Do you want to learn how to build wealth? Of course you do. Everyone loves the idea of being wealthy as much as they love a fairytale ending. The two characters destined to end up together walk off hand in hand into the sunset after vanquishing some villain or overcoming some harrowing difficulty. It’s a moving story of perseverance, effort, and patience.
To reach this ending, usually the hero has some unique attribute, possesses an edge others simply lack, or faces circumstances which provide the opportunity to seize the day. But what if someone who has none of these advantages could also rise above?
Or better yet, what if this person found a way to walk this path while ignoring the stress suffered by the stereotypical hero?
Let’s explore how an ordinary person can be the hero of his or her own financial future by learning how to build wealth through the incredible compounding machine known as the stock market.
Compounding Returns – Your Secret Super Power to Building Generational Wealth
Examining the success of a traditional hero in the stock market, one could presume he or she has some combination of superior intelligence, access to non-public influential information, or an incredible sense of timing.
These heroes do exist, but make no mistake that an ordinary investor does not need to possess any of these in great supply to be successful when learning how to invest money and realizing his or her own financial success.
The most reliable method to growing wealth is utilizing the last real edge in investing: time spent in quality investments. Albert Einstein is widely credited with claiming compounding interest to be the most powerful force in the universe.
To see proof, look no further than Warren Buffett, the investing paragon widely recognized as the best investor in modern history.
He relies on compounding to build wealth year after year. Ideally, his investment horizon is forever. That takes conviction to stick with an investment that long.
While he is not always accurate with his stock selections, he wisely couples the force of compounding with three major investing criteria:
- Finding an exceptional business that can be competitive over time;
- Paying only a fair (or discounted) price for the investment; and
- Employing only quality managers who deliver sustainable, industry-leading returns.
Buffett succinctly states of investing, “All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies.” Sure, it sounds simple, but if it’s so easy, why doesn’t everyone do it?
Many try to replicate Buffett by using his value investing approach and only invest in durable businesses run by competent managers. Usually where folks go wrong is that second criterion or not having patience for an investment to perform over time. Staying in an investment requires true conviction, especially when the going gets rough.
However, if our aspiring hero held stock in a company which meets all three of Buffett’s investing requirements and he or she did not need the money, why should there be a sale?
In truth, if there isn’t a need for the money and the three requirements are still met, holding the investment is a much wiser decision. This is a hard but important step in learning how to build your wealth.
But Why Pick One When You Can Pick Them All?
That’s all well and good, but what if a person feels unsure of selecting the companies which might meet those criteria? When it comes to building wealth in a diversified manner, Buffett has an answer for that as well.
He suggests purchasing a low-cost S&P 500 exchange-traded fund (ETF) and reinvesting the dividends across time. In this scenario, the compounding interest super power still applies. To illustrate, the S&P 500 has averaged an annual total return of just over 11% per year every year from 1938 through 2017.
Imagine if you’re just learning how to build wealth in your 20s, this super power could take you far in reaching your financial independence destination.
To see how this looks with an initial investment of $10,000 at the beginning of 1938, see the chart below (chart assumes reinvestment of dividends, no effects from taxes, and no contributions or withdrawals).
The chart shows some fairly remarkable information. First, you’ll notice the scale on the left. It isn’t your typical linear scale with equal spacing between hashes. Instead, it is a logarithmic scale which shows increments increasing by a factor of 10.
If you produced the same S&P 500 chart using a typical linear scale, it would produce something very similar to the chart displaying Warren Buffett’s wealth across his lifetime. And even if you can’t manage to amass $10,000 from day one, don’t worry.
You can learn how to build wealth from nothing simply by sticking with small contributions and increasing them across time. The point is to hold these low-cost, diversified investments for long periods of time. The difficulty comes when you’re only learning how to build wealth in your 40’s and you’re behind the curve.
Next, I will point out that while past performance isn’t necessarily indicative of future results, if a 22-year old would have hypothetically invested $10,000 at the beginning of 1938, set his or her account to reinvest dividends (ignoring tax consequences), this person would have retired (typical 46-year career from age 22 to 68 in today’s economy) with over $2 million in assets. There’s some wealth creation using compounding returns as your super power.
Even better, imagine how much wealth this person would have created if he or she made regular contributions to this account or started even earlier (once again, look at Warren’s chart starting at age 14). Needless to say, this person would have done very little and been handsomely rewarded. This person’s wealth would have grown tremendously by doing nothing.
Another takeaway from the chart is seeing that not every year has been positive. In fact, there have been consecutive years during that time which have had significantly negative returns from one year to the next. However, over a sufficient amount of time, stock market returns have always been positive. Take a look at the chart below to demonstrate this effect.
Understanding this chart might not be easy at first but by studying it you should notice some telling results. First, you will see the time frame starts with a daily return for the S&P 500 and spans all the way to the performance over a 20-year time horizon.
You will also see that the returns are split into positive and negative returns. Over the 90-year period examined, on average, 54% of daily returns have been positive while 46% have been negative. This shows an average daily bias toward the upside but most importantly, you see that this skews even more in favor of positive returns as time invested increases.
While this does not provide an indication of magnitude, merely that a period which was book-ended by two of the worst economic environments in American history, the S&P 500 still witnessed positive returns.
Additionally, this data shows if someone invested at the absolute peak of the market, after 5 years, 86% of the time, the investor would still have experienced a positive return. The probability only increases as more time passes. This should give people comfort knowing that time and discipline really pay off.
How to Build Wealth at Any Age – Invest in ETFs
If you are interested in beginning your investing journey and have some money set aside to invest, I’d recommend using Vanguard and purchasing their low-cost S&P 500 ETF.
Because of Vanguard’s size, it has been able to reduce fees to negligible levels and offer more opportunity to directly mimic the performance of the market. Personally, my wife and I use the service to invest in Vanguard ETFs because the company does not charge transaction fees if you purchase their branded funds.
A more scaled up approach to invest in ETFs includes robo-advisors like Betterment, Wealthfront, and even another service from Vanguard. These robo-advisors use scientific research to optimize which ETFs you hold and automatically rebalance your holdings across time as you make contributions and withdrawals.
Also, robo-advisors offer tax-efficient investing strategies to minimize the amount of taxes you pay on realized gains if held outside of a tax-advantaged investment account. These services charge slightly more than a basic Vanguard ETF but practically manage themselves while keeping you diversified. I will discuss the major components of robo-advising in another post.
How to Build Wealth By Going from Zero to Hero
Armed with this information, hopefully you will see investing doesn’t need to be as scary as some might think. Held long enough, investments in market ETFs produce not only positive returns, but history has shown them to be sizeable.
Starting out with an initial investment in an S&P 500 ETF (or other preferred market index) is a great first step for going from zero to hero when it comes to learning how to build wealth from nothing.
About the Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey to reach a Millennial retirement and connect with and help others who share the same goal.
Some of my favorite things to discuss include investing in index funds, how to save money, travel hacking with help from the Reddit churning community, house hacking and optimizing the benefits of my condo vs. apartment living, and tax topics like the earned income tax credit, common tax deductions, tax reform in 2018, or other useful tax topics. I want this to be a journey for us all to learn how to make a lot of money and pursue the lives we want.
Please continue to watch the site for more to come and post below with your questions or comments.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see my the disclaimer on my About Young and the Invested page.