The Three Best Rules for Building Wealth

These three rules trump all others.

  1. Spend less than you earn.
  2. Buy low, sell high.
  3. Watch every penny.

That’s it. You’re probably thinking: That’s it? They seem so trite. But follow these rules religiously, and you’ll almost certainly end up wealthier. At the very least, you’ll have more peace of mind. You’ll take control of your financial future, instead of bobbing about blindly on the capricious seas of fate.

Over the years, I’ve tried to flesh the rules out. See what you think.

1. Spend Less Than You Earn

Limit spending

This rule is the most important of them all. If you follow it and no other, you have a better than even shot at living comfortably, because the only way to get rich is to save and the best way to save is to limit spending. Yes, maximizing income helps, but you have more control of your spending than you do of your income. Non-rich people who manage to retire at age 50 or younger report having saved half or more of their income for several years. They made that money work for them by investing it and watching it grow dramatically over time, through the amazing power of compound interest. Aggressive savers bite the bullet. They control their appetites. They wean themselves from luxuries today, in order to enjoy luxuries and peace of mind later. They avoid impulse purchases. They wait till things are on sale. In short, they live like Scots so they can retire like lairds (and retire as early as possible). They listen to Jefferson: ‘Never spend money before you’ve earned it.’ And: ‘Never buy what you don’t want because it is cheap.’ To these rules, I would add: 1) Pay cash instead of credit: it’s harder to part with cash. (But yes, carry a credit card for emergencies.) 2) Don’t buy too much house or too much car. 3) Buy a reliable car, take good care of it, and drive it into the ground (more succinctly: drive a piece of crap). (And when you replace it, buy used, not new, and pay the whole price up front in cash.) 4) Dare to haggle. Ask your doctor’s office if they’ll give you a discount for cash. (Many will.) 5) Minimize taxes. Take every available credit and deduction. Err on the side of too little income-tax withholding: a big refund is a temptation to splurge. 6) Buy insurance (auto, home, life) to protect your assets, but be frugal about it. Don’t over-insure. ‘Buy term and invest the rest.’ Review your policies annually, prune needless coverage, ask about discounts.

This last rule is a key part of the the so-called ‘financial independence and early retirement’ or FIRE strategy that many people use to achieve their goal. Here’s a good summary of the FIRE strategy, and here’s a response to some concerns and misconceptions about it. /1

Maximize income

Within reason. Don’t make yourself, or your loved ones, miserable.

Borrow the minimum

Your biggest asset is zero debt. Avoid debt like the plague, because it is. Never borrow to pay for luxuries—or necessities. Of course, sometimes borrowing is unavoidable. But keep it to a minimum. Minimize the loan amount. Minimize the interest rate. Minimize the repayment term. Also, it’s a good idea to keep your borrowing costs down by maintaining a good credit rating. How do you do that? Never miss a payment, pay off your credit card bill every month without fail, and don’t open too many financial accounts in a short period of time, and never close an account if you can avoid it (account longevity boosts your score). Here’s an informative article about how wealth-minded people manage and improve their credit.

Pay off debt

Your biggest asset is zero debt. Pay off high-interest debt first. Pay down principal ahead of schedule, if there’s no penalty for doing so. Pay off your home mortgage as soon as you can (another reason not to buy too much house). But note: when investing can produce a better return than debt repayment, prefer investing. For example, if the interest rate on your debt is 3 percent, but investing can reasonably be expected to pay you 6 percent, then investing is the wiser use of funds.

Keep a cushion

Maintain an emergency fund equal to six months’ worth of basic living expenses. Keep it in a liquid, easy-to-access vehicle like a savings account, brokerage account, or certificate of deposit (CD), as opposed to a harder-to-access account like an IRA. But remember, the returns on such accounts are fully taxable (and these days, meager). So don’t keep more than the recommended six months’ worth of expenses in these kinds of savings vehicles.

