The path to financial wealth has been quite the same for hundreds of years. To get rich you need to acquire money, keep money and let money earn more money. The lessons in this article originate from the book The Richest Man In Babylon. A classic written in 1926 by George S. Clason.
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The rules to getting rich are simple at first sight but do require discipline and training. Discipline to control your expenditures and to pay yourself first. And knowledge that you need to build in order to successfully invest your money.
1. Pay yourself first
Every month most of us receive a paycheck. This is mostly used to pay bills: groceries, rent or the mortgage, insurance, clothing etc. This means that you pay others. The big secret here is that you need to understand that you forgot to pay yourself first!
If you earn €4000 a month, and have a rent of €2000, then you work half of the month for your landlord. And if you spent the other 2000, then you work for others the whole month!
Hence, the important rule to put at least 10 percent of your paycheck in your savings-account. This means paying yourself first before paying others. It might be a good idea to have a second saving account, so you are less tempted to redraw money. For example, saving 10% of a paycheck of 4000 means 400 each month. This is €4,800 per year. After a decade this is €48,000 (assuming no interest).
A feeling of safety and satisfaction gradually comes along if you start to fatten your bank account.
2. Control your expenditures
Controlling your expenses is key in order to reach financial independence. Many people increase their expenditures after an increase in salary. It is essential to realize that savings = income – expenditures. Buying a new car, a TV or expensive cloths will not bring you closer to riches. All these things cost money and do not provide you with a cash flow. They take away cash that you need to invest in assets (e.g. stocks or a real estate) that produce cash for you.
Instead, try to save more if you received a salary increase. It is fine to enjoy life and have fun with friends and family. But never forget your need to save. The best thing to do in order to control your expenditures is to know your costs. So, make a budget. This gives you an overview of your costs. Determine from your budget how you will spend your money. Benchmarking your costs to see if you can save money is also a good idea. Think of another energy company, internet or phone provider to decrease your monthly bills.
3. Invest to build wealth
Obeying to rule number one of paying yourself first, will provide you with money over time. Now you need to make sure that your money will make more money for you. Investing is a great way to let your money grow. Of course, you should always keep an emergency fund to prevent that you need to sell investments at unfavorable terms. And make sure that you understand your investments. Many people spend hours on comparing and researching TV’s, but only a few seconds on buying a company. So, make sure you know what you’re doing.
Investments can increase and decrease over the short-run due to market sentiments. But in the long-run, investments in good companies will reward the investor. This means that you need to have enough cash that you don’t need in the next, say, 5 years.
Passive income: let your money work for you
Passive income is income that you receive from on an investment that no longer requires your labor. Examples are dividends, rent or fees from a book that you wrote. Let’s use the dividends as an example of passive income. If a company earns enough money, it can decide to pay out some of its earnings to the shareholder. This is called a dividend.
The dividend divided over the share price is the dividend yield (e.g. a dividend of $1 and a share price of $10 means a yield of 1/10 = 10%). Over time, good companies like Coca-Cola can increase their dividend. If you hold on to your stocks you effectively get a higher yield on your original cost. For example, Coca-Cola raises its dividend from $1 tot $2 in 10 years. Then your yield on the cost price of $10 is 20% instead of 10% (we assume here that we bought Coca-Cola for $10). Dividends allow you to have a cash stream without the need to sell your investments. The good thing about investing income is that you can re-invest this income. This compounding will increase the speed at which your can get rich.
Inflation: beware of decreasing purchasing power
Besides wealth creation, investing can also protect you from inflation. Let’s dive into inflation for a bit. Assume you saved €48,000 in 10 years. One thing to realize is that the buying power of that €48,000 in 10 years will be less than it is today. This is due to inflation. Products and services tend to increase around 2 percent each year (in a stable economy).
For example, a book of €10 will likely cost around €12.20 in 10 years (10 * 1.02 ^ 10 as the price increases compound). The value of €48,000 in 10 years is approximately €39,377 today with an inflation of 2 percent. You can calculate this with the present value formula (48,000 / 1.02 ^ 10). The present value is the reverse of the future value (the calculation we used to determine that the value of the book would increase to €12.20 in 10 years due to inflation).
In conclusion, investing can help to preserve the buying power of your money as your money can grow due to investing with 2 or more percent per year.
Avoid losing money
In the book ‘The Richest Man in Babylon’ this is called “project your treasures from loss”. Warren Buffett calls “not losing money” his most important investing rule.
Money comes slowly and leaves quickly for those who try to make quick profits. Many people try to become rich fast by making risky investments that offer returns that are not reasonable. An example is the apparent attractiveness of Bitcoin and promises of doubling your money by sending your hard earned money to a charlatan. Do not get fouled by these unrealistic proposals. Instead, use common sense and try to get advice from honest experts with a good track-record. Following the rules of Warren Buffett is a great way to prevent yourself from a large capital loss. Aim at safe investments that you understand. Avoid too much debt and companies that have negative cash flows. Investing in real estate that you know could also be a safe option.
4. Additional advice to get rich and build wealth
Additional rules are given to create wealth over time. The first we’d like to share is to buy a home. Over time, you pay of the debt (mortgage) which means you increase your share of the house. Furthermore, this will lower your costs over time. Obviously, you need to ensure that you buy a house where you’d like to live at least 5-10 years. This to prevent the need to sell your house at a loss during a downturn of the real estate market. Remember that a house can increase in value over time but does not provide you with a cash flow (unless you rent-out a room).
The next advice is to make sure that you have enough funds available (future income) when you are no longer able to work. Most of us do have a pension-plan or saving-plan. But in case you have not, it might be a good time to start thinking about how much future income you will have. Do you have enough savings and dividend income for example to cover your needs after retirement?
Lastly, the book describes the advice to increase your ability to earn. Desire for a tangible and achievable result is important here. If you want a €500 raise, what are you going to do to achieve this? How can you excel in your work? Can you increase your skills by studying?
Save, invest and control your expenditures
Start today with these simple rules to get rich. Saving, investing and controlling your expenditures will steadily build your wealth over time. Patience and building knowledge are key. It might not look as much after a month, but after a year of applying these rules, the feeling of having some wealth becomes very satisfying.
As explained, saving alone it not enough. So, investing is crucial. It is essential though to not try to take too much risk. It is far better to steadily build your wealth with wise investments. Read about the stock market and stocks and get advice from a trusted source if needed. For the beginner, index funds of the S&P 500 and/or Euro 600 (the largest 600 European companies) could be a great way to get exposure to investing at very low costs. Start with small sums of money and see how you behave if your investment goes up or down.