THE H. KENT BAKER INVESTMENTS SERIES

THE SAVVY INVESTOR’S GUIDE TO BUILDING WEALTH THROUGH

TRADITIONAL INVESTMENTS

This page intentionally left blank

THE H. KENT BAKER INVESTMENTS SERIES

THE SAVVY INVESTOR’S GUIDE TO BUILDING WEALTH THROUGH

TRADITIONAL INVESTMENTS

BY

H. KENT BAKER,

JOHN R. NOFSINGER,

AND

ANDREW C. SPIELER

United Kingdom – North America – Japan – India Malaysia – China

Emerald Publishing LimitedHoward House, Wagon Lane, Bingley BD16 1WA, UK

First edition 2020

Copyright © 2020 Emerald Publishing Limited

Reprints and permissions serviceContact: permissions@emeraldinsight.com

No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. No responsibility is accepted for the accuracy of information contained in the text, illustrations or advertisements. The opinions expressed in these chapters are not necessarily those of the Author or the publisher.

British Library Cataloguing in Publication DataA catalogue record for this book is available from the British Library

ISBN: 978-1-83909-611-2 (Print)ISBN: 978-1-83909-608-2 (Online)ISBN: 978-1-83909-610-5 (Epub)

v

CONTENTS

List of Figures xiii

List of Tables xiv

About the Authors xv

Acknowledgments and Dedications xvii

Introduction xix

1. Building Wealth and Achieving Financial Freedom 11.1. What Is a Millionaire? 21.2. Can You Retire with a Million Dollars and

Live Comfortably? 31.3. What Tips Can Help You Become a

Millionaire? 51.4. How Can You Save More and Spend Less? 61.5. What Is the Difference Between Income and

Wealth? 71.6. How Do You Accumulate Wealth? 91.7. What Is Your Time Horizon for Building

Wealth? 101.8. How Important Is Investment Return to

Building Wealth? 111.9. What Is the Difference Between Passive

and Active Wealth Creation? 121.10. How Does Inflation Affect Wealth

Accumulation? 131.11. Do You Need a Financial Advisor? 14

vi Contents

1.12. What Are the Benefits of a Financial Plan? 151.13. What Are the Taxes on Earned Income and

Investment Income? 161.14. How Can You Avoid, Reduce, or Defer

Taxes? 171.15. What Is the Difference Between Financial

Capital and Human Capital? 181.16. How Can You Protect Your Wealth? 191.17. What Sources of Retirement Income Are

Available? 211.18. What Expenses Can You Expect in

Retirement? 211.19. How Do You Estimate Your Spending Needs

in Retirement? 221.20. How Can You Transfer Your Wealth to

Future Generations? 231.21. What Are Some Online Resources to Help

Learn More About Accumulating Wealth? 241.22. Takeaways 25

2. The Stock Market: Owning a Piece of Companies 272.1. What Do the Following Terms Mean –

Saving, Investing, Gambling, Trading, and Speculating? 29

2.2. What Are Equity Securities and Their Major Characteristics? 32

2.3. What Are the Pros and Cons of Investing in Stocks? 34

2.4. How Do Companies Distribute Profits to Investors? 35

2.5. What Methods Are Available to Analyze Stocks? 36

2.6. What Types of Investment Strategies Are Available for Stocks? 39

viiContents

2.7. Is a Buy-and-Hold Strategy Right for You? 442.8. What Types of Stocks Are Best for You? 462.9. How Are Stocks Bought and Sold? 472.10. How Do You Set Up a Brokerage Account

and What Types of Accounts Are Available? 482.11. Should Beginning Investors Use Margin

Accounts? 492.12. Should Novice Investors Engage in Short

Selling? 512.13. What Are Some Basic Types of Orders? 522.14. What Common Mistakes Do Investors Make

When Investing in Stocks? 532.15. What Are Some Investment Sites to Help

Learn More About Stock Investing? 562.16. Takeaways 57

3. Being a Lender Not a Borrower: The Bond Market 593.1. What Is a Bond and Its Major

Characteristics? 613.2. How Do Bonds and Loans Differ? 623.3. Why Invest in Bonds? 633.4. Who Are the Primary Issuers of Bonds? 633.5. Who Are the Major Investors in Bonds? 643.6. What Are the Risks Associated with Bond

