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One of the main reasons why many people start investing is that they hope that at some point in the future they might be able to become wealthy. However, there are also many individuals who are quite skeptical about the prospect of getting rich off investments. The fact of the matter is that they have the perception that it is unlikely for one to become a millionaire without any inheritance.
Now, despite this skepticism, the reality of the matter is that it is realistically possible for one to become a millionaire starting from scratch. In his book ‘The Millionaire Next Door: The Surprising Secrets of America’s Wealthy’, the author, Thomas J. Stanley mentions that from hundreds of American millionaires he has surveyed, more than 80% have not received any sort of inheritance. He further points out that accumulating a wealth of $1 million or higher is an attainable goal for one generation to achieve.
Obviously, this does not imply that becoming wealthy is easy or simple. It does take years of diligence, frugality, and sacrifice. Therefore, there are several steps one has to take in order for one to become a wealthy investor.
The first stepping stone in this journey is to create an emergency fund. This allows the market participants to retain their investments even in times of financial difficulty, without being forced to sell them for covering their financial needs.
The second obvious step is building a diversified investment portfolio. Now, there are several ways to go about it. Some people might prefer blue-chip stocks, while others might go for mutual funds. The most important thing here is to make investing money on a regular basis a habit.
Once the individual reaches a certain amount of net worth, $50,000 or higher, one might consider diversifying some of his investments into real estate. In this way, an individual can benefit from rental income as well as from the long term capital appreciation from the property investments. In addition to that, there are certain tax benefits one can receive for investing in the real estate market.
Finally, once an investor’s net worth reaches $1 million or higher, it might be the right time to start arranging investments for retirement. This involves positioning in a way that it can produce income on a regular basis, which can then rise over the years in order for it to maintain its purchasing power. Let us now go through each of those steps in more detail.
Creating an Emergency Fund
It might sound counterintuitive for some people, but actually, the first step for Investing to become wealthy is to create an emergency fund. This represents the cash reserves, one can easily get access to in times of financial difficulties. Many people use the instant access savings accounts or money market accounts for this purpose, while some others might hold on to their savings in the form of physical cash.
At this point, one might ask a number of very logical questions: why not move on straight to investing in stocks or paying off debt? Why is it preferable to hold on to cash reserves which earn very little or no interest? Are not the opportunity costs for this too high to be ignored?
Well, those are indeed some valid arguments. However, the fact of the matter is that at several points in life, everyone will face some types of financial emergencies. It might happen that one’s car might break down, or some appliances might have to be fixed or replaced at home. Alternatively, an individual might lose a job and might remain unemployed for several months.
Now, in each of those cases, if an individual has no cash reserves to use, then one has to resort to borrowing money or liquidating some of the investments. It goes without saying that this is problematic in many ways.
Firstly, if one has to sell some of its investments, then the investor might take a substantial loss on them. In order to illustrate this better, let us take a look at this chart, which depicts the Dow Jones Industrial Average index for the last 5 years:
source: cnbc.com
As we can see from the image above, the index composed of stocks of some of the top 30 US corporations has risen considerably over the years. Back in the Autumn of 2015, the index stood near 17,500. However, during the subsequent years, the Dow Jones Industrial Average index has risen considerably, reaching 27,800 by September 2020. This means that in this 5-year period, the index has risen by 58.9%, which is an impressive return for any investment.
Consequently, if an individual had a well-diversified portfolio of Dow stocks, or subscribed to an index-linked mutual fund then the investor would receive substantial returns. However, as we can see from the above chart, this rise was not represented by a straight line. There were a number of pullbacks and corrections along the way. The largest of those corrections came during the Spring 2020, as a result of the economic disruptions caused by an outbreak of the COVID-19 pandemic.
Therefore, if one has to resort to selling investments in stocks and mutual funds in times of the market correction, one might do so at a sizable loss. It goes without saying that this can be very damaging for the individual’s net worth.
Borrowing money in order to pay for emergencies can equally have a negative effect on one’s investments. This is because at some point those loans have to be repaid along with an interest. Consequently, those investors will be forced to divert some of their savings towards monthly repayments. As a result, there will be less amount of money available for investing.
Due to all those reasons, it is much better for investors to have an emergency fund. This provides them with funds to fall back on in times of financial difficulties. In this way, the market participants can keep their investments intact, so that they can achieve a long term growth without any disruptions.
As for the exact size of the emergency fund, it is worth noting that every financial expert and commentator has his or her own opinion on the subject. For example, according to Dave Ramsey’s baby steps, people at first should save $1,000 for emergencies, before repaying debts or start investing. Once they repay all of their liabilities, except for their mortgage, then they can increase the size of their emergency fund to 3 to 6 months worth of expenses.
So this might be a good starting point for building a proper cash reserve. However, it goes without saying that the proper size of the emergency fund will depend on many factors, such as the size of the family, the cost of living in the location where the investor resides, and many other variables.
Why Invest in the Stock Market?
At this point, one might ask a question: Why to invest in the stock market to get rich? After all, in this asset class, the principal of the investment is not secure and is very much subject to the daily market fluctuations. Why can investors not become rich by investing in savings accounts, certificates of deposit, and government bonds?
It is true that people can accumulate wealth by investing in those fixed income assets. However, the problem here is that considering the current conditions, it is an uphill battle, with the odds definitely against the investor.
The fact of the matter is that back in 2000, when the Federal Funds Rate was above 6% and bonds yields were much higher than nowadays, people could earn decent returns on savings accounts and CDs. In fact, it was possible for people to benefit from large interest payments and grow their net worth considerably in the process.
