Article Updated for 2021
Eight Financial Habits to Help Build Long-term Wealth
One in three Americans have no retirement savings whatsoever and 56% of Americans have less than $10,000 in savings. The goal of this post is to keep you from falling into that group. Below, we'll look at eight financial habits that will get you on track for building long-term wealth and becoming independently wealthy.
1.) Budgeting
In George S. Clason’s The Richest Man in Babylon (one of the classics regarding personal finance), the title character states, “That what each of us calls our necessary expenses' will always grow to equal our incomes unless we protest to the contrary." Budgeting is that act of protest that we do with ourselves to ensure that we are keeping our expenses in check and creating the necessary margin between our income and expenses so that we might start to build wealth. It doesn’t matter if you make $30,000 a year or $300,000 a year, if you are not budgeting, then chances are that you’re spending the majority of what you’re making and are effectively living paycheck to paycheck (or at least not saving enough).
I once met with a young petroleum engineer fresh out of college who was making upwards of $250,000 a year. She was single with no kids, and was anxious about figuring out how she was going to pay her energy bill for the month! A quick calculation of where her money was going showed the culprit to be that she was devoting large portions of her income to shopping (mainly high dollar purses), fine wines and going out to eat. Together, we set up a budget for her where she could still use some of her paycheck to spend on the things she enjoyed doing, but within moderation to where she could pay her expenses and begin to build wealth.
Regardless of who you are and how much you make, budgeting is an important habit to begin practicing. While the old tried and true envelope budgeting system is effective and still works well, there are several great apps and programs that utilize technology to help streamline the budgeting process. Mint.com, You Need a Budget, Tiller (what I personally use), and Personal Capital are all very popular and solid choices when it comes to budgeting software. Find what works best for you and stick with it!
2.) Pay Yourself First
Going hand-in-hand with budgeting is the concept of paying yourself first. The concept is simple, by setting aside and designating a portion of your discretionary income (10-15%) towards savings right when you are paid, you ensure that you are actually saving money for emergencies, a rainy day, retirement etc. and are not allowing it all to be spent on frivolous current expenses. Start off by building up enough cash in a savings account to take care of 3-6 months’ worth of your family’s expenses. This will be your “emergency fund” that will allow you to take care of unforeseen expenditures and unexpected drops in income (such as when in-between jobs). When you have ample cash in your emergency fund, you can start directing ongoing savings towards investments and paying off of any significant debts you might have, both of which will increase your net worth over time.
3.) Max Out Matching Contributions in Employer-Sponsored Plans
In order to incentivize employees to save more for retirement, employers will often match employee contributions to their 401(k)s, 403(b)s, or other employer-sponsored retirement plans. There is usually a cap on the amount that they will match, which is usually a percentage of the employee’s income. For example, if Craig’s employer offers employees a dollar for dollar match in their 401(k)s up to 3% of income and Craig makes $100,000 annually, the company will match Craig’s contributions up to $3000 (3% of his income) each year. Craig has the ability to contribute up to $19,500, but the company will only match the first $3,000 that he puts into the account annually.
While it might seem tempting to forego saving for retirement (especially for younger professionals in their 20’s and 30’s) in exchange for a larger paycheck, I would encourage you to max out the employer match, if at all possible. In the above example, by Craig merely contributing 3% of his income toward his retirement account, he’s instantly doubled his money ($3,000 + company match = $6,000)! How many places can you have a 100% return on your money instantly without taking significant risk?*
Also, take into account that, barring some exceptions like a Roth 401(k), retirement contributions are done on a pre-tax basis. This means that those who make a contribution will not feel the full effects of the contribution on their take-home pay, as some of that money would otherwise be going to the government to pay for taxes. In the above example, assuming Craig is not married and has no kids and ignoring any other deductions, $720 of Craig’s $3,000 would be going to pay for federal taxes, meaning that a $2,280 difference in take home pay for the year (or $190 a month) will result in $6,000 going towards his retirement savings! Long-term, this will make a significant impact on his retirement savings.
*Note: the company might have some sort of vestment schedule that requires you to work there a few years before being fully vested in the match, meaning that if you leave after a year or two, you probably would leave with 20-40% of the company’s matching portion, not the whole amount.