Investing? 653.7. What Is a Credit Rating and What Does It

Indicate? 683.8. What Is the Treasury Yield Curve and Why

Is It Important? 703.9. How Do Changes in Interest Rates Affect

Bond Prices? 713.10. How Do You Invest in Bonds? 713.11. How Do You Measure a Bond Investment’s

Return? 72

vii i Contents

3.12. What Are Bond Quotes and How Do You Read Them? 73

3.13. How Do Bonds Trade? 743.14. What Are the Tax Liabilities of Bond

Investments? 753.15. What Happens If a Bond Defaults? 763.16. What Are Callable and Convertible Bonds? 773.17. What Are Green Bonds? 793.18. What Are Treasury Inflation-Protected

Securities? 793.19. What Are Asset-Backed Securities? 803.20. How Do You Invest in a Portfolio of

Bonds? 813.21. What Are Some Bond Investing Strategies? 823.22. Why Do Companies Have Many Bond

Issues? 833.23. What Common Mistakes Do Investors Make

When Investing in Bonds? 843.24. What Are Some Investment Sites to Help

Learn More About Bond Investing? 853.25. Takeaways 86

4. Designing Your Portfolio: The Role of Asset Allocation, Diversification, and Rebalancing 894.1. What Is an Asset Class and Asset

Allocation? 904.2. Why Is Asset Allocation Important? 904.3. What Assets Make Up Traditional and

Alternative Investments? 924.4. How Do Traditional and Alternative

Investments Differ? 934.5. What Role Should Traditional or Alternative

Investments Play in Your Portfolio? 964.6. What Factors Influence Your Asset Allocation? 97

ixContents

4.7. What Types of Asset Allocation Strategies Are Available? 101

4.8. What Online Asset Allocation Tools Are Available? 105

4.9. What Is an Asset Allocation Fund? 1074.10. What Are Some Guiding Principles of Asset

Allocation for “Typical” Investors? 1084.11. What Is the Best Asset Allocation for You? 1104.12. What Is Portfolio Diversification and Its

Key Benefits? 1124.13. How Are Diversification, Asset Allocation,

and Risk Related? 1134.14. What Level of Diversification Is Best? 1144.15. What Kinds of Diversification Mistakes Do

Investors Make? 1144.16. What Can Go Wrong with Diversification? 1174.17. What Is Portfolio Rebalancing and Its

Benefits and Costs? 1184.18. What Strategies Are Available for

Portfolio Rebalancing? 1204.19. What Ways Are Available to Rebalance

a Portfolio? 1214.20. What Mistakes Should You Avoid in

Rebalancing a Portfolio? 1224.21. Takeaways 123

5. Using Mutual Funds and ETFs to Achieve Your Financial Goals 1255.1. What Is a Mutual Fund? 1265.2. What Are the Advantages of Owning

Mutual Funds? 1295.3 What Are the Costs of Mutual Funds? 1315.4. What Are Other Disadvantages of

Mutual Funds? 133

x Contents

5.5. What Are the Different Mutual Fund Categories? 135

5.6. What Are the Different Investment Strategies of Mutual Funds? 138

5.7. What Is an Indexed or Passively Managed Fund? 139

5.8. What Do Actively Managed Mutual Funds Try to Accomplish? 140

5.9. Can You Just Select the Actively Managed Funds that Outperform the Market After Fees? 142

5.10. What Fund Characteristics Should You Examine? 143

5.11. How Can You Evaluate the Performance of a Mutual Fund? 145

5.12. How Do You Invest in a Mutual Fund? 1495.13. What Is an ETF? 1495.14. What Are the Advantages of Using ETFs? 1505.15. What Are the Disadvantages Associated

with Investing in ETFs? 1525.16. For What Asset Classes and Strategies Can

Investors Use ETFs? 1535.17. How Can You Use Mutual Funds and ETFs

to Achieve Your Investment Goals? 1555.18. What Online Resources Are Available for

