Building wealth is a topic that can spark heated debate, promote quirky "get rich quick" schemes, or drive people to pursue transactions they might otherwise never consider. But are "three simple steps to building wealth" a misleading concept?

The simple answer is no. But while the basic steps to building wealth are simple to understand, they're much more difficult to follow.

Basically, to accumulate wealth over time, you need to do three things:

  1. Make money. Before you can begin to save or invest, you need to have a long-term source of income that's sufficient to have some left after you've covered your necessities and debts.
  2. Save money. Once you have an income that's enough to cover your basics, develop a proactive savings plan.
  3. Invest money. Once you've set aside a monthly savings goal, invest it prudently.

This makes a simple equation: 

  • Savings=IncomeSpending\text{Savings} = \text{Income} - \text{Spending}Savings=IncomeSpending

Understanding 3 Simple Steps to Building Wealth

Step One: Make Enough Money 

This step may seem elementary, but for those just starting out or 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. Are you making enough to save in the first place?

Keep in mind that there's only so much you can cut in costs. If your costs are already cut down to the bone, you should look into ways to increase your income. Also, are you good enough at what you do and do you enjoy it enough that you can do it for 40 or 50 years and save that money? 

Key Takeaways

  • There is a basic formula for building wealth: make more money than you spend, avoid debt, and invest your savings wisely.
  • The first step is to earn enough money, which is easier if you're doing work you enjoy, are good at, and pays well.
  • The second step is to save enough money, which can require disciplined budgeting and planning.
  • According to this basic method of wealth-building, taking on a bit of risk and making prudent investments is the third step.

There are two basic types of income—earned and passive. Earned income comes from what you "do for a living," while passive income is derived from investments.

Those beginning their careers or in a career change can start with four considerations to decide how to derive their earned income:

  1. What do you enjoy? You will perform better and be more likely to succeed financially doing something you enjoy.
  2. What are you good at? Look at what you do well and how you can use those talents to earn a living.
  3. What will pay well? Look at careers using what you enjoy and do well that will meet your financial expectations.
  4. How to get there? Determine the education, training, and experience requirements 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 periodically, but at least once a year.

Step Two: Save Enough Money

You make enough money, you live pretty well, but you're not saving enough. What's wrong? The main reason this occurs is that 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. Make sure to categorize your expenditures. Sometimes being aware of how much you spend can help you control your spending habits. 
  2. Trim the fat. Break down your wants and needs. The need for food, shelter, and clothing are obvious, but also 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 can 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.
  4. Build your cushion. You never really know what's around the corner. Aim to save around three to six months' worth of expenses. This prepares you for financial setbacks, such as a job loss or health problem. If saving this cushion seems daunting, start small. 
  5. Get matched! Contribute to your employer's 401(k) or 403(b), and try to get the maximum your employer is matching. 

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 and there could include programming your thermostat to turn itself down when you're not home, using regular 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 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 Three: Invest Money Appropriately

You're making enough money and saving enough, but you're putting it all in conservative investments like the regular savings account at your bank. That's fine, right? Wrong! If you want to build a sizable portfolio, you have to take on some risk, which means you'll have to invest in securities. So how do you determine what's the right level of exposure for you?

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 or liquidity needs, and any other factors 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 should be based on your investment policy statement. 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 because they have time on their side.

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 it. Diversification takes the timing element out of the game. A qualified investment advisor can help you develop a prudent diversification strategy.