Save wisely (and avoid needless taxes)

Invest any savings above and beyond your emergency fund in a Roth IRA or workplace Roth 401(k). You can also keep money in a tax-deferred retirement account such as a traditional IRA or 401(k). But prefer the Roth variants, subject to the considerations below. /2

Set a specific savings goal

One of the most important things you can do is to set a specific savings goal, a specific dollar amount that you will need to have set aside in income-generating assets, in order to be able to quit working and live off those investments. Start from how much you think you’ll need to live on, then determine how much you’ll need to invest to generate that amount, assuming certain rates of return and inflation. The following rules of thumb can help you do this:

The Financial Freedom Formula. Multiply your age times your net worth, then divide by your yearly expenses. When the resulting figure is above 1,000, it’s safe to quit your job.

The Multiply by 25 Rule. You can retire safely when you have 25 times your annual expenses invested in income-generating assets. For example, if you will need $40,000 to live on annually, then you will need $1 million in savings to be confident you can make withdrawals without outliving your savings. If you will need $50,000 to live on, then you will need $1.25 million in savings. And so on.

The Four-Percent Rule. You can safely retire when your income-generating assets are sufficiently large that you can live comfortably by withdrawing up to 4 percent of them each year without reducing principal.

Obviously, each of these rules assumes certain rates of return and inflation. For example, the four-percent rule assumes a 7-percent annual return on stocks, minus 3 percent a year from inflation. Those are reasonable figures, and most people use them, but you should keep an eye on reality and adjust as needed.

2. Buy Low, Sell High

Put your money to work

It’s better to make your money work for you, than to work for your money. As a general rule, try to put every penny you can (beyond your six-month emergency fund) into appreciating assets and income-generating investments.

Protect your seed corn

Never eat your seed corn unless you are literally starving. Avoid dipping into your income-generating investments, and never reduce the principal, except when absolutely necessary.

Invest early and often

If possible, participate in all of the following kinds of investments, and contribute to each of your accounts the maximum the law allows, every year. These are listed in order, from most valuable to least. /3

1) Your employer’s defined-benefit pension plan. Be sure to study the vesting rules. ‘Vesting’ means that you’ve participated long enough to qualify for the pension and keep the money your employer has contributed to it. If you leave your employer’s pension plan before you’re vested, you forfeit that money.

2) Your employer’s group health benefit plan, if offered. A workplace health plan is almost always going to be a better financial deal for you than individually purchased health insurance (alas!). The latter is usually more expensive thanks to (in my opinion, misguided) federal tax laws. If you can manage to find individual-purchase health insurance (or an insurance alternative, such as health care sharing) that is a better value than what an employer is likely to offer you—go for it. But otherwise, prefer workplace coverage. To keep your premium costs down, choose the highest deductible option you can afford. But don’t skimp on network adequacy: pick a plan that gives you access to your preferred doctors and hospitals.

3) A Health Savings Account (HSA). Use it for routine medical expenses. An HSA is a truly great way, not just to pay for medical expenses, but also to save for retirement. The money in an HSA is not taxed, if you use it for medical expenses (if you use it for non-medical purposes, you have to pay taxes and a 20 percent penalty). After you turn 65, you can take the money out of your HSA, penalty-free, for any purpose. Note: HSAs are linked to health insurance. To be able to contribute to an HSA you must also have a qualified high-deductible health plan (HDHP), as defined in the tax code. A growing number of employers offer an HSA-qualified HDHP option, but many still do not. Try to persuade your employer to do so. Of course, you can always buy your own HSA-qualified HDHP on the individual-purchase market, in which case you will own it and won’t lose it when you change jobs.

4) Your employer’s defined-contribution retirement savings plan, if offered (preferably a Roth 401k). A defined-contribution plan is always vested by definition. You own the money from day one. When you leave your employer, you keep the money and are allowed to roll it over into a personally owned IRA or Roth IRA (about which, see the next point). If your employer offers an IRA or Roth IRA, participate (especially in a Roth) and accept every penny of available employer matching contributions. (But as a general rule don’t contribute beyond that amount.) If you want to invest more, do so through a private Roth IRA that you purchase, own, and control (again, see next point). Note: This rule does not apply if you’re a federal employee. If you are, you will want to use the Thrift Savings Plan, the best 401(k)-style savings plan in existence (because its fees are significantly lower than others’): contribute as much to your TSP account as your budget can afford and roll any personal IRA or Roth IRA over into your TSP, when you can. If you roll over a Roth, it will remain a Roth within your TSP. You cannot convert it into a traditional IRA (and you shouldn’t want to).