4.) Avoid Debt
Not all debt is created equal and there are some instances where debt with a reasonable interest rate could be a good/necessary option (business loans, home mortgage, student loans, etc.), but as a general rule debt should be avoided if possible. If you’re carrying large balances on your credit cards from month to month and most of your purchases require financing (furniture, cars, etc.), you’re probably living beyond your means and are digging a larger hole for yourself somewhere down the road. Debt, particularly high-interest debt, is a vampire that will suck you dry and will be a significant hindrance for you in your ability to build wealth. If you currently have large amounts of debt, I’d encourage you to aggressively attack it! Earmark a large portion of your discretionary income in your budget (see above) to pay down debt quickly, using either the debt snowball or debt avalanche methods to get out of the hole.
5.) Embrace Building Wealth Slowly
Rome wasn’t built in a day and, barring a crazy outlier like you winning the lottery or receiving a large inheritance, your wealth won’t be built in a day either. Avoid the guys that are trying to sell you their system on how to day trade like a pro in two weeks. Avoid, like the plague, people that are trying to sell you on an investment that’s “GUARANTEED” to make a 20% rate of return annually (no one makes guarantees like that unless they’re idiots, con-men, or idiotic con-men). Don’t put all of your savings in some hot stock that a tv personality tells you is definitely going to double over the next 12 months.
Instead of trying to time the market or investing time/money in get-rich-quick schemes, I'd suggest making consistent, fixed dollar purchases of a solid index fund (such as Vanguard's Total Stock Market Index Fund) on a monthly or quarterly basis. Regardless if the market is trending up or down, continue to invest the same amount of money consistently. It sounds simple enough, but what will happen over time is that you will buy more shares of the fund at a discount when the market is low and buy fewer shares at a premium when the market is high. Doing this consistently over a couple of decades will help you build wealth in a systematic, disciplined way.
6.) Avoid Losing Wealth Quickly
A recent study by Dalbar showed that over the last 30 years, the S&P 500 achieved annualized returns of 10.35%, while the average equity investor only achieved annualized returns of 3.66%. In dollar terms, $10,000 invested in the S&P 500 thirty years ago would be worth $191,942 today, while the average equity investor’s $10,000 would have only grown to $29,399! What is the reason for this large difference in return? While there are several factors that contribute to this disparity, the main factors are behavioral in nature and can be summarized by two words: fear and greed.
You’ve heard the old adage “buy low and sell high,” and it sounds quite simple, but many investors do the exact opposite. They buy into the market when everyone is making money and the market is hot, and then when the market experiences a significant drop they freak out and pull their money out at the exact worse time. They then keep the money in cash until the market has recovered, effectively missing out on the recovery, and then reinvest the money back into the stock market. This cycle then repeats itself all over again.
When the market experiences a significant drop, fear can get the best of even the most seasoned of investors that have been investing for years. Getting out and going to cash in the middle of a market correction, even for a few days, can effectively erase years of growth in a portfolio and can lose substantial amounts of money for the investor in a very short period of time. To avoid substantial loss of long-term wealth, fight the urge to go to cash when the market drops (as it will from time to time) and stay invested.
7.) Protect Your Biggest Assets
One of the biggest risks to your long-term wealth is not having your largest assets adequately protected from loss. There are many things that it’s good to be cheap on, but being too cheap when it comes to your insurance coverage can cost you massively somewhere down the road. Adequate term life insurance coverage, homeowners and auto insurance coverage (along with an umbrella policy), and long-term disability income insurance are all incredibly important and should not be overlooked. I know it’s not the most exciting topics to talk about, but nothing can drain a family’s wealth (or ability to accumulate wealth) faster than inadequate insurance coverage.
8.) Have a plan
It’s not enough to have a goal of retiring at 55, or wanting to have enough money saved to pay for your children’s college, or wanting to have all of your student loans paid off. Rather, you need a plan in place in order to make your goals a reality. A good plan takes a big goal and breaks it down into smaller, actionable steps. If you don’t know where to start, hire a professional to help you get started.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
