Wealth building is essential to accomplishing a variety of goals like buying your home or retiring in style. Establishing a solid financial foundation will help you survive stock market corrections, recessions, health emergencies and other setbacks.
This outline of sound financial principles covers every aspect of your financial life from investing to building credit to retirement planning. So whether you’re new to building your wealth, or you’ve been practicing sound financial principles for awhile, these steps will get you on the path to financial freedom.
- Invest Early and Often
In a recent study by GOBankingRates.com, 43% of respondents age 25 to 34 said they weren’t investing in stocks, bonds or real estate. They cited familiar reasons for staying on the sidelines—they didn’t feel as though they had enough money to invest, they feared losing money in market downturns, or they found investing to be complicated and intimidating. But by sitting things out, they’re sacrificing the two most potent forces when it comes to building wealth through investment: time and compounding interest.
Say a 21-year-old invested $100 a month toward retirement and earned an average return of 8% per year. By age 67, without ever increasing that contribution, our investor would have $524,000. But an investor who started at age 30 would net just $254,000 under the same conditions.
- Control Your Investment Fees
The fees you pay for mutual funds or exchange-traded funds may seem trivial, but like your returns, your costs compound and could have a major impact on your portfolio over the long term. Say you invested $10,000 in an actively managed large-company U.S. stock fund charging 1.04% of assets in annual expenses (the category average) and held it for 30 years. Assuming it earns an 8% annualized return, it would grow to nearly $74,000, and you would have paid more than $10,000 in fees. But if you plunked $10,000 into the Vanguard S&P 500 ETF, which tracks the broad U.S. stock market and charges 0.03% in expenses, you’d end up with $100,000 (using the same assumptions), and you’d have paid only $365 in fees.
A strategy known as dollar-cost averaging can help. By investing a set amount at regular intervals (say, in your 401(k) plan), you’ll buy more shares when prices are down and fewer when they’re up. The practice lowers your average price per share over time and provides a disciplined way to buy low.
- Diversify Your Investments
Not putting all your “eggs in one basket” means you’re less susceptible to a sharp drawdown in any one type of investment. The reason diversification works is that you are including investments that are not correlated to one another. When one investment does well, another will act differently. As a result, a diversified portfolio is likely to lag any investment that’s going gangbusters but will hold up when that investment slides, providing smoother results over time.
- Invest Age Appropriately
Asset allocation—how your portfolio is divided up into stocks, bonds and cash—is a key driver of long-term performance. Figuring out the right mix depends largely on your time horizon and your ability to tolerate risk. The younger you are, the more risk you can take on because you have time to make up any losses. If you’re in your twenties or thirties, a portfolio that is 80% to 100% invested in stocks is fine. But in your forties and fifties, you may need more balance, with a portfolio of, say, 25% to 40% bonds and the remainder in stocks. And as you get closer to retirement, the shift continues. Money you need in less than five years should be invested in less-risky fare, such as bonds or cash.
Target-date funds do this for you. Choose a fund with a target year closest to the time you plan to retire and experts manage everything else, from how much you hold in stocks, bonds and cash to when your portfolio needs to be rebalanced.
- Don’t Spend More Than You Earn
Creating a budget and sticking to it positions you for success in many other components of your wealth plan—saving for retirement and buying a home, for example. Even if you feel comfortable with how much you spend and save, sketch out a plan for your money. If the word budget turns you off, think of it as an intentional money spending plan. You choose where to allocate your monthly spending in line with what’s important to you.
If money is tight or if you’re just starting to get a handle on where your money goes, budgeting may mean closely tracking your spending for a while. There are numerous methods to categorize expenses and allot how much of your income should go toward each, but many involve evaluating your essential spending (such as for rent or mortgage payments, utilities, insurance, and groceries) and discretionary spending (such as for entertainment, dining out and cable TV) and making sure that saving for retirement and other goals fits into the picture. Apps such as Mint and Personal Capital can help you monitor saving and spending.
- Manage Your Debt
Do your best to avoid carrying a balance on a credit card. Interest rates average nearly 17% and can be much higher, so you could easily pay hundreds or even thousands of dollars extra on a big purchase. If you already have high-rate credit card debt, it’s usually smart to focus on paying it off before you tackle debts with lower rates or those that may come with tax deductions on the interest, such as student loans or a mortgage. For more on distinguishing which types of debt can eventually help you get ahead financially and how to get rid of those that don’t, see Good Debt, Bad Debt.
Transferring or refinancing debt can help you trim interest. Some credit cards charge no interest for a year or more on balance transfers.
- Make Saving a Priority
If you have cash to fall back on in an emergency, such as a job loss or large, unexpected expense, you won’t have to rack up debt or jeopardize your retirement savings by withdrawing from your 401(k) or IRA.
Stash at least three to six months’ worth of living expenses in a savings account. Online banks usually offer the highest interest rates on savings accounts, and some come with no minimum-balance requirement or monthly fee.
One of the best ways to save is to automate it. As you build your emergency fund, arrange regular transfers—say, every other week or monthly—from your checking account to your savings account. You can also have money automatically pulled from checking into your brokerage or IRA account. One of the big advantages of an employer-sponsored retirement plan, such as a 401(k), is that your employer deducts your contribution from your paycheck so it’s gone before you miss it.
- Build Your Credit
A healthy credit history opens the door to the best interest rates on loans, lower insurance premiums, and the ability to rent an apartment or get a wireless phone plan. To help lenders evaluate your creditworthiness, companies such as FICO and VantageScore calculate a credit score based on the information in your credit report. Generally, a credit score of about 750 (on the standard scale of 300 to 850) qualifies you for the best loan terms. You can push your credit score into the upper tier by following a few basic rules: Pay all of your bills on time, use a low percentage of the credit available to you on credit cards (the lower, the better; try to stay below about 20%), and don’t apply for multiple credit cards at once.
- Save Enough to Retire in Style
The ability to retire comfortably, with little worry that you’ll run out of money, is a primary motivator to build wealth during your working years. The amount that you’ll need to save depends on the age you expect to retire, the lifestyle you want to have in retirement, and how much you may receive from sources such as a pension or Social Security benefits.
If you have access to an employer-sponsored retirement plan, such as a 401(k) or 403(b), that’s usually the best place to start saving, especially if your employer matches your contribution up to a certain percentage of your salary. Last year, the average match was 4.7%, according to Fidelity Investments. If you make $50,000 a year, that’s an extra $2,350 that goes into your account from your employer.
Traditional employer plans deduct pretax money from your paycheck (you will pay income taxes on withdrawals). And more than half of employers now offer a Roth option. With a Roth account, contributions are made after taxes are withheld, but your withdrawals aren’t taxed in retirement.
Implementing these savvy financial principles will get you on your way to building your wealth so you can live a life of financial freedom.
For more information on wealth building, check out my Women Talk Finances Happy Hour.