5) Personal IRAs. As soon as you can afford it, open both a traditional IRA and a personal Roth IRA, outside the workplace. As I’ll explain, the Roth variant has advantages, so I’d start there.

6) Debt repayment. As a general rule, this item should be low on the list of your investment priorities when the interest rate on your debt is low—but high when it’s high.

Sidebar: Roth versus traditional

When it comes to choosing between traditional and Roth variants of financial accounts such as IRAs and 401(k)s, I advise erring on the side of the Roth variant. What’s the difference? With a traditional account, you put untaxed money in and pay taxes on it when you take it out. (And you get an income-tax deduction at the time of your contribution.) With a Roth variant, it’s the reverse: you put money in after it’s been taxed and take the money out, untaxed. (There’s no tax deduction for contributing to a Roth.) The traditional variants are called ‘tax-deferred,’ the Roth variants are called ‘tax-free,’ ‘tax-advantaged,’ or ‘tax-exempt.’ Which approach is better? The short answer is the Roth. The longer answer is it depends on one and only one thing: your tax bracket at the time you make the contribution versus your tax bracket at the time you’ll make a withdrawal. If you are confident your retirement-years tax bracket will be lower than your working-years tax bracket, prefer the traditional account. But if in doubt, prefer the Roth. But wait. How can you be sure? Honestly, it’s impossible. But the prudent assumption is that you will be in a higher tax bracket in retirement than you were in your working years, because of Uncle Sam’s enormous fiscal challenges plus the tendency to lose tax deductions as you age. Therefore, the safer rule is to prefer the Roth options. (Many financial advice columns say just the opposite. I think they’re mistaken.) My best advice: open both kids of account, max out all of your accounts every year, and prioritize your Roth (tax-free) accounts. Having too much money in your traditional, non-Roth accounts can expose you to needless taxation in retirement, because of the IRS’s mandated withdrawals (known as ‘required minimum distributions’ or RMDs). And be sure to talk to a financial advisor about how best to sequence and time your withdrawals to maximize tax efficiency.

Plan to claim Social Security around age 70

Should you take Social Security at age 62? age 65? age 67? even later? This is a question you should think about carefully before you pull the trigger. As a default, my instinct is to advise filing for benefits on the later side. In this, I am swimming against the current of popular opinion, and perhaps of human nature. Most people file for Social Security retirement benefits ‘early,’ often at age 62, the earliest age allowed, rather than waiting till the traditional retirement age or beyond. The arguments for early retirement are straightforward. A bird in the hand is worth two in the bush. You don’t know how long you’ll live. And Congress might cut future Social Security benefits to fill the program’s funding shortfall (though personally I think that’s unlikely). So why not eat hay while the sun shines? All of these reasons make a certain amount of sense. But here’s why I think everyone should consider waiting till their ‘normal retirement age’ (it’s 67 for people born in 1960 and thereafter), if they are in good health and can keep earning a decent income. If you claim your Social Security benefits early, they will be permanently reduced by a considerable percentage (up to 30 percent for those who retire at 62). By contrast, if you retire late (up to age 70), they’ll be permanently increased, by similar amounts. Yes, increased. (There’s no benefit to waiting beyond 70.) So my advice is if you’re in good health in your sixties and have a decent earning potential and expect to live for many years to come, prefer to file sometime between the ages of 67 and 70, with a slight preference to doing so on the later side. But—and this is important—for some couples, it may actually make sense for the spouse with the smaller earnings history to go ahead and start drawing Social Security somewhat earlier, while the other spouse keeps working for a few years (because after one of the spouses dies, the surviving spouse receives the higher of the two amounts). Again, study the issue and, if necessary, consult experts. Ultimately, the decision will be personal, and there isn’t necessarily a right answer. One way to approach the question is to ask: ‘What is my breakeven point?,’ the age at which retiring will probably produce the same amount of income as, or less than, a later retirement date would do. This date is the point at which you should go ahead and file for benefits. The biggest factor in determining the breakeven point, of course, is health. If you’re pretty sure you won’t live for many years past the breakeven point, then you should retire earlier. A good illustration of the tradeoff calculation is found here. The basic rules are here. But don’t over-think it. If you retire too early, it’s not the end of the world. They’re sending you a check every month!