Mutual Funds and ETFs? 1575.19. Takeaways 158

6. Maximizing Retirement Plans 1596.1. Why Are Retirement Plans So Important in

Building Wealth? 1616.2. What Tax Advantages Are Available to

Retirement Plan Investments? 1636.3. How Does a 401(k) Plan Work for

Company Employees? 168

xiContents

6.4. Should You Invest in Your Company’s Stock as Part of Your Retirement Plan? 170

6.5. How Does a 403(b) Plan Work for Employees of Non-profit Firms, Governments, and School Districts? 171

6.6. How Does a 457 Plan Work? 1726.7. How Does a Thrift Savings Plan Work for

Federal Employees and Military Personnel? 1736.8. What Is an IRA? 1746.9. What Is a Roth IRA, Roth 401(k), Roth

403(b), or Roth TSP? 1776.10. Is a Traditional IRA or Roth IRA Right for

You? 1786.11. Why Would You Want to Convert an IRA

Into a Roth IRA? 1796.12. What Are SIMPLE IRA and SEP Plans for

Small Business and the Self-Employed? 1816.13. What Are the Penalties for Early

Withdrawal from a Retirement Plan? 1826.14. How Can You Invest in More Than One

Plan? 1836.15. What “Catch-Up” Options Are Available

for Making Larger Contributions? 1836.16. What Happens to Your Plan When You

Change Employers? 1846.17. What Happens to Your Retirement Plan

After You Retire? 1856.18. Takeaways 186

Index 189

This page intentionally left blank

xii i

L IST OF FIGURES

Figure 2.1. Risk Level of Various Types of Stock 46Figure 3.1. Risk Level of Various Types of Bonds 64Figure 5.1. Mutual Fund Categories and Their Risk

and Expected Return 135

xiv

L IST OF TABLES

Table 1.1. Factors Affecting Retirement 4Table 1.2. Wealth Accumulation Based on $10,000

Contributions per Year 12Table 3.1. Credit Ratings 69Table 6.1. Summary of Retirement Plan Characteristics 167Table 6.2. Summary of Traditional IRA Tax

Deduction Rules 176Table 6.3. Summary of Roth IRA Contribution Limits 178

xv

ABOUT THE AUTHORS

H. Kent Baker, DBA, PhD, CFA, CMA, is University Pro-fessor of Finance in the Kogod School of Business at Amer-ican University. He is an award-winning author/editor who has published 36 books and more than 300 articles and other publications. He is among the top 1% of the most prolific authors in finance. He serves on numerous editorial boards and is the editor of two investment book series. His scholarly work has been presented at nearly 190 conferences. He is internationally known for his work in investor behavior, dividend policy, and survey research. He has consulting and training experience with more than 100 organizations in the United States, Canada, and Europe. He has received numerous research, teaching, and service awards including the Southern Finance Association’s 2019 Distinguished Scholar and American University’s Scholar/Teacher of the Year.

John R. Nofsinger, PhD, is the William H. Seward Endowed Chair in International Finance at the University of Alaska Anchorage. He also works as a portfolio manager for Denali Advisors. He has written or edited 14 finance trade books, textbooks, and scholarly books. He is a prolific scholar who has published 70 articles in prestigious scholarly and prac-titioner journals. He is most widely known in the areas of behavioral finance, socially responsible investing, and biology

xvi About the Authors

of finance. He has presented his scholarly work more than 60 times at universities and academic conference and more than 50 times at practitioner associations, industry confer-ences, businesses, and individual investor associations. He has been quoted or appeared in the financial media, including The Wall Street Journal, Financial Times, Fortune, Business Week, Smart Money, Money Magazine, Washington Post, Bloomb-erg, Nightly Business Report, and CNBC, and other media from The Dolans to MarketWatch.

