Six Steps to Build Wealth
Step 1: Emergency Savings Fund
Building a strong Emergency Savings Fund is the most important (and most neglected) step towards financial freedom. After reading this section, you will understand:
- Why you need an Emergency Savings Fund
- How much you personally should save
- Which savings account to use
You need an Emergency Savings Fund to have easy-to-access money, also known as money with ‘liquidity’.
Imagine for a moment that you have no money in a savings account, but suddenly find yourself unemployed and in need of cash. In a bind, you sell off stocks which not only takes 2-3 days to get the money, you also lose money from fees / selling at the bottom of the market. Or maybe you are forced to take out a loan against your own home (Home Equity Line of Credit). Even worse, you may not have either option, and are forced to put large expenses on a credit card and risk slipping into debt.
This is why before you begin investing your money into the stock market, you need to ensure you have a rock-solid amount of cash to defend against life’s problems. Your Emergency Savings Fund will also give you the confidence to invest, knowing you are prepared for the worst.
The textbook answer to how much money you should have in your Emergency Savings Fund is 3-6 months of expenses, which brings up two natural questions.
- How much money on average do you spend in a month?
- Should you hold more money (6 months expenses), less money (3 months expenses), or somewhere in the middle?
- Your risk tolerance
- Job Security
- Number of dependants
In order to illustrate the above considerations, we will bring in two friends James, and Mary.
James is a 23 year old Accountant recently out of college. He is single, living by himself. Top priority is aggressive retirement investing.
- Job security: Fortune 500 company, plays important role, paychecks every two weeks.
- Health: No health issues, active, healthy diet.
- Dependants: Zero.
- Monthly expenses: $2,500
James should aim towards the lower end of the savings spectrum since he has a steady flow of income, no dependents, is in good health, and is eager to invest more in the stock market.
James should set a goal of $7,500 for his Emergency Savings Fund.
Mary is 35 year Real Estate Agent. She is married with two daughters, and her husband does not work. Top priority is family security.
- Job security: Large, sporadic paychecks due to volatile nature of an entirely commission based job.
- Health: Chronic health issues.
- Dependants: Three.
- Monthly expenses: $4,500
Mary should aim towards the higher end of the savings spectrum since her paychecks are volatile, has a family to take care of, isn’t in the best health, and is most concerned with avoiding financial troubles.
Mary should set a goal of $27,000 for her Emergency Savings Fund.
When it comes to what vehicle to use for your savings, you have three main options:
- Savings account
- High-yield savings account (HYSA)
- Certificate of deposit (CD)
HYSA: A High-yield savings account functions identically to a savings account, but with 12x the national average savings rate. You can find my personal recommendations here.
- Pros: High interest rate, liquid
- Cons: 2-3 day wait if you use a different bank for checking
SAVINGS ACCOUNT: A savings account is similar to a checkings account, with a slightly higher interest rate, and slight restrictions on withdrawals.
- Pros: Liquid, Easy to use if same bank as checkings
- Cons: Not as much interest as the HYSA
CD: A Certificate of deposit is where you agree to lend the bank your money for a period of time, (6 months, 1 year, etc.)
- Pros: Occasionally higher rates than HYSA
- Cons: Not liquid, HYSA can still beat interest rates
Now it should be clear as to why the HYSA is superior. The savings account may be an alternative if you are willing to trade significantly better interest rates for the convenience of inter-bank transfers, but the CD should really only be used for short term savings where you know when you will need the money (Down payments on house, weddings, etc.)
Step 2: Company 401(k)
The Company 401k Match is hands down, the best investment you will ever make. Once you are satisfied with your Emergency Savings Fund, it is time to reap the rewards of the closest thing to free money out there.
A ‘401k Match’ happens when your employer promises to match either a portion, or the full amount of the money you invest in your 401k, up to a certain (%) of your paycheck.
For example, let’s use two different people, Zack and Jake. Both make $4,000 a month, and each has a different employer with a different 401k match program.
Zack: Zack’s employer offers a 100% match up to the first 4% of his paycheck he contributes. That means if he invests just the minimum to get the match (4%), that $160 will leave his monthly paycheck, but $320 will be invested on his behalf. Just one year of this, and he will have gotten over $1,920 in ‘free’ money invested on his behalf!
Jake: Jake’s employer offers a 80% match up to the first 6% of his paycheck he contributes. That means if he invests just the minimum to get the full advantage of the match (6%), that $240 will leave his monthly paycheck, but $432 will be invested on his behalf. Just one year of this, and he will have gotten over $2,304 in ‘free’ money invested on his behalf!
While the ‘match’ portion of the 401k match is the best part, there is an added benefit of these funds being tax-advantaged, due to the 401k’s status as a retirement account. This means you also avoid paying capital gains tax on these funds, which leads to lots of extra money down the road.
Unlike an individual brokerage account where you decide which Stocks/Exchange-Traded-Funds (ETFs) you want to invest in, your employer will have a select amount of different funds to choose from.
