Personally I love investing. I started to learn about it some years ago and always found the concept fascinating.
But some people just aren’t very into it. They might find it confusing, or just boring. My wife is very much that way.
So if the stock market doesn’t interest you, or even downright scares or confuses you, do you really need to invest in it?
Wealth Is Not Static
We often think of money as static. If I hand you a dollar, it will still be a dollar tomorrow. If you hold that dollar for a year, it’ll still be a dollar then.
But money isn’t defined by the hard cash you hold in hand, or value you see in your bank account. It’s constantly fluctuating.
Money is a representation of value. When you have a dollar, it means that you can trade that dollar for a dollar’s worth of value.
The problem is that what a dollar’s worth of value is fluctuates over time. A dollar 50 years ago was worth a lot more than it is today.
Indeed, that dollar you hold in hand will be worth a little less the longer you hold it, thanks to inflation. In a year, it might only be worth around 98¢ of future value in comparison to the value it holds today. In many years, it’ll be worth far less.
If I hand you a dollar bill today, I can only guarantee that it’ll get you a dollar’s worth of value today. Assuming inflation is gradually rising, the longer you hold that dollar, the less value it’ll be worth. You won’t know the exact worth of that dollar until it reenters the economy, by means of you buying something with it.
And of course money is only valuable in comparison to what you can buy with it. A stack of hundreds sitting under your mattress is worth exactly nothing if you never plan on doing anything with it. It’s just paper.
So you can see currency as a contract that says, “This money can be traded for an equal amount of value from the marketplace.” But that “equal amount of value” will change day-by-day.
OK I know this seems a little abstract. Why should you care about this?
Because money is never just money. Some people think they are safe to just sit on their money, keeping it stashed under a mattress, or in a checking account. But they aren’t safe: from the day that money is received, it is steadily losing value.
Presumably you want to build wealth. If that’s your goal, then your money losing value is actually accomplishing the opposite.
Income Isn’t Enough
But, you might argue, “I don’t just have a dollar bill, though. I do work that earns me a steady paycheck, so my money is growing.”
But that doesn’t solve the problem at all.
You see, income is not wealth, it’s cashflow.
People often make the mistake of believing that income is wealth. They envy high-income earners, who make hundreds of thousands per year. But, such people can be just as poor, if not more so, than those making far less.
Income describes the rate of cash inflow. Said another way, it describes how much money you receive over time.
But it’s only half the story, because you don’t just receive money endlessly. You also spend it.
So every month, you have money coming in and going out.
But take these two examples:
- Person A makes $2,500 per month in take-home pay. On average, they spend $1,500 per month.
- Person B makes $7,500 per month in take-home pay. On average, they spend $7,250 per month.
At first glance, you might think Person B is better off. They’re making far more, after all.
But income only describes money inflow. When you look at expenses, it’s clear that Person A is in a far better financial situation.
Now that doesn’t mean that Person B doesn’t have more of an opportunity to fix their situation and do far better. Perhaps they could cut their expenses down to $5,000, then they’d be saving $2,500 per month. But as it is, Person B is “less wealthy” than Person A, just considering these datapoints.
Wealth is actually a measure of your net worth. Net worth is just assets ➖ liabilities. In other words, money and other things of worth, minus all of your debts (credit cards, student loans, etc).
If your net worth is increasing, then you are becoming wealthier. If it is decreasing, you are becoming less wealthy. Sounds pretty simple, right?
But you must disconnect net worth from the idea of income. Income can correlate to higher net worth, but it doesn’t necessarily. Why do you think there are so many celebrities who come into money, then lose it all through bad financial management?
But still, you might think that higher income is all you need for greater wealth, as long as you lower your expenses and try to save every month, as I suggested in my last post.
The problem is, it’s not enough. Just relying on monthly savings alone will not make you wealthy.
Notice I don’t say “probably”. There is a 0% chance that relying on your savings rate alone will make you wealthy.
Check out the below chart that shows how much you might save in a year, with a hypothetical monthly take-home pay of $5,000 and a savings rate of 10%.
The monthly expenses vary, as they would in reality, but by the end of the year, $6,000 have been saved.