Andrew C. Spieler, PhD, CFA, FRM, CAIA, is the Robert F. Dall Distinguished Professor of Business and Professor of Finance in the Frank G. Zarb School of Business at Hof-stra University. He is the founder of Advanced Quantitative Consulting. He has published over 40 articles, book chap-ters, and books in wide ranging topics including real estate, fixed income, hedge funds, and behavioral finance. His work has been presented at over 60 universities and conferences. He received three “Best Paper” awards from the American Real Estate Society. He was also the recipient of two “Dis-tinguished Teacher of the Year” and two “Researcher of the Year” awards at Hofstra University. He is the Co-director for the annual conference sponsored by the Breslin Real Estate Center. He is frequently quoted by the financial press includ-ing The Wall Street Journal, New York Times, MSNBC, ABC News, Fox News, and others.

xvii

ACKNOWLEDGMENTS AND DEDICATIONS

“The most valuable of all talents is that of never using two words when one will do.”

—Thomas Jefferson

In writing The Savvy Investor’s Guide to Building Wealth Through Traditional Investments, we tried to keep Thomas Jefferson’s advice in mind. This book is short but filled with many powerful ideas. Its publication would have been impossible without the support of several parties. We appreciate the professionalism of everyone at Emerald Publishing, especially Charlotte Maiorana (Senior Editor). Charlie Wilson (Associate Editor), Sophie Barr (Senior Content Editoro and S. Rajachitra (Senior Project Manager). We also owe our respective institutions – Kogod School of Business at American University, College of Business and Public Policy at the University of Alaska Anchorage, and Frank G. Zarb School of Business at Hofstra University – a debt of gratitude. Finally, we thank our families for their support and understanding: Linda and Rory Baker; Anna Nofsinger; and Terry, Harrison, Teresa, Robin, Kate, and Hudson Spieler.

This page intentionally left blank

xix

INTRODUCTION

Would you like to be a millionaire or better yet a multi-millionaire? If you’re like most people, your answer is “yes.” This goal is not beyond your reach. As Morton Shulman once quipped, “To make a million, start with $900,000.” However, most people don’t have the luxury of starting with this amount of money so let’s take a hypothetical example. Assume you have a defined contribution plan in which both you and your employer deposit a total of $158.13 at the end of every month into an S&P 500 Index fund that earns a 10% year-ly rate of return. If you don’t withdraw any money along the way, how much money do you have in your fund after 40 years? Take a guess. You’d have slightly more than $1 million. You’d be a millionaire. Although the assumed inputs may not mirror your situation, the key point is that regular investing and the power of compounding leads to higher wealth accumulation over time. Thus, small efforts can create big results in terms of your wealth. Keep in mind, however, that the purchasing power of your money would be much less 40 years from now than today due to price inflation.

“Money, if it does not bring you happiness, will at least help you be miserable in comfort.”

Helen Gurley Brown

xx Introduction

How can you build wealth? The answer is simple but not easy. It is more common sense than magic secret. You become swealthy by starting early, spending less than you make, man-aging risk, and saving and investing regularly and wisely over the long term. Along the way, focus on what you can control, such as the amount of risk you’re willing to take, the costs you’re willing to incur as well as your investment horizon, asset allocation, and behavior. The single greatest factor in growing your long-term wealth is the rate of return you get on your investment, which is determined over time by the market. This roadmap to wealth is straightforward, but it requires discipline and patience. Little by little, a little becomes a lot.

Unfortunately, many people lack sufficient discipline and patience. Others wait for some fortuitous event to occur such

as winning a lottery or inheriting a large sum of money. For most people, such events never occur. Conse-quently, they aren’t wealthy and will never be. It’s sad, because many of them could

have become wealthy if they’d only been proactive and taken the necessary steps to building wealth. Don’t be one of these people. Building wealth takes planning and requires both productive work and dedication.

As an investor, you face many challenges. Savvy investors turn challenges into opportunities. After you eliminate high consumer debt, especially high-interest debt, and build up suf-ficient savings to handle emergencies, you need to decide how and where to invest your hard-earned money. Most people don’t know much about investing and some don’t even know

“Too many people spend money they haven’t earned, to buy things they don’t want, to impress people they don’t like.”