When deciding which option is best for you, you want to look for three things:
- Low Expense Ratios
- Index Funds
Expense Ratios: Different funds have different expense ratios, which are fees you have to pay the middle man. When comparing stock options, you generally want to find the option with the lowest expense ratio possible, as this means more of your money will go towards the stocks, and not paying the bank.
Index Funds: An index fund simply means a group of stocks bundled together. We want to look for index funds (also known as ‘mutual funds’ or ‘ETFs’) that match the entire US market. These often have similar performance to well known indices such as the Standard & Poor’s 500 index (S&P500).
Target-Date-Funds: These are funds that will automatically rebalance your assets to optimize your risk and returns as you get closer to retirement. These can be good or bad, based on how much you value have direct control over your investments. If you want to rebalance your stock / bond ratio on your own, you should avoid these funds and select low cost, total index funds of your choice. However, if you are a “set it and forget it” type person, targeted-date-funds are the perfect option for you.
At the end of the day, even if your employer doesn’t offer the greatest fund choices with the lowest expense ratios, it is always in your best interest to contribute as much needed to achieve the full match.
There are two important things to consider before leaving your current employer.
- Whether you are vested or not
- Whether you should roll over your 401k to your next employer, or keep it with your old employer
Certain companies will require that you be ‘vested’ with them, meaning you will lose the portion that the employer matched unless you stay with the company for a certain number of years. While other companies will consider you vested immediately with no waiting period. The consideration here is if your company requires a certain amount of time to become vested, and you are near that point, it is often best if you can stay with that employer till vested before jumping ship.
Another consideration is whether to ‘roll’ your 401k over to the new employer, or keep it with the previous employer. While you will no longer have the option to contribute to your old employers’ 401k plan, the money will continue to grow even after you leave the company. Deciding which 401k plan is better is determined by seeing which one offers total stock market index funds, with lower expense ratios. If your new employer offers funds with lower expense ratios, you can choose to ‘roll’ the money from your previous 401k into the new one.
Step 3: Pay Off Debt
Paying off debt will not only help you financially, but it will eliminate a lot of mental anguish. Now that you’ve began taking advantage of your 401k match, it’s time to tackle high interest payments.
When paying off debt, there are two different methods:
- Snowball Method
- Avalanche Method
Snowball Method: With the snowball method, you begin with the smallest balances first, to the largest, with no regard to interest rates. While many people cast this method to the side since it is mathematically flawed, (you will pay more interest over time), there are two key advantages it brings to the table.
- The small, frequent victories are very encouraging, and can often help people who struggle with debt crawl out of it.
- The overall minimum payments will also decrease, meaning it can be great for lowering the load, especially if a person’s income is not the most reliable.
Avalanche Method: With the avalanche method, you will begin with the highest interest rates, and work towards the lowest interest rate. The obvious advantage is that
- Save the most money over time, as you pay the least amount of total interest
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Certain debts have such a low interest amount, that it is best to pay the minimum payment on your loan, and invest the difference in the stock market.
As an extreme example, let’s say you have a car loan with a (1.1%) interest rate, and that the stock market is returning (7.0%) interest rate on average. After you make your initial minimum payment on your car loan, you have extra money lying around, and now have a choice between putting more money towards paying off your car loan, or skipping to step 4 to begin investing in your Roth IRA.
With an interest rate as low as (1.1%), it is better to begin investing in the stock market, since the benefit of earning (7%) interest back far exceeds the (1.1%) interest you would avoid paying on the car loan. This naturally begs the question, “What interest rates for loans should I pay down aggressively, and which should I stick with just minimum payments?”.
If I were forced to give you an answer, I would say aggressively pay off interest rates above (5%), and pay the minimum payments on loans with interest rates lower than (5%). However, remember that personal finance is personal. If you find that having debt stresses you out, it can often times be worthwhile to forget the math, and aggressively pay off loans before investing even if they are as low as (3%) or (4%). You will have to determine within yourself what level of debt you are comfortable with holding.
If you are deep into credit card debt, an option you can look into is 0% balance transfer credit cards.
Let’s say that you have a credit card with a $4,000 balance, with a (24%) interest rate. You can transfer that $4,000 balance to a new credit card that has an introductory rate of (0%) interest rate, to essentially stall those interest rates. This can be an easy way to stall those high interest payments while you work on paying down debt with the snowball / avalanche method!
Step 4: Roth IRA
A Roth IRA is the best place to invest in stocks. It has special tax-advantages, along with greater flexibility than your Company 401k!
When considering which mutual funds / ETFs you should buy, we will follow a similar methodology that we used when deciding between fund options for our Company 401k.
When picking the perfect stocks/ETFs, we are hunting for:
- Low Expense Ratios
- Total Index Funds
Expense Ratios: Remember that different funds have different expense ratios, which are fees you have to pay the middle man. When comparing stock options, we want to find the option with the lowest expense ratio possible, as this means more of your money will go towards the stocks, and not paying the bank.