Even if you extend that out 5 years, you’ll only have saved $30,000 ($6,000 per year for 5 years). That might seem like a good bit of money, but keep in mind that it’s only half of what you make in a single year of working. Does it seem like this is an efficient way of building wealth?
In fact it’ll take 10 entire years of saving 10% to make the amount of money you earn in 1 year.
Sure if your savings rate is higher, you’ll save more in less time. A 20% savings rate will see you save 1 year of income in just 5 years.
But you’re missing one crucial part of the equation: unless you want to work the rest of your life, one day that income will dry up.
Then, the savings will need to be sufficient to allow you to live the type of lifestyle you prefer in retirement.
Hint: No matter how much you save, if you just stick that money in a checking account and do nothing else with it, it’ll never be enough.
Below is a chart that demonstrates this. Note that I’ve included the effect of inflation, increasing expenses a bit each year. To make it more realistic I’ve also increased income in line with inflation so the savings rate is always 10%.
In this chart I’m assuming retirement is 40 years out. Notice that your net worth increases steadily over those 40 years, but once income dries up, the net worth plummets within only a couple of years.
Now if you put this money into a savings account that earns a bit of interest, this will offset the effect of inflation a little, but generally not entirely, and it still won’t be enough. Even with a high-yield savings account offering 1.5% interest, savings will still dry up within a few years of retirement.
Below is a dynamic chart where you can play around with the numbers. Enter your years until retirement, your savings rate, and interest earned.
Hopefully you can see that no matter how much of your income you’re able to set aside each month, relying on your income alone to grow your net worth is never enough.
And forget about any other large expenses. Want to buy a house? That’ll take away from the meager savings you’re able to build up. Have an unexpected medical bill, car repair, vet bill, or any other number of emergencies that arise from time to time? These will all eat away at your retirement savings, making it last even less time.
Maybe this seems hopeless. Maybe you’ve seen that no matter what numbers you enter above, it’s never enough to live comfortably in the long-term.
But that’s just because you don’t yet know the true secret to growing wealth. As you’ve just seen, it’s not income. But what is it?
How to Grow Wealth
In order to truly grow your wealth over time, we need to introduce another set of variables into our wealth equation: assets and liabilities.
I mentioned them briefly above. Remember, assets are the sum of all your money, plus any other things of value you own. That could include property, a business, precious metals, crypto currency, foreign currency, bonds, and yes, stocks.
Liabilities are things you owe to others. This includes all debts like credit cards, student loans, and so forth. I mention them only briefly to say that your liabilities eat away at your wealth, just as you’ll soon see that assets grow your wealth. Limit your liabilities to the best of your ability and they won’t be a major concern.
But now to assets. Assets are things that hold value. But a good asset will not only hold value, but grow in value.
Cash is the first type of asset, which we’ve already discussed. It holds value, but loses it over time thanks to inflation, so it’s a poor store of long-term value.
There are also cash equivalents, which are things like savings accounts that earn interest, money market accounts, certificates of deposit (CDs), treasury bills, etc. These hold value a bit better, but still won’t grow very much. They are mostly useful for short-term liquid funds that you will need within the next few years.
Note one thing before moving on: many things may be valuable and yet not be an asset. Your car, for example, is not an asset because it doesn’t hold value. It steadily loses value the moment you drive it off the lot.
Your home, however, if you own it, is an asset, because it will tend to increase in value over time.
A business is an asset because you can make money from it, or even sell it for a higher amount in the future. However it’s obviously an asset that takes quite a bit of work.
Assets change the wealth equation because no longer is money just something that sits there. Now it can actually grow month-after-month, year-after-year, even when you aren’t bringing in income. It’s what is meant by putting your money to work.
This is how wealth is created. Wealth is not received via your paycheck, it is grown organically by investing in things of value which are expected to grow over time.
As you saw above, you will never become wealthy by increasing your income alone. You will only become wealthy by reducing your liabilities, and increasing your assets.
Again, wealth = assets ➖ liabilities. Decrease liabilities, and your wealth grows. Increase assets, and your wealth grows.