Seek a high return, within reason

I repeat: within reason. It depends on how much risk you can tolerate. You should certainly try to earn more from your savings than what a simple bank account offers. My own goal for a return is about 6 percent a year on average, which forces me to be heavy on stocks (and thus, I confess, to take on a lot of risk).

Prefer stocks when you’re young, bonds when you’re old

In your 20s, you can afford to be aggressive. Invest mostly in stocks and other high-risk, high-reward investments. But as you age, gradually shift your portfolio toward stabler investments like bonds and safer investments like cash. A lifecycle fund (discussed below) does this automatically. My own lifecycle fund is scheduled to be about one-quarter in bonds when I’m 50 and about two-thirds when I’m 65.

Avoid market-timing

Invest passively and ride things out. Resist the urge to time the market. Ramp down your exposure to riskier investments as you approach your retirement date. But not too much. Remember, your nest egg has to last for decades during retirement. And people are living longer than ever. You want to keep your money growing, if possible. So again, take as much risk as you can bear, no more, no less. If in doubt, play it safe and err on the side of too little risk, knowing that you may be denying yourself some modicum of wealth. But that’s better than losing everything.

Prefer a passive approach

The two basic ways to seek a high return are active investing and passive investing. Active is too risky for most people, because there’s no guarantee anyone can beat the market. If most fund managers and financial experts don’t beat the market, how are you going to? Virtually all actively managed funds fail to beat the market. Index funds, however, are the market. With an index fund, you just buy a piece of everything and sit back. The passive approach basically says: ‘I am not smarter than the market, but perhaps I can be as smart as the market.’ The logical corollaries of this statement are: diversify, buy and hold, and keep costs down. My advice is pick from one to five mutual funds (or exchange-traded funds) that track broad market indexes and which have strong performance records and rock-bottom fees. (ETFs are baskets of securities that trade on exchanges just like stocks; their fees tend to be lower than mutual funds’, but they can only be purchased through brokers, who charge a commission on each trade.) Prefer funds with a broad focus. The narrower the focus, the higher the volatility and potential risk. And as the old saying goes: Past results do not guarantee future performance.

Diversify

As a general rule, diversifying your investments reduces your risk exposure without loss of return. So diversify, and not just across stocks, but across all investment types (U.S. stocks, U.S. bonds, international stocks, international bonds, alternatives, cash). Also, across all stock categories (large cap, mid cap, small cap). And across geography (U.S., emerging markets, developed markets). And across all sectors of the economy (industrials, consumer defensives, tech, health care, materials, communications, utilities, consumer cyclicals, financials, energy). Intimidated? Start out simple. Invest in a broad mutual fund that follows the entire U.S. stock market, like Vanguard’s VTSAX. Then, when you’re ready, diversify further by adding mutual funds that fetch a higher return. You shouldn’t need more than five good funds, and some people think you can get by with only two (a whole-market fund plus a small-cap or international fund with which to enhance your overall return). There are hundreds of index funds to choose from. Morningstar.com is a great source of information to help you compare options.

Buy and hold

This means: Be patient. Don’t churn or day-trade. Don’t sweat the temporary downturns, even the big ones. Of course, we all feel a powerful urge to sell during a crash. (As I mentioned earlier, I’ve done so on occasion, when I suspected the market might be at its peak.) But assuming you have time enough to recover, resist that urge. By the time you’re sure it’s a crash, it’s already too late, and all you’ll be doing is foolishly ‘buying high and selling low.’ Your best hope is to ride it out. But wait a minute. Doesn’t ‘Buy low, sell high’ mean that you should take advantage of downturns to snap up bargains? The answer is: Yes! Go ahead, snap them up. But don’t overdo it. And mentally be prepared to lose all of whatever you spend that way. In the end, ‘buying low, selling high’ is really just the respectable cousin of gambling. Gambling is fun, of course, especially when you win. But gambling is not investing. So while I use the expression, ‘Buy low, sell high,’ what I really mean is: ‘Buy and hold something that seems virtually certain to gain in value over a long period of time.’ Such as, for example, a passively managed index mutual fund.