Will Smith

xxiIntroduction

where to begin. As a result, they either never get started investing or make costly mistakes. A good way to start building wealth is to invest in traditional investments – stocks, bonds, and cash or cash equivalents. Stocks and bonds are the heartbeat of Wall Street. You can invest in a single security, which most individual investors don’t do, or in a pooled investment vehicle, which combines the funds of many investors for the purposes of investment. Pre-packaged products such as index mutual funds or exchange-traded funds offer economies of scale, which provide lower trading costs per dollar of investment, diversification, and professional money management. When you invest in stocks and bonds, you can receive a future income stream in terms of dividends and interest, as well as the alluring prospect of capital growth and compounding returns over time. Creating wealth with these financial instruments is tied to the market’s performance, which you can’t control. Additionally, one of the most powerful avenues to invest and build wealth is through retirement plans.

Before you begin your wealth-building journey, you need to be honest about what you know and what you don’t know about invest-ing. The Savvy Investor’s Guide to Building Wealth Through Traditional Investments is intended to help you learn about

“Acknowledging what you don’t know is the dawning of wisdom.”

Charlie Munger

“If your ship doesn’t come in, swim out to meet it.”

Jonathan Winters

“Building wealth is a marathon not a sprint. Discipline is the key ingredient.”

Dave Ramsey

xxii Introduction

traditional investments and to become a better investor, especially if you are a novice or an inexperienced investor. As Maya Angelou once wrote, “Do the best you can until you know better. Then when you know better, do better.” Thus, as Robert Kiyosaki notes, “Financial freedom is available to those who learn about it and work for it.”

1

1

BUILDING WEALTH AND ACHIEVING FINANCIAL

FREEDOM

“You can be young without money, but you can’t be old without it.”

—Tennessee Williams, American playwright

“Who Wants to Be a Millionaire?” was a popular American television game show based on the same-titled British pro-gram. Not surprisingly, few contestants walked away with the top prize. Winning $1,000,000 is difficult! Of course, nearly everyone would like to be a millionaire but how can this be accomplished besides winning a game show or lottery? Fortu-nately, several paths are available to becoming rich.

A recent study of wealthy individuals identified three com-mon ways they built their fortunes. Saver-investors focus on having no debt, living well below their means, and sav-ing and investing for many years. Virtuosos are those who are the “best of the best” in their career, industry, or profes-sion. They work for large, publicly held companies that have stock options or own their own highly profitable businesses. Dreamers pursue a big dream and make it a reality, which

2 The Savvy Investor’s Guide to Building Wealth

lead to some massive gain or income. If you want to be rich, you need to select a path that’s right for you and stick with it for many years. With a few exceptions, each path requires considerable time to accumulate wealth.

This book follows the first path by focusing on saver-investors. Its primary goal is to discuss how investors, especially novice investors, can use their financial capital to build wealth with traditional investments. Savvy investors can predictably accu-mulate wealth with some basic strategies, financial knowl-edge, and patience. In other words, everyone has the potential of building wealth and some can become millionaires or even multi-millionaires and achieve financial freedom.

This chapter discusses the difference between income and wealth, ways to reduce and estimate retirement expenses, and the impact of inflation on future purchasing power. It offers realistic scenarios to start your journey to saving and invest-ing more, spending less, and increasing your wealth.

1.1. WHAT IS A MILLIONAIRE?

For many people, the term “millionaire” conjures up images of extremely wealthy people enjoying the sun on their private yacht. The news media bombard us with pictures of the rich and famous including millionaire athletes, entertainers, and business executives. These images seem distant from the lives of most hardworking everyday people. Let’s examine the defi-nition of a millionaire a bit closer. Traditionally, a millionaire is someone with net assets greater than $1,000,000 excluding the equity in a residence. Thus, if you can accumulate those seven figures you too can join the “two comma” club with $1,000,000.

At one time, becoming a millionaire was the epitome of success. Today, some of the luster of being a millionaire has

3Building Wealth and Achieving Financial Freedom

diminished because it’s almost commonplace. During 2018 about 11.8 million households in the United States consisted of millionaires. This number represents about 3% of the US population. Of course, some people are mega rich because they’re members of the ultra-exclusive “three comma” club with at least $1,000,000,000. The United States has the most billionaires in the world followed by China.