But liabilities can only be decreased to 0, which is why they are not my main focus here.
But assets can be grown virtually without limit.
Notice that income is nowhere in this equation. In the wealth equation, the only role of income is to purchase more assets. You put that income to work by converting it to long-term, sustainable assets.
The Best Asset for Growing Wealth
But many of the assets I listed above either do not grow very much (like money market accounts, CDs, etc), are expensive to procure (like real-estate), or require a lot of work (like owning a business).
Wouldn’t it be nice if there was an asset type that grew significantly and reliably over time, was not expensive to purchase, and did not require a lot of work?
If such an asset existed, that would be the holy grail of assets, would it not?
Well, I’m happy to say it does exist.
And, in case you haven’t figured it out yet, that magical asset is stocks.
Now don’t run away screaming. I promise it can be just as easy as I’ve said.
- It grows significantly: The stock market has grown an average of 10% per year historically (sometimes far more).
- It is inexpensive: Depending on your approach, you can get started easily for less than $100.
- It requires little work: You can be as involved as you prefer. You can set it and forget it, and still get great results.
The stock market is the single greatest investment for those who want to grow their wealth. Sure you can invest in other assets as well, but I firmly believe that every investor should have a strong foundation in stocks before dabbling in anything else.
When you own a share of stock, you literally own a fraction of that company. The value of your stock is directly connected to the value of the company. As the company’s value increases, the value of your stock increases.
Just like with money, the value of your stock is defined by how much someone else will give you for it.
Today a share of Apple (AAPL) might cost $320. That just means that someone was offering a share of Apple for $320, and I was willing to buy it for that price.
But let’s say after a few months, Apple reports higher profits, or makes some business change that increases their value in the eyes of investors. Now the stock might be worth $330. That means that I hold a share of Apple, and someone is willing to pay me $330 for it.
Without doing any work at all, my asset (1 share of Apple) has increased $10 in value. If I wanted to, I could sell it and convert that stock back into hard cash. Or, I might hold on to it for years so it can potentially gain far more value.
That’s the stock market in a nutshell. When you buy a stock, you are purchasing an asset that you hope will grow in value over time, thereby increasing your wealth.
There is obviously a lot more to it. Which stocks should you buy? How do you know what will go up? These are all questions for future posts. Here I simply want to show how easy stocks can be, and why they are so valuable for building your wealth.
The Final Picture
So let’s get down to actual numbers. If the stock market returns about 10% per year, how will this affect your long-term net worth, especially after retirement?
Firstly, please note that 10% is only a historical average. It will often return far more, or far less, than this amount. But over time, the stock market always goes up if you broaden the view enough.
Below is a historical chart of SPY [quote symbol=”SPY” attribute=”companyName”/]. This is simply a representation of the S&P 500, or the market as a whole, to demonstrate its performance over time.
Notice that in the last 16 years, SPY has gone up 286%. That’s an average of 17.9% per year, well above the 10% average I mentioned above.
However that’s not the whole story. You can zoom into any part of the chart to see the details. It’s gone way up some years, and way down other years. In 2009 it even fell lower than its start in 2003.
But, in time, it went up, as it always has.
So when I say 10%, this is a very loose average. Some decades may return 20%+ as the last 10 years have done. Other decades may only return 5%.
However, let’s assume that it’ll grow 10% indefinitely. How will this affect your retirement?
I’m going to use the dynamic chart I showed earlier, except the interest will now say “return” and will default to 10%, and you can even set your current monthly take-home pay to adjust this chart to your personal circumstances.
Before I show you the chart, I want to mention that you may very well need to save more than 10%. Play around with the numbers below. There will be a savings rate at which you never run out of money, but it actually grows after retirement. I allow the chart to go out 35 years after retirement to show how much can be accumulated in that time. If you can still live off of your wealth after 35 years, you’re certainly set.
I hope the above has made sense. If there are any points that are unclear to you, feel free to ask and I’ll do my best to clarify, and expound upon them in future posts as well.
There is far more to this topic, but hopefully you have gotten a good idea of the importance of investing in the stock market. I’d love to hear your thoughts in the comments!