Having examined how you can grow net worth by reducing spending and growing income, we now come to the most powerful tool for growing net worth: Investing. Reducing spending produces quick wins in growing net worth, but there’s only so much cost cutting you can do until you are living on a bare bones budget. Increasing earned income is a great way to increase your net worth that, theoretically, has no ceiling, but we all know that raises don’t come easily. Also, even if you do get that raise, you’re still trading time for money.
What if there was a path for you to augment employment income by having your assets work for you and earn money for you?
The Miracle of Compounding Interest
I started investing when I got my first full-time job out of college. I put 5% of my salary into a 401(k) and, following my older brother’s advice, I maxed out a Roth IRA. For better or for worse, I socked money away in both accounts and didn’t spend much time looking at them except to rebalance occasionally. I say this was “for better” because shortly after I started working full time, the subprime mortgage crisis contributed to the stock market crashing and, as a result, my 401(k) and IRA accounts lost almost half their value. Had I been more attentive to my retirement accounts, I would have seen them hemorrhaging value which likely would have caused me grief. While I’m very committed to leaving my retirement accounts alone until retirement, I’d rather not test my resolve.
You may be thinking, “you’re not much of a personal finance person if you only put 5% of your salary into your 401(k).” If I remember correctly, I received a 3% match on this contribution but, you’re right that 5% is less than I’d recommend anyone invest. Over time I gradually increased my contributions so that now I contribute over 20% of my gross income to my 401(k) and also max out IRA contributions. Now I have well over a decade’s worth of compounding interest rewarding me for my efforts.
What is compounding interest? A plain English example: You start off with $1,000 and earn 10% interest annually. The first year you earn $100 in interest, which leaves you with $1,100 total. The second year you earn $110 (10% of $1,100) in interest, which leaves you with a total of $1,210. Keep repeating this math (or, even better, use this great compounding interest calculator: http://www.moneychimp.com/calculator/compound_interest_calculator.htm) and you’ll have $1,610.51 at the end of five years.
The beauty of this $610.51 growth (the difference between the red line and the blue line in the picture above) is that you didn’t trade time for money to gain the $610.51. Instead, your money sitting in an investment account worked for you to earn more on your behalf. Extend your timeline to 15 years and your initial $1,000 turns into $4,177.25. Mind you this growth is happening without you adding a penny extra. Change the initial $1,000 to $5,000 with the same 15 year timeline and 10% interest rate? You wind up with $20,886.24.
If you use your imagination a bit, you’ll see how you can leverage compounding interest in a very powerful way. It’s not very likely that you’d make contributions to your retirement accounts only in your first year of employment but never again, right? If you make the first year contribution of $5,000 then add $5,000 every year for 15 years at a 10% interest rate, at the end of 15 years you end with $179,748.65. Not bad, huh? Key takeaway: $29,748.65 in growth that occurred (your $150,000 of deposits subtracted from the $179,748.65) didn’t require your time, sweat, energy, or tears. Instead, your money worked for you.
One of the most powerful variables in growing wealth via compounding interest is time. If you extend the previous example from 15 years to 30 years, you witness astounding growth.
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Albert Einstein
The Basics: How to Invest in the Stock Market
You may be thinking, “OK, great buddy. I want some of this stock market action and having my money work for me. Where do I start?” A common place to start, and where I started, is in an employer-provided 401(k) retirement plan. Think of the 401(k) retirement plan as a wrapper for investments, and stocks as an investment you can put inside this wrapper.
A significant benefit of the 401(k) retirement plan is the tax advantages that come along with it. When you invest in the 401(k), your annual taxable gross income is reduced by the amount you invest, and the invested money is not taxed until you withdraw it. If your employer, for example, uses Fidelity to manage their 401(k) plan, you would create an account on Fidelity’s web site or use the account created for you by your employer. Once you log into the account, you’ll be able to select from likely a variety of investment choices.
One very common selection to make in 401(k) plans is a target date retirement mutual fund, which automatically adjusts the mutual funds holdings (think stocks, bonds, and cash) as you approach your targeted retirement date. In general, it’s a good idea to move gradually from riskier investments (think stocks) to less risky investments (think bonds and cash) as you approach retirement.
The volatility of stocks could cause the loss of a significant amount of your nest egg as you enter retirement, so it’s best to have some protection against this volatility. A great example: Retirement portfolios immediately after the sub prime mortgage crisis lost almost 50% of their value. It took roughly three years (until 2012) for the stock market to recover the lost value. How would you feel if you planned on retiring in a given year and then observed almost half your nest egg evaporate?
I’ve just described investing in the stock (often referred to as the equities) market, but there are many, many other types of investments. An alternative investing technique I’ll discuss next is real estate, specifically rental property, investing.
A Second Investment Vehicle: Real Estate
A brutal reality I observed during the subprime mortgage crisis were retirees needing income from their 401(k) accounts while seeing almost 50% of their balances evaporate. Hindsight tells us that the stock market recovered these losses within a few years, and then entered a very long bull market, but I could empathize with the fear and anxiety experienced by retirees who depended on their 401(k) to navigate retirement.
About the same time, I learned of a concept I found fascinating: The multi-legged retirement stool. In short, what if your retirement income didn’t solely depend on a 401(k), with its commensurate stock market volatility, but was also funded by another source of income? A three-legged stool has stability not by relying on one or two legs but on three legs. Similarly, your retirement income could have more stability if it didn’t only rely on income from the equities market.
While I love the simplicity of investing in index funds within a 401(k) and and a Roth IRA, I also love the dependable income stream produced by rental residential properties. People will always need a place to live, so there will always be a demand for residential real estate. Though we’re certainly witnessing significant disruptions of rental income streams during the COVID-19 pandemic, I sleep better at night knowing I have three disparate sources of potential income: Employment, retirement accounts, and rental property.
My long-term plan for bear markets (significant stock market downturns) is to rely more on rental property income to fund my lifestyle while simultaneously leaving my 401(k) and IRA accounts untouched so as to not make paper losses real losses. In other words, while the stock market may be down and your retirement account balances may be down, these losses aren’t realized until you withdraw money from retirement accounts, thereby selling shares at lower prices when it would be better to sell at higher prices.
In the worst case scenario of both the stock market being significantly down and your renters not paying their rent, a scenario that is highly unlikely but that is occurring with some landlords in the country as renters lose employment during the pandemic, take advantage of your emergency savings to tide you over until either the stock market or rental income stabilize.