“You can either pretend to be rich now, or really be rich later, but not both.” In other words, frugality now is essential to building wealth. The key to obtaining great wealth is to first recognize that in most cases the return to capital is much greater than the return to labor. In fact, in some sense, the whole point of your career is to make the transition from getting your money from labor to getting your money from capital. Once you are generating a lot more wealth from your investments than from your work, you can retire comfortably and confidently.
Whether you are part of the poor getting poorer or the rich getting richer usually depends upon which side of the interest rate you are on. When the interest rate goes up, the poor say: “Oh, no. Now I will have to pay more.” while the rich say: “Oh, great. Now I will be getting a better return on my money.” But to invest, you need money to make money. Where does that money come from?
There are some investments that pay off big time. A college education is one of them. But that doesn’t mean that you should borrow excessively to go to college. Keep the expense down by getting tuition waivers, scholarships, and student-work arrangements. Going into debt should never be taken lightly. It is a major barrier to wealth creation. Avoid debt whenever you can. Debt is only to be taken on as a last resort when the payoff is clear.
Take public transportation, especially if it is subsidized or free as in Kansas City. If you must have a car, buy a dependable used car, and not a fancy new car. With a car, you need liability insurance, because it is often required by law, and you probably can’t afford to hire a gang of lawyers to defend yourself if you get sued. But if you have enough money to replace your rusty old car with another dependable rusty old car, you may not need collision insurance unless you are an especially poor driver. It is important to remember that insurance has to have a negative expected value. The odds have to be against you in a gambling casino. The house on average has to make money, which means you on average have to lose money. The same is true in insurance. Self-insurance is usually better on average than commercial insurance if you have enough money to self-insure.
The key to wealth creation is to appreciate the power and importance of compound interest. The number of years it takes to double your money after checking the box that says “Reinvest Dividends” is given as follow: Number of years = ln(2) / ln(1+(APY/100)) where “ln” refers to the natural logarithm and “APY” is the annual percentage yield of your investment including the value of the additional shares you obtained by reinvesting your dividends. For example, if APY=10 percent, then APY/100 = 0.10 so the number of years to double your money = ln(2)/ln(1.10) = 7.27254 or about seven and a quarter years. To calculate how many years it would take at 10 percent APY to grow your investment by a multiple of 10 use the formula: Number of years = ln(10)/ln(1.10) = 24.1588579 or just over twenty-four years before your investment reaches ten times its initial value. An investment of $10,000 becomes $100,000 in a little over 24 years, and $1,000,000 in just over 48 years. At that rate, an investment of just $10,000 at age 20 becomes more than $10,000,000 by age 93. Young people who ignore the power of compound interest may be leaving a lot of money on the table.
But where do you get a good return on your money? For most people the answer is the stock market. As long as corporations keep emphasizing shareholder value with great dividends and stock buybacks that drives up their stock price, you can expect to get a good return over the long term. One conservative strategy is to simply invest in broad market exchange traded index funds with very low expense fees such as Schwab’s SCHB, Vanguard’s VTI, or iShares’ ITOT. When you get older you may want to transition to the corresponding broad market dividend funds. Purchasing shares in individual stocks sometimes amounts to gambling while investing in broad market funds tends to be less volatile and does not require the day-to-day attention to a particular stock’s performance.
Young people tend to think in terms of the next few weeks or the next few months and not so much in decades. Old people in their 80s and 90s have learned to think in terms of decades, but it is too late. Thinking long-term can pay off big time if you are young, and not so much if you are really old. In retirement my wife and I often go trash walking in the campus parking lots. Unfortunately, it is in the student parking lots where we often find (in addition to lots of trash) loose change — pennies, nickels, dimes, and quarters, and occasionally a few dollars. We hardly ever find money in the faculty-staff parking lots.
When you and your friends eat at McDonalds, do you buy the big mac or the quarter pounder with cheese, or do you buy the chicken sandwich off the dollar menu? Being secretly rebellious can be fun. Don’t let them know that you are beating them at the frugality game. Take pride in being secretly “cheap.” Buy as little as possible and pay as little as possible for what you buy. Thinking longer term means not trying to impress your friends by buying the latest, most expensive gizmos or keeping up with the latest fashions but knowing that many years from now at your class reunion, you may be the wealthiest person in your graduating class.
( Important Note: The author takes no responsibility for any investment decisions, decisions regarding insurance, or other actions you may take in response to reading this column. The author is not a certified investment advisor. If you want specific investment advice, you need to contact a professional, certified investment advisor. )