Keep costs down

A basic rule of investing, whether passive or active, is to avoid needless fees and hidden costs. Even ‘modest’ investment-management and trading fees can be serious fortune-shrinkers in the long run, thanks to the power of compound interest. Avoiding costs is yet another reason to go with a broad index fund that simply buys and holds everything in a given market. Passively managed funds have lower costs than actively managed funds, and ETFs are cheaper than mutual funds. Funds have to publish their fees (‘expense ratios’), so it’s easy to compare. For example, as of this writing, the Vanguard Total Stock Market Index (VTSMX), the largest index fund, charges just 0.17% per year. The expense ratio for the ETF version of the fund, Vanguard Total Stock Market ETF (VTI), is a mere 0.06%. The expense ratio for Vanguard’s Total Stock Market Index Fund Admiral Shares (VTSAX) is a way-low 0.04%. By contrast, the average expense ratio for actively managed U.S. stock funds is a much costlier 1.32%. (By the way, can you guess what the expense ratio for the federal employees’ Thrift Savings Plan is? It’s a rock-bottom 0.03%. Can you say ‘pampered’?) Here is what I would say is the most you should ever pay for a particular kind of mutual fund:

  • Large-cap stock funds: 1.25%
  • Mid-cap stock funds: 1.35%
  • Small-cap stock funds: 1.40%
  • Foreign stock funds: 1.50%
  • Bond funds: 0.90%
  • S&P 500 index funds: 0.15%

But remember, those are ceilings. I would suggest trying to keep your overall expense ratios below 0.5% if possible.

Get good advice

By all means, get good advice, but as we’ve noted, most ‘experts’ fail to beat the market. And if you do pay for advice, be sure to prefer ‘fee-only’ financial advisors over ‘fee-based’ salesmen. The former get paid more when your portfolio grows more, and less when it shrinks (they’re paid based on total assets under management). The latter get paid regardless of what happens (they’re paid on commission), and thus have an incentive to sell you things that aren’t necessarily in your best financial interest.

Employ dollar-cost averaging

This is a way to reduce your risk. It means buying (or selling) on a scheduled basis, rather than according to predetermined prices (market timing). By doing this, you lock in any gains and diminish any potential losses. A typical example of dollar-cost averaging is when you contribute X dollars to your workplace 401(k) with each paycheck, or X dollars to your personal IRA or Roth IRA each month.

Rebalance

Rebalancing is another way to reduce risk, and a very important one. It means selling off investments that have grown a lot and buying investments that have declined a lot. In other words, it’s ‘buying low, selling high,’ but on the basis of reason rather than emotion. You can rebalance based on the amount of time that has passed or on the amount of change in relative values between parts of your portfolio. Even the most passive investor needs to be active about rebalancing. But of course, too-frequent rebalancing can rack up excessive trading costs. A target-date fund, also called a lifecycle fund, can be a good compromise: it rebalances itself automatically to reduce your risk exposure as you approach your target retirement date. I use one myself. Use common sense and don’t worry too much about it.

Designate beneficiaries

Don’t forget your loved ones. Designate a beneficiary (heir) for your life insurance and each of your investment accounts. Keep your beneficiary designations up to date. This is important, because financial institutions typically do not follow what you’ve written in  your will but rather give the money to the person or persons you’ve designated on that specific account, or,  if you’ve failed to designate a beneficiary, then they give the money to someone they think you probably would have wanted it to go to, based on local law and/or their own sense of what’s appropriate. Don’t give them that much discretion.

Get married

Yes. Get married. And marry well. A good spouse is your best long-term investment. Buy and hold.

Use an annuity to mitigate risk—sparingly

An annuity (a guaranteed income stream that you purchase from an insurance company) can be a useful component in an overall financial plan. The basic idea is that you give the insurance company some of your money, and in return the insurance company gives you a guaranteed income stream for life. While that stream will be smaller that you might have earned from stocks and bonds, it will be guaranteed: you won’t lose all of your money in a crash. You’re buying peace of mind. Everyone should consider using an annuity (such as a life insurance retirement plan, or LIRP) to avoid the risk of outliving their money. But I wouldn’t go overboard. It’s a bad idea to turn all of your wealth over to an insurance company. That company could go out of business, or the government could find a way to change the rules of the game, and then you’d be left empty-handed. Keep the bulk of your money under your control.

