Investing Simplified–It’s Not What You Make, It’s What You Keep
At this blog, we frequently discuss the “Golden Rule” of personal finance. SPEND LESS THAN YOU EARN. INVEST THE DIFFERENCE WISELY. GROW RICH.
Anyone can understand that if you spend less than you earn, you have a surplus. If you spend more than you earn, you’ll have debt. This part of the rule is simple, even if it is not easy for most to practice.
Investing is a different story. When starting out, we were quickly overwhelmed by the variety of investment options. We didn’t know where to start and chose to throw up our hands and hand off responsibility (and a large chunk of our returns) to a financial adviser. This is actually better than what many people do, which is to get overwhelmed and not even try at all.
What if we can make investing ridiculously simple? What if we could actually eliminate the second part of the “Golden Rule?” Then it would look like this: SPEND LESS THAN YOU EARN. GROW RICH.
We actually can do this if we understand what investing is at its core. Investing is just an extension of our simplified rule. When we invest, we are using our money to make us more money. We simply want to earn as much return as we can (earn more), with as little cost as possible (spend less) to get the best net return. Every financial decision, including every investment decision, can be analyzed in this way. Remember that in building wealth, savings rate is the key. Savings rate is the amount of the money that you make that you actually keep. It is a measure of your efficiency. The same concept of seeking maximum efficiency applies to investing.
The idea of maximizing returns (earning more) is intuitive. It is also reinforced every time we meet with a financial adviser or receive our 401(k) statements that show us our rate of return on investment. This is by design. Investment return (earning) is what everyone wants you to focus on because this is how investments are sold. However, returns that you see on paper are rarely the same as the money you actually will ever possess. This is because even in our simplified “Golden Rule”, there are still two parts, and what we earn is only the first half. We still have to look at our spending. Cost is the part of investing that others don’t want you to think about. However, to not look at costs would be to miss half of even our simplified rule.
There are a few costs that must be considered when investing. The first are the actual costs of the investment. Any investment has a cost to purchase. There can be commissions, ongoing internal expenses of the investment, and other fees. These fees are how those selling investments, be they financial advisors, brokers, insurance agents or real estate agents, typically are paid. With paper investments these can be difficult to decipher and can add up quickly. Usually, these are represented as a percentage of your assets and look small (often in the range of 1-2% of your assets annually). Remember that they look small because they are based on a percentage of the assets that you have already earned. Whether you make or lose money, the fees will be there. See our experience with investment fees here. With physical investments there are other fees such as the cost of storing gold or maintenance costs with rental properties. A good general rule is: IF YOU DON’T PAY ATTENTION TO INVESTMENT COSTS, YOU’LL PROBABLY PAY MUCH MORE THAN YOU THINK!
The next cost that must be considered is taxes. Every time you make money you have some tax obligations. However, some investments are much more, or less, tax friendly than others. You can also pay much more, or less, in taxes based on the timing of when you realize these gains. Another good rule is: IF YOU DON’T FULLY UNDERSTAND THE TAX IMPLICATIONS OF YOUR INVESTMENTS, YOU’RE PROBABLY PAYING MORE THAN YOU NEED TO!
The final cost that needs to be considered is your time. Many people don’t consider the fact that your time has value. Don’t be one of those people. What you should invest in is largely dependent on the time that you have and your current financial situation. For lower wage earners, investing time and money in education, allowing you to increase earning power, is likely very beneficial. Likewise, more labor intensive investments like rental properties or starting a small business may make perfect sense because they can quickly allow you to earn more than you would in the low wage job. Over time, this can also provide ongoing passive income. For higher wage earners, a simplified approach of increasing savings rate through decreasing spending and using a very passive approach of low cost, tax friendly, paper investments may be smarter and more profitable. They may already have the ability to earn enough to achieve financial freedom quickly, and a time consuming investment strategy could eat up hours that could be used more profitably. The bottom line is you need a strategy that fits your needs. Remember: IF YOU DON’T CONSIDER THE TIME INVOLVED IN AN INVESTMENT STRATEGY, IT WILL PROBABLY BE MUCH MORE THAN YOU ANTICIPATED!
Understanding these concepts can provide a framework for all future investment decisions. You want to look for investments that provide a worthwhile return when considering the risk and the costs that you will incur. Always remember your wealth is not based on what you earn. Wealth is based on what you actually keep.
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