Over time, the term “millionaire” has been shifting to sig-nify individuals with an annual salary of $1 million or more. According to the Internal Revenue Service, you’d need to earn about $500,000 per year to be part of the top 1% of earners. The media talk about the “millionaire’s tax” on high-income earners and additional real estate taxes on expensive homes. Some politicians have proposed a “wealth tax” on the so-called “1%.” This definition of a millionaire is certainly a much higher standard with only about 1 in 400 US house-holds reaching this elusive income mark. Clearly, the defi-nition is shifting over time to identify the true elite earners. Although becoming a millionaire is a lofty goal, this chapter focuses on the traditional definition. Savvy investors know that developing a consistent investment plan using traditional asset classes can potentially help to accumulate the first mil-lion, then the second million, and so on. Of course, building wealth doesn’t happen overnight. It’s achievable but involves taking greater risks to gain higher expected returns.

1.2. CAN YOU RETIRE WITH A MILLION DOLLARS AND LIVE COMFORTABLY?

This is truly the “million dollar” question. The goal of invest-ing is to accumulate assets to improve or maintain your lifestyle, particularly in retirement. As previously noted, no “one size fits all” approach is available to building wealth or

4 The Savvy Investor’s Guide to Building Wealth

becoming a millionaire. The right approach for you depends on several important factors such as your expected time hori-zon, spending patterns, tax status, and planned bequest to heirs. As a starting point, you should note some important

but general observations in the Table 1.1.To get a sense of your comfort zone, consider the projected

withdrawals in retirement based on the following assump-tions (rounded):

The final result allows you to spend $62,500 each year in retirement for 20 years. At first glance, that sounds like a livable amount, but the analysis ignores inflation. Prices won’t remain the same during the 20 years of retirement. Assuming inflation of 3% per year, a more realistic estimate of your actual purchasing power would be closer to $48,000 per year.

Funds at retirement $1,000,000

Retirement age 67

Life expectancy 20 years

Planned inheritance none

Earnings rate 4%

Tax rate 15%

Annual withdrawals $62,500 after taxes

Table 1.1. Factors Affecting Retirement.

Factor Change in Retirement

Retire later More comfortable

Withdraw more Less comfortable

Longer life expectancy Less comfortable

Higher tax rate/location Less comfortable

Larger bequest Less comfortable

5Building Wealth and Achieving Financial Freedom

1.3. WHAT TIPS CAN HELP YOU BECOME A MILLIONAIRE?

Here are the “big four” tips on becoming a millionaire as a saver-investor: (1) save more, (2) spend less, (3) limit taxes, and (4) invest wisely.

• Save more. The first tip seems obvious: save more of your earnings. The more you save, the less risk you need to take to increase your wealth. Although most saver-investors have a modest income, they often save 20% or more of their salary. As discussed in later chapters, you should make sure to save at least enough to get your employer’s 401(k) match, if you’re part of a defined contribution plan. Think of your employer’s contribution to your retirement plan as “free money.” To get this “free money,” you need to contribute a minimum amount specified in your sponsor’s plan.

According to an old adage, “A penny saved is a penny earned.” In other words, if you spend less, you can save more. And the savings is likely to grow if invested wisely so a penny saved can become two or more pennies in the future.

• Spend less. The second tip is to spend less. Savvy saver-investors live below their means. As simple as this advice sounds, it’s not easy to follow given the convenience of credit cards and “buy now, pay later” offers. In fact, the average credit card debt per US household was $8,398 in June 2019, which is $1.07 trillion in total credit card debt divided by 128 million US households. Spending less requires controlling expenses and being disciplined such as sticking to a budget. Otherwise, savings and retirement accounts can dwindle quickly.

“If inflation continues to soar, you’re going to have to work like a dog just to live like one.”