Total Index Fund: An index fund simply means a group of stocks bundled together. We want to look for index funds (also known as ‘mutual funds’ or ‘ETFs’) that match the entire US market. These often have similar performance to well known indices such as the Standard & Poor’s 500 index (S&P500).
With these two principles in mind, we will now aim to setup a simple three-fund portfolio, developed by “Bogleheads”.
We will want our Roth IRA to consist entirely of:
- US Domestic Stock
- International Stock
As far as what % we wish to hold in each category, we generally want to hold a majority of US Domestic stock, increase our bond holdings as we age, and have a small portion of the fund (10-15%) be an international fund to add diversification. This means that the allocation split between the three funds depends largely on your age, for instance:
22-year old asset allocation:
- 85% Domestic Stock
- 15% International Stock
- 0% Bonds
40-year old asset allocation:
- 60% Domestic Stock
- 10% International Stock
- 30% Bonds
These are by no means the only options, but rather a general framework as an example! Ultimately, you will have to decide which split you want for your three-fund portfolio.
The best brokerage to use are ones that offer low cost, total index funds. Today, there are three brokerages that dominate when it come to offering strong, affordable investments for the masses.
Fidelity: Fidelity is best known for their zero-expense ratio funds. Yup, you heard that right! They revolutionized the investment frontier by offering consumers a way to invest in mutual funds with no transaction costs.
Vanguard: Vanguard’s strength is built upon the companies principles. The company was the first bank to ever offer investors the option of a low cost total index fund, and it is for that reason that they have their well deserved cult following.
Charles Schwab: Another great option (and the bank I personally use for my Roth IRA & brokerages accounts) is Charles Schwab. They offer low cost index funds (0.03%) that are competitive with Vanguard & Fidelity, as well as offering amazing customer service that I can attest to.
The bottom line is that if you go with one of the brokerage’s above, you simply cannot go wrong. If you are having trouble deciding between which brokerage is best, you can help guide your decision by looking at their individual dashboards for which one you like the look of best, or by using the broker that your company 401k uses (if they use fidelity, Vanguard, or Charles Schwab) in order to have the convenience of having both retirement vehicles in one place.
Step 5: Company 401(k)
This is where I will write about why you should keep investing in your company 401k.
In step 2, we were investing just enough money to take full advantage of any possible 401k matches our employer would offer us. This ensures that we get every last free dollar we can.
However, even the money we contribute into our 401k that is not matched is a great investment.
Since Roth IRA’s and Employer 401k’s are both retirement accounts they both enjoy the distinct advantage of avoiding capital gains tax. Therefore, after you max out your $6,000 annual contribution limit for the Roth IRA, you should set your sights towards maxing out the $19,500 annual contribution limit of an Employer 401k.
We choose to fund our Roth IRA before contributing beyond the 401k Employer match for two main reasons:
- Roth IRA flexibility: Unlike Employer 401k’s, the Roth IRA allows you to withdraw money with no added fees on principle you contributed 5 years prior. While I would NEVER recommend withdrawing from retirement accounts, it is always better to at least have the option.
- Roth IRA control: Since you can choose to trade any Stocks/ETFs/Mutual funds you desire inside your Roth IRA, you can almost always invest in funds that have lower expense ratios than what your employer can offer, therefore making you more money.
While it may seem like we are talking smack on investing in Employer 401ks, keep in mind that they are FAR better investments than non-tax advantaged brokerage accounts.
Step 6: Push Your Limits
First off, congratulate yourself. If you have made it to step 6, that means you have accomplished what few Americans are able to do. If you still have expendable income you wish to invest, you have three main options:
- Normal brokerage accounts
- Real estate
- Alternative investments
This is by far the easiest, and most passive of any option. You simply continue investing into low-cost index funds with the same brokerage you use for your Roth IRA. While you will have to pay capital gains tax, you will continue to reap the rewards of the stock market.
Pros: zero effort, easy to access money if need be.
Cons: May not generate the highest rate of return.
Many individuals have made their fortune’s through Real Estate. While it is riskier, and much more hands on, it has the potential to make huge rates of return.
Pros: Leveraged, Diversified (if owned along with stocks), and potential for high returns.
Cons: Leveraged, More hands on, and potential to lose money.
*You will notice we put ‘leveraged’ as both a pro and a con. This is because when we use leverage, (using money that is not yours), we will either make large returns, or be left with a significant debt.
What do we mean by ‘Alternative Investments’?
It’s my fancy way of saying, invest in whatever the hell you want.
Whether you want to start your own business, dabble in angle investing, or explore things like crypto, the world is your oyster.
Typically, this third route will have the largest amount of risk/reward ratio. While Stocks & Real Estate both stand the test of time, taking a risk on “the next best thing” can leave you with loads of wealth, or nothing to show for it.
Proceed with caution!