However, nowadays the realities on the ground are completely different. The Federal Funds Rate is now all the way down to 0% to 0.25% range. As a result, the interest rates on major US commercial banks on CDs are now within 0.01% to 0.25%. There are indeed some online banks, which offer slightly higher rates, near 1%, but it is always difficult to come up with higher rates of return.
Now, here it is worth remembering that the long term average US inflation rate is near 3%. So even if an individual finds a certificate deposit, which pays a 1% interest rate, he or she will still be losing 2% on average in terms of the purchasing power. The yields on the bond market are also at their historic lows, in fact after the outbreak of the COVID-19 pandemic, the 10-year treasury yields fell below 1%.
Consequently, it is not surprising that many investors are looking elsewhere to find some decent returns to preserve their purchasing power and earn a steady income in the process. One of those places where this is achievable is the stock market. Even during the aftermath of the outbreak of the pandemic, it is still possible to find dozens of decent stocks with a dividend yield of 3% to 5%.
It is true that in the stock market the principle of investment is under risk and subject of daily market fluctuations. However, for many investors, this is a risk worth taking, especially when the alternative is to invest for 0.01% to 1% yields.
How to Become Rich by Investing in the Stock Market?
Once investors have their fully-funded emergency fund in place, they can move on to investing in stocks. At this point, it might be a good idea to choose an investment strategy to follow. The fact of the matter is that some investors focus on value investing. This means that they are trying to find undervalued stocks, which have the potential for future growth and buy them at a discounted rate. As a result, they hope to increase their potential rate of returns.
On the other hand, some investors focus on building an income portfolio. They do so by purchasing stocks which have a long and consistent history of dividend payments. As a result, they benefit from quarterly income from several of those companies. Here it is also worth noting that investors always have an option to reinvest those dividends and buy additional shares. This can be very helpful in building the stock portfolio much faster, then without those reinvestments.
Another major aspect of investing to get rich is to make investments on a regular basis. In fact, there are brokerage companies which offer regular investing options for the market participants. This means that the investors have to make a predetermined amount of monthly payments, usually $50 or higher towards purchasing a particular stock.
The brokerage firm then pulls together all those buy orders from dozens of investors and purchases them in bulk. This allows them to save a significant amount of money on commissions. The brokerage firms then pass on some of those savings to their clients. As a result, investors can purchase their favorite stocks at very low commission rates, typically ranging from $1 to $5.
Another major benefit of this type of regular investing is that it helps investors to build a habit. It goes without saying that over time the investor can adjust its monthly or weekly contributions, depending on the personal circumstances. For example, if an individual experienced some financial hardships, then it might be worthwhile to reduce those monthly payments. On the other hand, if one’s income rises, then it can be a good idea to increase the amount of those monthly or weekly contributions.
Simply put, if an individual invests $100 for every single week, that is $5,200 per year and $52,000 in 10 years. Here it is worth remembering that one does not have to save $1 million in order to become a millionaire. In fact, a significant portion of it can be filled up by the capital appreciation and as well as by the dividend payments.
For example, if one invests this $52,000 in dividend paying stocks, with an average yield of 4%, then the investor will receive a monthly income of $173.33 per month, which is the equivalent of $2,080. At the same time, if the average price of those stocks in the portfolio rises by 5%, then this will increase the net worth of the individual by $2,600.
It goes without saying that as the size of the investment portfolio grows, it will produce a more significant amount of income, and the larger the capital appreciation will become. Obviously, there will always be a certain degree of fluctuation in the market. The value of the investments might fall from time to time. However, if an investor does proper due diligence when picking those stocks, in most times those pullbacks and corrections might represent an opportunity to buy high quality investments at a sizable discount.
Diversification Into Other Investments
Once the investors accumulate a sizable amount of capital, there is nothing stopping them to diversify some of their investments into real estate. Firstly, here it is worth mentioning that paying off one’s mortgage can free up a significant amount of money for investing.
Since one does not have to spend money on rent and mortgage repayment, the investor can simply channel those funds towards other investments. In addition to that this approach can also have psychological benefits. Knowing that his or her home is fully paid off, the investor will know that even in times of economic hardship, there is no risk of foreclosure. With such peace of mind, it is much easier to conduct a productive analysis and make some smart investment decisions.
Once the home of residence is fully paid off, the investor can purchase some rental properties. In this case, the market participant can benefit in several ways. Firstly, an individual can get tax benefits due to mortgage payments. In addition to that, the rent itself can be used to pay those mortgages, without an investor having to come up with these payments. Finally, several studies have shown that in the long term property prices rise at least in line with inflation. So this is one of the best investments to protect one’s purchasing power and create more diversified portfolios.
Build Wealth by Investing – Key Takeaways
- The first stepping stone for building wealth is to have an emergency fund in place. This represents a cash reserve, which one can use in times of financial difficulties. This approach can ensure that investors do not have to liquidate some of their assets at a loss if one faces some sort of emergency.
- One of the most important factors for successful investing is consistency. In fact, many brokerage companies offer their clients regular investment options. This means that the market participant can specify the amount, which one invests in specific securities on a monthly or weekly basis. This approach has a number of advantages. One of these is the fact that regular investing helps to build a habit. In addition to that those brokerage firms offer lower commission rates for those types of transactions since they are able to pull together the buy orders of dozens of different investors.
- Another major component of successful investing is to choose one’s investing strategy. The fact of the matter is that some market participants prefer value investing. This involves purchasing undervalued stocks and then benefit from the long term capital appreciation. On the other hand, some investors prefer to invest in income, choosing the stocks of those companies which have a solid track record of returning money to shareholders.
