I have written about wealth and what it truly means to be wealthy. This article is going to focus on the money side of wealth, but remember that true wealth is not just about having enough money. Actual wealth is also about your health and relationships. Without good health and sincere relationships, it makes it more difficult to ever feel wealthy.
Why does someone want to be wealthy? Do they just want to brag about having a $5,000,000 net worth? Or do they want the freedom and security to do more of what they love?
If people dig deeper, most people want to be wealthy because of the latter - freedom of time and to feel safe/secure.
Back To The Title - Here Is One Proven Way To Become Wealthy
I will not hide the ball any further. As long as history repeats itself, here is the proven way to become financially wealthy:
Give compound interest enough time to work its magic.
Is it really that simple? Yes.
Then, why doesn't everyone become wealthy? That's where it gets complicated.
I am going to start by explaining what compound interest is and how powerful it is in the real world. Then, I will go into this second question about why everyone doesn't take advantage of it.
What Is Compound Interest?
Technically speaking, compound interest is when your interest earned starts earning you additional interest. Then, you allow this process to keep repeating itself again and again.
In layman's terms, compound interest is when you make money from investments. And, instead of taking that money and putting it into your bank account, you use those earnings to make more money.
How Compound Interest Works In The Real World
Historically, the S&P 500 has returned an interest rate of over 10% annually. This is over a long-term perspective.
Over the short term, the stock market is volatile and may be down one year then up over the next two years. However, if history repeats itself, investing monthly over 10+ years will return you around the 10% mark (or 7% if you want to account for average inflation rate, which I like to do).
Here is one example and a chart for you visual learners.
Let's assume Joe starts working when he turns 18 years old. Joe does not have a high paying job, but he understands the power of compound interest and needing to take advantage of it early.
He earns $45,000 a year starting out at his new job. His salary is low, so he is not able to invest what I recommend of 25% of his income. But, he doesn't let this stop him.
He calculates that he is able to invest 6.5% of his income into a Roth IRA, which comes out to $245.34 a month. This is a low enough amount that it hardly affects his day-to-day life, and he is still able to enjoy his life in the present. He puts all his Roth IRA dollars into a low-cost index fund that follows the S&P 500.
Side note - Theoretically, Joe would be able to up this dollar amount as he gets pay raises. But, for illustration purposes, let's assume he never increases the $245.34 monthly investment.
Let's jump forward to retirement for Joe. At 65 years old, Joe decides that he wants to step away from the traditional 9-5 job. He has side projects that he enjoys doing, and he wants to spend more time doing those things and spending time with his loved ones.
Will Joe be able to retire and still continue his lifestyle?
... Yes!
As you can see from this chart, Joe has invested $138,374.49 over his working career. That might sound like a big number, but spread out over his 47 year working career, that is a small amount of his salary that he had to use.
Using a 7% return rate to account for inflation (this keeps the final value in today's figures), his money invested earned him $861,625.51 in interest alone!
So, at age 65, Joe has roughly $1,000,000 sitting in his Roth IRA. Remind you, all money in a Roth IRA is tax-free. So, if Joe uses the 4% withdrawal rule during retirement, he will have $40,000 tax-free every year until death.
Since he had to pay taxes on his $45,000 salary during his working career, he will actually get a pay raise during retirement!
Here is another fun example.
Phil graduates college at 23 years old and lands a decent paying job making $60,000 a year. He is fortunate enough to be able to invest 25% of his gross income monthly from the beginning.
He invests $1,000 a month into his company's 401(k) and $250 a month into a regular brokerage account as a bridge account to access if he chooses to retire early. Both accounts are invested into the same low-cost index fund that Joe used above.
After making his monthly investments, he lives off the rest of his income.
Let's fast forward to Phil's 55th birthday. He has become burned out with work. He is open to coming back into the workforce, but wants to retire from his current job.
Will Phil be able to retire and keep his current lifestyle?
... Sure will!
Using the same assumptions above (7% annual interest rate to account for inflation), Phil will have $1,372,248.77 in his 401(k) that he will be able to access at 59 1/2 years old and $343,062.19 in his taxable brokerage account.
So, at 55 years old, if Phil chooses to withdraw just 3.5% from his retirement accounts annually using the same perimeters in the 4% withdraw rule, his annual income would be $60,035.88. Technically, he would be able to quit his job at 55 years old and receive a pay increase.
Okay, Cool. But, I Am Almost 60 With Little Money Invested!?! Am I Screwed?
The great thing about compound interest is that you are allowed to play with the numbers as much as you like.
Yes, if you start later in life, savings rate is going to matter the most. In other words, you'll have to deprive yourself a little more in the present to reach your goal.
But, if you are 10+ years from retirement, you can make some serious strides towards bettering your life after retirement.
Let's say Sam started investing at 55 years old with no savings at all. He realizes that he is late to the game, so he invests 35% of his $80,000 salary monthly into a low-cost index fund.
After 15 years, assuming a 5% annual return on his investments (the shorter the time-horizon, the smaller assumptions a person should use), he now has over $620,000 to supplement his social security. And, $200,412 was earned through interest alone.
So, because Sam made the decision to start investing at 55 years old instead of just relying on social security, he will have an additional $2,066 a month during his retirement years. Not shabby at all for starting late in the game.
Why Isn't Everyone Financially Wealthy?
I explored this topic back in April of 2023.
What it boils down to is this - how to build wealth is simple, actually building that wealth is very difficult.
In all the above scenarios, everything worked out as planned for Joe, Phil, and Sam. There were not any life circumstances that derailed their monthly investments.
In the real world, there are PLENTY of reasons to skip just one month of investing. Some of these reasons are legit and outside of our control. However, there are other reasons that are sensationalized in our heads and are primarily caused by our poor spending habits.
If a person claims they do not have enough money to invest but cannot tell you how much money they earn and/or what their monthly spending rate is, they need to reevaluate their finances. I suggest that everyone should at least do a one-time budget plan.
In summary, take advantage of compound interest as early as possible. Even investing $25 a month is a great start to building that investing habit. Time is a person's biggest advantage to building wealth so do not wait until tomorrow.
Also, don't use the excuse that you are too old to invest. If you do not know where to start, here is one place for ya!
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