Invest With a New Frame of Mind

I mean two things by this: First, when I use the word “invest” in this instance, I don’t mean just putting money into a savings account or the stock market. You should treat every decision you make in your life as an investment decision. For example, when you’re deciding whether or not to go out to dinner tonight, whether or not to add the GPS satellite system to your new car order, whether or not to go on that clothes shopping spree, or something as simple as paying $20 each month for HBO: look at each decision as an investment. It’s fine to spend your money, but you’d be surprised how much you can accumulate if you start investing with a new frame of mind.

Second, and most important, invest with a new frame of mind. Look at the money you invest with a new frame of mind. Instead of feeling like you’re putting away $100 this month when you could be buying a new DVD player, think of it this way: That $100 you just invested will pay you dividends for the rest of your life. That’s right, at a 10% return rate, you will receive $10 per year FOREVER from that investment. Moreover, if you leave the investment return in the same account, that $10 per year will grow each year. That means that if you invested $100 a month for 10 months, that your investment would return that same $100 every year.

Use this state of mind constantly and think of each investment you make. Instead of spending an extra $5,000 to upgrade your new car purchase to the sport package, you could invest that money and earn over $500 per year. In ten years when you sell your car, that $5,000 will be worth closer to $13,000 (with compounded interest at 10%) and you will be earning about $1,300 per year (or over $100 per month).

Save money

The smartest words ever said by anyone: “A penny saved is a penny earned.” Start small. Don’t give up. Don’t dip into your savings unless it’s an emergency. Every little bit helps. Did you know that if you saved $1 per day and invested it at 10%, you’d have almost $200,000 in 40 years? Every little bit counts and it is very important that you take this financial advice, get out of debt and save money - and start saving it now!

You can save money in many different ways. For example, using coupons at a grocery store or buying things on sale that you’d buy regardless of whether or not it was on sale save you money. You can also save money by foregoing spending until a future date or by foregoing spending on non-essential items. For some people, self-control is a real issue and if the money isn’t “accounted for” immediately, they tend to spend it on impulse and luxury items that are non-essential. If you find yourself in this category, or have trouble saving, you should create an investment account that is automatically funded each month. To do this, you may need to create a monthly budget to determine a monthly savings goal. If you do create a budget, make sure that it is realistic, matches your lifestyle and that it leaves plenty of room for miscellaneous expenses that seem to pop up regularly. If you create an unrealistic budget you’ll likely save less than what your budget calls for, become frustrated and resort to your old ways.

Take Appropriate Financial Risks

If you want to build wealth you need to take risks. The higher level of risk that you take, the higher your return should be. With that said, only take the risks that are appropriate to you! For example: You have the choice of investing in a savings account, a money market account, a certificate of deposit (CD), a bond fund, a large cap stock fund and an aggressive mutual fund (mostly tech stocks). Each investment has a different level of risk and each investment makes sense for different people. Typically, the higher level of risk that you take, the higher your potential investment return. The right investment for you depends on many things, but the two most important factors are 1) your realistic time horizon, and 2) your aversion to risk. Regarding time horizon, if you have 40 years to retirement, you should invest your money in the highest risk, highest yielding sectors (maybe 70% stocks, 15% bonds and 15% money markets). But if you are close to retirement or can't afford to risk your investments, the majority of your investments should be allocated toward the low-risk investments such as savings accounts, money market accounts, CDs and maybe even a bond fund. Regarding risk aversion, you must make this decision yourself. If you have trouble sleeping at night because you're investing in stocks, you should probably sway toward the lower risk investments.

The major takeaway from this section is that it is important to take risks. The more risk you take the more you can expect to earn and accumulate over the long-term. However, be conscious of yourself and your goals and do not take more risk than your time horizon or your own personality will allow.

the Compounding Effect of Money

The compounding effect of money is extremely important when making any financial decision. The compounding effect of money is often overlooked or underestimated by people when making decisions. When applied to all of your financial decisions, this effect is the KEY to long-term success! To illustrate the compounding effect of money, let me use some financial examples:

Suppose you had invested $1,000 today in a 5% savings account. In one year, that account would be worth $1,050 [$1,000 + ($1,000 x 5%)], yielding a $50 gain. However, in year two, that same initial investment would be worth $1,102.50 [$1,000 + ($1,000 x 5%) + ($1,050 x 5%)], yielding a $52.50 gain. And in year three, the same $1,000 would be worth $1,157.63, yielding a $55.13 gain. By year ten, the initial $1,000 investment would be worth $1,629 and by year 25 it would be worth $3,386.

From looking at this example, you can see that investing $1,000 today is much more valuable than investing $1,000 even a couple of years from now. To accumulate wealth, you MUST use the time value of money and the compounding effect of money to your advantage.