George Gobel

6 The Savvy Investor’s Guide to Building Wealth

• Limit taxes. The third tip is to reduce your tax bill. This step can be a complicated issue and is discussed in more detail in later chapters. For now, the idea that lowering current taxes and/or deferring taxes is good. Sometimes, you can eliminate some taxes entirely based on lifestyle choices such as by installing solar panels to get tax credits, moving to a state with no state income tax, or taking advantage

of the gift tax exclusion. Under the US tax code, if the amount stays below the gift tax exclusion, you won’t have to worry about any tax. For example, the annual gift tax exclusion in the United States for 2020 is $15,000.

• Invest wisely. Investing wisely is what savvy investors do and that’s the main focus of this book. By properly using

traditional investments you can build wealth over time. To invest wisely, you need to not only to have sufficient knowledge but also the discipline to carry out your plans.

1.4. HOW CAN YOU SAVE MORE AND SPEND LESS?

People are tempted daily with instant gratification purchases. It takes discipline to spend less and live below your means. Try to go just one day without spending money while out of your house – walk/bike to work or pack your own lunch – and

“I’m proud to be paying taxes in the United States. The only thing is, I could be just as proud for half the money.”

Arthur Godfrey

“I believe that through knowledge and discipline, financial peace is possible for all of us.”

Gordon Ramsey

7Building Wealth and Achieving Financial Freedom

you’ll see spending less is not so easy! As many know, those fancy latte drinks can add up quickly.

A safe, prudent guideline to follow is the “pay yourself first” rule. Specifically, make sure that you immediately invest some part of your paycheck before it touches your hands. For example, contribute to your employer 401(k) plan with a direct payroll deduction or your own individual retirement account (IRA) with withdrawals from your checking account after your paycheck direct deposit.

Another easy “pay yourself first” idea is to establish a col-lege savings plan known as a 529 plan with small, frequent contributions. Although the rules about current tax deduc-tions for 529 plans vary by state, many states allow a state tax deduction. Your investment is immediately earning a return while reducing your tax bill. Regardless of where you live, all 529 plans allow the funds to grow tax-free, and the with-drawals are tax-free when used for qualified higher educa-tion expenses. The chance to have years of tax-free growth is highly attractive.

Another large expense individuals pay over a lifetime is interest on debt, especially credit card debt. When you buy a car, house, and other products, you may be using debt. The interest paid on that debt is related to your personal credit score. A higher credit score reduces the interest rate owed on the debt and thus reduces the payments. Savvy investors pay their bills on time to keep a high credit score and save thou-sands in interest payments over the years.

1.5. WHAT IS THE DIFFERENCE BETWEEN INCOME AND WEALTH?

To the average person, the terms income and wealth are interchangeable. Although income and wealth are related

8 The Savvy Investor’s Guide to Building Wealth

ideas, they have important differences. Income represents the inflows from wages (mostly) and investments (much less) for the typical hardworking person. Wealth is the difference between your assets such as retirement accounts, savings accounts, life insurance policies, and home and your liabilities such as your

mortgage, student loan, and credit card balances. Income is always positive, but wealth can be negative even for edu-cated professionals.

Income is more normally distributed than wealth. That is, income looks more like the “bell curve” with most observa-tions clustered near the middle. Some outliers exist such as high-level business executives and professional athletes that earn extremely high incomes. In contrast, wealth is distrib-uted in a highly unequal fashion, with the wealthiest 1% of US families holding about 40% of all wealth and the bot-tom 90% of families holding less than 25% of all wealth. Of course, you can probably name some extreme outliers such as individuals who have accumulated billions of dollars of wealth. By way of comparison, according to the US Bureau of Labor Statistics (BLS), the median wage for American workers in the first quarter of 2019 was $905 per week or $47,060 per year for a 40-hour workweek. However, the bot-tom quarter of wealth is negative. Negative wealth doesn’t mean that the bottom 25% of the population is hopelessly poor. For example, young earners may have positive, even high, income but negative wealth as they pay back student loans and consumer debt. Over time, your income is likely to rise into your 50s and 60s and then drop as you enter retirement.

Wealth, however, starts out small or negative but accumu-lates over time. Wealth typically reaches its maximum just before you stop working. Although the value of your portfolio

“Wealth is largely the result of habit.”

John Jacob Astor