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Building Wealth When Starting Small

Building Wealth When Starting Small

Financial independence seems like a complex goal, yet its principles are surprisingly straightforward.

Emergency Fund

It begins with the unglamorous yet essential step of building an emergency fund. This is your safety net, the buffer that protects you from life's unexpected turns. Without it, every minor mishap becomes a potential financial disaster.

Start Here:

  1. Set a Goal: Aim to save 3-6 months' worth of living expenses.
  2. Open a Savings Account: Choose a high-yield savings account for your emergency fund.
  3. Automate Savings: Set up automatic transfers from your checking account to your emergency fund.

Invest Early

Once you have that foundation, the next step is to start investing as soon as possible. Time is your ally when it comes to compounding interest. The earlier you start, the more you benefit from what Einstein reportedly called the eighth wonder of the world.

Start Here:

  1. Learn the Basics: Understand different investment options (stocks, bonds, mutual funds).
  2. Open an Investment Account: Consider starting with a low-fee brokerage or a robo-advisor.
  3. Start Small: Begin investing a small, manageable amount each month.

Increase Savings

But starting isn't enough. You must also continue to increase your savings rate. This isn't merely about hoarding money; it's about expanding your capacity to invest in your future.

Start Here:

  1. Review Your Budget: Identify areas where you can cut back.
  2. Set Savings Goals: Define specific short-term and long-term savings targets.
  3. Automate Increases: Regularly increase your savings rate, even by small amounts.

Eliminate Wasteful Spending

Alongside this, it's crucial to avoid expenses that don't contribute to your wealth. Every dollar spent on fleeting pleasures is a dollar not growing towards your independence. This isn't to say you shouldn't spend any of your disposable income (i.e., the money left over after all your expenses are paid) as it would be a shame to miss out on great family moments, vacations, and other experiences just to become a millionaire. But keep an eye on expenses that get away from you, like subscriptions you're not using, or unhealthly habits that you want to break.

Start Here:

  1. Track Your Spending: Use an app or a spreadsheet to monitor where your money goes.
  2. Identify Unnecessary Expenses: Look for subscriptions or habits that don’t add value.
  3. Create a Plan: Redirect the money saved from cutting wasteful spending into your savings or investment accounts.

Let's look at an example of the opportunity cost (i.e., the potential value of the money spent if it were invested instead) of something like smoking/vaping:

Assume someone spends $150 per month on smoking or vaping. To calculate the opportunity cost:

Determine the monthly expense: $150

Calculate the annual expense: $150 x 12 months = $1,800 per year

Consider a 5-year period

Assume a conservative 7% annual return on investment, based on investing that money in the S&P500 instead.

Using a compound interest calculator, if this $150 monthly were invested instead:

After 5 years, the total would be approximately $10,950.

This $10,950 represents the opportunity cost - the amount of money that could have been gained if the $150 monthly expense was invested instead of spent on smoking or vaping.

The breakdown:

Total amount invested: $9,000 ($150 x 60 months)

Interest earned: $1,950

Total value after 5 years: $10,950

From this example, imagine someone offers to give you $10,950 in 5 years if you invest $150 a month with them. Alternatively, you can choose to spend that $150 each month on a bad habit with no financial return. Which option would you prefer?

This simple calculation and example demonstrates how small regular expenses can add up to significant amounts over time when considering the potential for investment growth.

Take Advantage of Specific Types of accounts

Tax-advantaged accounts offer a way to accelerate your journey. By using these vehicles, you're not just saving; you're saving smartly, letting you keep more of your hard-earned money. I'll discuss how tax-advantaged accounts work in another post.

Start Here:

  1. Research Options: Learn about tax-advantaged accounts like IRAs, 401(k)s, and HSAs.
  2. Contribute Regularly: Set up automatic contributions to these accounts.
  3. Maximize Benefits: Take advantage of employer matching if available.

Automate the process

Automation simplifies this process. By automating your finances, you remove the temptation to stray from your plan. It ensures that your savings and investments continue to grow, even when you're not paying attention.

Start Here:

  1. Set Up Direct Deposit: Direct a portion of your paycheck into your savings and investment accounts.
  2. Use Automation Tools: Utilize apps and online banking features to automate bill payments and transfers.
  3. Review Regularly: Periodically check and adjust your automated processes to align with your goals.

Paycheck Increase Should Not Translate to Spending Increase

Finally, beware of the marginal propensity to consume. As your wealth grows, so too can the temptation to spend more. Resist this urge. True financial independence isn't about affording everything—it's about needing less and appreciating more.

Start Here:

  1. Adjust Your Budget: Allocate any pay increases towards savings and investments instead of new expenses.
  2. Stay Disciplined: Avoid the temptation to upgrade your lifestyle with every raise.
  3. Set New Goals: Use additional income to accelerate your progress towards financial independence.

In essence, financial independence is built on simple, consistent actions over time. It's a path marked by discipline, smart choices, and an eye on the future.