest it. Once you've set aside a monthly savings goal, you need to invest it prudently.

Getting on Track
Step1: Making Enough Money
This step may seem elementary, but for those who are just starting out, or are in transition, this is the most fundamental step. Most of us have seen tables showing that a small amount regularly saved and compounded over time can eventually add up to substantial wealth. But those tables never cover the other sides of the story - that is, are you making enough to save in the first place? And are you good enough at what you do and do you enjoy it enough that you can do it for 40 or 50 years in order to save that money? (For related reading, see Understanding The Time Value Of Money and Delay In Savings Raises Payments Later On.)

To begin, there are two types of income - earned and passive. Earned income comes from what you "do for a living," while passive income is derived from investments. This section deals with earned income.

Those beginning their careers or in the midst of a career change can think about the following four considerations to decide how to derive their "earned income":

  1. Consider what you enjoy. You will perform better and be more likely to succeed financially doing something you enjoy.
  2. Consider what you're good at. Look at what you do well and how you can use those talents to earn a living.
  3. Consider what will pay well. Look at careers using what you enjoy and do well that will meet your financial expectations.
  4. Consider how to get there (educational requirements, etc.). Determine the education requirements, if any, needed to pursue your options.

Taking these considerations into account will put you on the right path. The key is to be open-minded and proactive. You should also evaluate your income situation annually.

Step 2: Saving Enough of It
You make enough money, you live pretty well, but you're not saving enough. What's wrong? There's only one reason why this occurs: your wants exceed your budget. To develop a budget or to get your existing budget on track, try these steps:

  1. Track your spending for at least a month. You may want to use a financial software package to help you do this. If not, your checkbook is the best place to start. Either way, make sure you categorize your expenditures. Sometimes just being aware of how much you are spending will help you control your spending habits. (For more insight, see The Beauty Of Budgeting and The Indiana Jones Guide To Getting Ahead.)
  2. Trim the fat. Break down your wants and needs. The need for food, shelter and clothing are obvious, but you also need to address less obvious needs. For instance, you may realize you're eating lunch at a restaurant every day. Bringing your own lunch to work two or more days a week will help you save money.
  3. Adjust according to your changing needs. As you go along, you probably will find that you've over- or under-budgeted a particular item and need to adjust your budget accordingly.
  4. Build your cushion - you never really know what's around the corner. You should aim to save around three to six months' worth of living expenses. This savings prepares you for financial setbacks, such as job loss or health problems. If saving this cushion seems daunting, start small. (Learn how to save for the unexpected. Read Build Yourself An Emergency Fund.)
  5. Get matched! Contribute to your employer's 401(k) or 403(b) and try to get the maximum your employer is matching. Some employers match 100% of the participant's contribution, and this can be a big incentive to add even a few dollars each paycheck. (To learn more, read Making Salary Deferral Contributions - Part 1 and Part 2.)

The most important step is to distinguish between what you really need and what you merely want. Finding simple ways to save a few extra bucks here there could include programming your thermostat to turn itself down when you're not at home, using plain unleaded gasoline instead of premium, keeping your tires fully inflated, buying furniture from a quality thrift shop and learning how to cook. This doesn't mean that you have to be thrifty all the time: if you're meeting savings goals, you should be willing to reward yourself and splurge (an appropriate amount) once in a while! You'll feel better and be motivated to make more money.

Step 3: Investing It Appropriately
You're making enough money and you're saving enough, but you're putting it all in conservative investments. That's fine, right? Wrong! If you want to build a sizable portfolio, you have to take on risk, which means you'll have to invest in equities. So how do you determine what's the right exposure for you? (Confused about risk? Read Determining Risk And The Risk Pyramid.)

Begin with an assessment of your situation. The CFA Institute advises investors to build an Investment Policy Statement. To begin, determine your return and risk objectives. Quantify all of the elements affecting your financial life including household income, your time horizon, tax considerations, cash flow/liquidity needs and any other factors that are unique to you.

Next, determine the appropriate asset allocation for you. Most likely, you will need to meet with a financial advisor unless you know enough to do this on your own. This allocation will be based on the Investment Policy Statement you have devised. Your allocation will most likely include a mixture of cash, fixed income, equities and alternative investments.

Risk averse investors should keep in mind that portfolios need at least some equity exposure to protect against inflation. Also, younger investors can afford to allocate more of their portfolios to equities than older investors, as they have time on their side. (To read more, check out Asset Allocation Strategies, Five Things To Know About Asset Allocation and Achieving Optimal Asset Allocation.)

Finally, diversify. Invest your equity and fixed income exposures over a range of classes and styles. Do not try to time the market. When one style (e.g., large cap growth) is underperforming the S&P 500, it is quite possible that another is outperforming. Diversification takes the timing element out of the game. A qualified investment advisor can help you develop a prudent diversification strategy. (For more insight, see Benchmark Your Return With Indexes.)

Conclusion
Building wealth over time depends on the successful execution of three steps: 1) having enough income, 2) saving an adequate portion of that income and 3) investing what you save prudently. Getting on the path that leads to wealth begins with a thoughtfully constructed plan and diligent execution of that plan. An investor who stays on that course should in time find that he or she is successfully building wealth.

Related Articles
  1. Investing Basics

    Explaining Unrealized Gain

    An unrealized gain occurs when the current price of a security exceeds the price an investor paid for the security.
  2. Investing Basics

    Explaining Risk-Adjusted Return

    Risk-adjusted return is a measurement of risk for an investment or portfolio.
  3. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  4. Fundamental Analysis

    Calculating Return on Net Assets

    Return on net assets measures a company’s financial performance.
  5. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
  6. Savings

    6 Ways to Save Money on Back-to-School Stuff

    Those school-supply lists just keep getting longer each year. Here's how to shop smart.
  7. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
  8. Investing Basics

    Explaining Financial Assets

    A financial asset is intangible property that represents a claim on ownership of an entity or contractual rights to future payments.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  10. Retirement

    Strategies for a Worry-Free Retirement

    Worried about retirement? Here are several strategies to greatly reduce the chance your nest egg will end up depleted.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  3. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  4. Security

    A financial instrument that represents an ownership position ...
  5. Series 6

    A securities license entitling the holder to register as a limited ...
  6. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
RELATED FAQS
  1. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>
  2. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
  3. Where can I buy penny stocks?

    Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
  4. What are the best ways to use your 401(k) without a penalty?

    The best way to use your 401(k) retirement savings account is to take normal distributions after you reach retirement age. ... Read Full Answer >>
  5. Can I take my 401(k) in a lump sum?

    Establishing a retirement savings plan during your working years is a necessary part of comprehensive financial planning. ... Read Full Answer >>
  6. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!