Be prepared

Part of being diversified means anticipating worst-case scenarios. Sometimes, the investment gods laugh at us, and overturn all our carefully prepared diversification plans by causing everything to lose value at once. Crashes happen. And when they do, smart people don’t panic, because they’re prepared for just such a scenario. That’s why everyone’s portfolio should include the ultimate form of diversification: a bit of physical cash and a bit of physical gold. Yes, I mean physical. Buy a good safe and a shotgun. Seriously. Keep it where you can get to it. In a crisis, you may lose access to your digitally stored cash, and safe-deposit boxes can be confiscated by the government. But physical cash will still spend (assuming no hyperinflation), and gold is nature’s perfect store of value, in good times and bad. How much gold should you keep on hand? Experts say no more than 1 or 2 percent of your investable net worth. Expert Jim Rickards suggests no more than 10 percent. ‘Investable net worth’ here means the total value of all your liquid assets minus the value of your primary home and your business, if any. So if your investable net worth is $50,000, then you should keep somewhere between $500 and $5,000 worth of physical gold on hand. I prefer coins (recent ones rather than ones with historic value), but small bullion bars are also fine. I’d keep an equal amount of physical cash.

3. Watch Every Penny

Read your statements

Yes, it’s boring, but you’ll thank yourself. You’ll find mistaken and fraudulent charges and needless fees, and you’ll enjoy slaying them. Track your spending habits and monitor your bank account balances. Track your investments and net worth. (I use PersonalCapital.com to do this.) Keep one eye on your home’s potential resale value, just in case. And be sure to annually check your ‘taxed Medicare earnings’ history at ssa.gov to make sure Social Security will pay you, in retirement, every penny you’re entitled to. Be the captain of your fate! /4

Educate yourself

Learn everything you can about money and investing. Read financial websites. Get advice from professionals.

Make wealth building a personal hobby

Why not? Money can’t buy you happiness, but try living without it.

Note: Not professional investment advice. Follow at your own risk. Use common sense. Drink responsibly. Bathe regularly.

Dean Clancy, a former senior official in Congress and the White House, writes on U.S. health reform, budget, and constitutional issues. Follow him at deanclancy.com or on twitter @deanclancy.


Notes

1/ As their respective labels suggest, term life insurance lasts for a specified term, while whole life insurance lasts for your whole life. Term is the more economical of the two, and is a great way to provide financially for your loved ones after you die. Whole life is more expensive, and when properly designed can be an investment, one that provides you with a guaranteed income stream while you’re still alive.

2/ It’s better to have a few large accounts than numerous small ones. My advice is have four retirement accounts: one IRA, one Roth IRA, one workplace 401(k), and one Roth 401(k), and house them all with one investment firm like Vanguard or Fidelity. But prioritize the Roths. And whenever you leave a job with a vested 401(k) or Roth 401(k), roll it over into a consolidated account of the same type.

3/ Investments do not come without risks. No risk, no reward. Higher risk, higher reward. The younger you are, the more risk you can probably afford to bear, since you presumably have more time to recover in the event of a market dip. And market dips do happen, serious ones at least every decade or so. If you’re unable to bear those ups and downs, avoid risky investments. But if you’ve got the stomach, go for it.

4/ How to annually check the accuracy of your Social Security earnings history at ssa.gov. Why do this? Because your Social Security retirement payments will be based on the average of your highest 35 years of income, or, if you worked fewer than 35 years, all years of income. The higher your ‘high 35’ average, the higher the payments you’ll receive. So it’s vital that the Social Security Administration has accurate records of your earnings. It’s your responsibility to ensure that those records are accurate. Each year after April 15, pull out a copy of your IRS tax return (Form 1040) and go to ssa.gov and look at your reported earnings history (the column marked ‘taxed Medicare earnings’ (not, by the way, the column marked ‘taxed Social Security earnings’—confusing, I know). Then look at line 1 of your 1040 for that tax year (line 7 for pre-2018 tax years), to find your wage and salary income, and then look at line 4 of schedule SE, to find your self-employment income. Now add these two figures together. Does the resulting figure match what ssa.gov reports under ‘taxed Medicare earnings’? It should. If yes, you’re good. If not, contact SSA to obtain a correction. But don’t correct errors in your favor!

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