Wednesday, November 28, 2007

3 steps to achieve financial success

I believe that most Americans can achieve financial success. I am living proof that it's possible. Granted, I have a well paying job, but I don't make an obscene income. Besides, I know plenty of people in my income range that have little to show for their years of working. And I think that even if my income was more modest, I would still be well on my way to financial independence; I just wouldn't have accumulated as much.

Here are the three steps that I feel are necessary to achieve financial success:

1. Live below your means. I realized that to make money, I needed capital, and to generate it I had two options: reduce my expenses or increase my income. I increased my income by gaining valuable work skills and hopping jobs, but that may not always be possible depending on the stage of your career. I also kept my overhead low, and that is something that everyone can do.

For one thing, I never tried to keep up with the Joneses. I knew from reading "The Millionaire Next Door" that self-made millionaires lead pretty modest lives, and people who flaunt extravagant lifestyles are financing those lifestyles at enormous opportunity cost. I kept my focus on becoming debt free and saving for early retirement.

I differentiated my needs from my wants, and carefully evaluated each expense that fell into the "wants" category. If it didn't match my priorities, then I opted to forgo it or found cheaper alternatives. That meant no luxuries like designer clothing, Starbucks, BMWs, concerts, etc., but I really didn't care about those things anyway. That doesn't mean I always deprived myself, I just made sure that any money spent on non-necessities was used to buy things that brought real, lasting happiness. I bargain shopped to find the best deals, and I made sure that I could pay off the credit card bills when they arrived. I also understood the eroding effect of taxes on my money: the combined impact of income tax and sales tax meant that only about half of every dollar I earned was available for me to use, so I spent them very sparingly.

2. Save. I knew my ability to work was finite, and I wanted to have the option of not having to work as soon as possible, so I treated my earnings like lottery winnings. I socked away the max into my 401(k) plan immediately upon starting my first job, and continued to do so as I changed jobs (and never cashed out). I figured I wouldn't miss 15% of my salary, and even if I did I could always scale it back. I survived just fine though, and because I kept my expenses low, I was able to save a significant portion of my take home pay and use it to pay off my first house early. I also started a ROTH IRA as soon as I was eligible, and maxed it out every year.

3. Invest.I learned about the amazing power of compounding, and the risk of inflation. Because I started early and had a long time horizon, I was able to invest aggressively. So far it has worked out pretty well for me.

There you have it, the three key steps to building wealth. These aren't new ideas, and it takes time and patience to see the results, but as someone who has done it I can confirm that they will work for you--unlike most get rich quick schemes. I think the most difficult part is the first step, where you have to make the paradigm shift from instant gratification to delayed gratification. Think of robbing your future self when you spend your money in the present, and perhaps that will help you resist the temptation to buy stuff you don't really need.

So if you want to do something to get started on the road to wealth, here is a simple action you can take now: log into your employer's 401(k) plan, and bump up your contribution amount. Remember, if you find that you can't live without the reduction in take home pay, you can always change it back, but I'm betting that you'll learn to live without it, and you'll be thanking yourself later.

1 comment:

carr_likean said...

Good post. It is difficult to improve on those steps as a general formula for achieving financial success. I never did have a problem avoiding extravagance and so, living within(though not necessarily below) my means. My greatest regret, however, is that I did not seriously start thinking about steps 2 and 3 until I was 30 and had already been working for 6 years. It would have made a world of difference had I started earlier. Oh well, it's better late than never.