This second example shows how the compounding effect can work against you:

Suppose you borrowed $20,000 to purchase a car and your auto loan was at a 10% interest rate (for 5 years). Your monthly payments would be $424.94. Because the $20,000 loan continues to compound over the life of the loan, you actually pay $25,496.45 over the five-year period, meaning that you’ve in essence paid $5,496.45 because you spent the money before you had it. In fact, in your initial payments, the interest alone will account for almost 40% of your monthly payments. In this case, the bank or lender that gave you the loan uses the time value of money to their advantage.

Now look at this scenario, where instead of making the $424.94 car payment, you invest that payment at the same rate as what your car loan was (granted it’s a little high for a savings rate, but not unreasonable for other investments). Now, instead of paying the bank, you are actually earning interest and compounding the benefit yourself. After one year you will have saved $5,340 and have earned $240 in interest. After two years, you will have saved $11,239 and have earned $1,039 in interest. By the third year, your investments will be worth almost $18,000 and you will have earned $2,457 in interest. By month 40, you will have enough money to purchase a $20,000 car in cash!

So let’s weigh the differences between the two scenarios above. In the first case you paid the bank $5,496 to borrow the money and in the second case you earned $2,457 and could buy the car in cash after just 40 months (just over 3 years)! The opportunity cost of the first alternative versus the second alternative results in a net difference of $7,953 (a $2,457 gain versus a $5,496 loss). That means that by making a simple deferral decision (buying the car in 3 years versus today), you can get ahead by almost $8,000!

Time value of money

The most basic law in finance! The time value of money states that a dollar today is worth more than a dollar at some time in the future. Okay, it’s not that simple to understand at first glance so let me delve into this advice a little with some financial examples:

If I invest $1,000 in a 5% savings account today, it will be worth $1,050 in one year. Therefore, if I can have $1,000 today or choose to have $1,000 one year from now, it is always better to have the money now. By saving and investing today, you make the time value of money work for you.

Let’s look at the reverse of this, to see how the time value of money can work against you. Suppose instead of receiving $1,000 that you spent $1,000 by purchasing merchandise on your credit card. Remember that a dollar today is worth more than a dollar tomorrow, so in this case, you will have lost money because you will need to pay off your credit card account with money from the future (which is worth less than money today). In addition to having to pay with future money, you will also have to pay interest expense. So, in this case, if you paid off the credit card in one year (assuming 15% interest), you’d have to pay $1,150.

You should think about the time value of money before making any decisions. Another, maybe even more important concept related to the time value of money is the compounding effect of money.

Oportunity cost

Opportunity cost is defined as the cost of pursuing one alternative versus another. For example, if you were going to spend $500 on a new bike, the opportunity cost would be that you would not be able to buy anything else with or invest that $500. For the purposes of financial planning, you should look at the cost versus the benefit of each decision you make. In this case, you could spend $500 on the bike or you could invest the same $500 in a savings account. In five years, the bike will be worth $25 and the $500 investment will be worth $650 (including interest). The opportunity cost of buying a bike is the long-term benefit that you will receive if you did not buy the bike and invested it. Technically, the opportunity cost is not limited to the cost of investing the money, but also includes any other opportunity you could spend the money on (investing, buying something else, saving the money, etc). By carefully evaluating your alternatives and by weighing the opportunity cost of each decision, you can vastly increase your long-term wealth.

First rule: don't spend everything you earn

The most important way to generate wealth is to live within or below your means. For example, if you make $30,000 a year, then live like you make $25,000 a year and save, pay down debt, or invest the remaining $5,000. So many of my friends that have incomes over $50,000, $75,000 and even $150,000 have spent everything they’ve earned and have almost nothing to show for it. Don’t try to compete with your friends or neighbors, don’t spend money fruitlessly, and most importantly, don’t spend more than you make. Many people read this and think, “I’d love to spend less money but I can’t, I have to pay my car payment, the credit card bills, groceries, I need a vacation, I need new clothes for work, etc, etc.” Most of these expenses could be avoided or deferred (like a vacation, a car purchase or buying clothes). The other expenses (like your credit card expenses or mortgage) could likely have been avoided if you had lived within your means when you created the expense. For example, your car payment would be less if you’d opted for the used versus new car, or your credit card expenses would be lower if you hadn’t bought that new computer or those 5 pairs of shoes. Even your mortgage or rent could be less if you chose a different location to live. With that said, there is a fine line between spending appropriately and spending above your means. Just remember that it is always better to forego purchases until you can pay for them in cash rather than to borrow from the future to meet your needs now. The most common exception to this rule is buying a house. Although it will raise your cash expenses dramatically, it is often wise because 1) it’s an investment which will add to your future net worth, 2) the interest is tax deductible which effectively lowers your income tax liability, 3) your mortgage payments will add to your net worth as you pay down the principal on the loan, and 4) you were probably paying rent anyway so it will in effect turn your rent payment into an investment.