In this post I look at how to become wealthy by saving and investing your money. I thought this may be a timely piece as many people still think that they have no hope of ever achieving financial freedom. In fact I recently read an article about how large numbers of Canadians are still living paycheque to paycheque. Year after year these reports say the same thing over and over again: that the vast majority of people have no savings and would be screwed if their paycheque was delayed by even one week! Certainly fewer people would find themselves in that situation if they embraced the 2 most important habits of wealthy people: saving and investing.
Start Saving Money
Needless to say, to break the cycle of living paycheque to paycheque a person only needs to start saving a small portion of every paycheque that they receive. There are different views on exactly how much to save – anywhere from 10% to 25%, but obviously, the more a person can save, the more they can invest and the sooner they’ll be financially free.
The habit of regularly saving money is the most important step in building wealth and achieving financial freedom. If one can develop this habit and continue to practice it, there’s no question they will succeed in achieving financial freedom at some point. It all depends on how much money they choose to save. To make saving money easier I highly recommend automating your savings.
Start Investing Money
Once a person starts saving some of their money, they can start to invest it. Just remember that with greater returns comes greater risk so it’s important to have long term investment horizon. When it comes to investing for retirement, financial advisors typically say to save and invest your money with the idea that once a person hits the ripe old age of 60 or 65, they can begin to deplete their retirement funds until they die (hopefully there is still money left before that happens).
For those seeking financial freedom in their thirties or forties this approach simply won’t work. We need to be far more aggressive in our savings strategies and far more aggressive in our investing strategies. For us, I feel that our investment strategy must include two primary objectives.
The first main objective of any long term investor is to beat inflation. Inflation is imply the rising cost of living. It’s the reason that a dollar today will be worth less next year and so on. The inflation rate is typically around 2%. But that number is not really all that accurate because it excludes food and energy prices which can vary considerably due to the volatile nature of commodity markets.
As a long term investor it’s important to buy assets that will beat inflation. Historically, two asset classes have kept pace with or beat inflation: stocks and real estate. If a person invests only in the safest of assets, like guaranteed deposits or a savings account, overtime they will experience a residual loss of purchasing power due to inflation. So if someone wants to play it safe and invest only in the safest of assets, then they should be aware that they can still “lose” money due to inflation.
Build Passive Income
The second main investment objective for any financial freedom investor is to establish and build out streams of passive income. Passive income is basically money that you don’t have to work for. It includes things like dividends, distributions and rental income. In contrast to actively earned income, which comes from dragging ourselves out of bed each morning to go to work, passive income comes from assets that we buy with our savings.
These assets produce income independently of ourselves. Initially a person’s passive income will be small and insignificant. Over time though, it will grow into a relatively substantial sum of money. After about 5-7 years it starts to take on a life of its own as it grows more quickly from (1) continually investing one’s personal savings, (2) the power of compounding as a result of the reinvestment of that passive income and (3) annual dividend or rent increases.
At some point in the future, a person’s passive income will exceed their living expenses. This usually happens once the mortgage is paid off. At that point that person is financially free and no longer a slave to their job.
To achieve both objectives we need to invest in:
1. low-cost index funds that track the broader stock market or
2. quality dividend stocks or
I must say that people have had varying degrees of success with all 3 investing choices. My approach has been to use a combination of all 3. This gives me some diversification and I know that over time, all 3 approaches have been successful in building a person’s wealth and passive income.
Photo Credit: Photo courtesy of Stuart Miles/FreeDigitalPhotos.net