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Sunday, February 17, 2013

How to Get Rich



There are 3 primary ways to get rich:  inheritance, high salary, and investment.  We'll focus mainly on how to get rich through investment since this is the only way to get rich that is available to most people.


Pile of hundred dollar bills
Pile of hundred dollar bills
Image courtesy of David Castillo Dominici via FreeDigitalPhotos.net

Inheritance

Inheriting money is probably the easiest way to get rich.  However, if your relatives are not rich, you will not get rich through an inheritance.

High Salary

Some people, such as actors and sports stars, get rich from making a very high salary for their labor.  This usually requires a great deal of talent, skill, and good fortune and can be achieved by only a few people under special circumstances.

Investment

Most people who get rich do so by owning something that increases in value.  The fundamental strategy to get rich is to make investments that grow in value over time.  The amount you can invest and the rate of return on the investment will determine how long it takes for you to get rich.
    

Risk and Reward

There is a relationship between risk and potential reward.  For example, you could start a small business or invest in a start-up company and end up with a very high rate of return.  However, there is a significant chance that you could lose money as well.   At the other end of the risk spectrum, you could put your money in a savings account.  There is essentially no risk of losing your money in this investment, but your rate of return would be very low, currently less than 1% per year.

Most types of investments have a risk level and rate of return between the high risk/high return of a start-up business venture and the low risk/low return of a FDIC insured savings account.  Stock market investments are popular.  Historical long-term return of stock market investments is about 8.8% including price appreciation and dividends.


Real estate is another popular investment vehicle.  Real estate property values depend on both local and national/global factors.  The local economy influences real estate prices.  If a community is popular and people are moving in, then the real estate market will be strong for residential and business property.  Factors such as interest rates and tax policy also impact the market price for real estate.  Since real estate prices can be volatile and depend on local economics, a real estate investment may be higher risk than a stock market investment.

How long does it take to get rich?

How long it takes to get rich through investment will depend on how much you can invest and the rate of return on your investment.  Let’s consider some investment scenarios that require various levels of skill and active management of the investments on the part of the investor.

Stock Market:
Let’s assume you get the historical average return of 8.8%.  A stock market investment does not require much skill or work on the part of the investor.  You could invest in an index funds or mutual funds and allow your investment to grow without daily intervention.

Real Estate:
Let’s assume you have some skill in real estate investment and can follow the hot markets.  This would take significant skill and a fairly high level of attention to your investments.  For example, you might invest money to buy a home in an up-and-coming neighborhood, fix it up and sell it.  You may gradually purchase some homes, rent them out, and sell them as they appreciate in value.  Let’s assume you can sustain a 15% average return on investment over time in real estate investments.  This will not only require cash but hands-on work as well.

Start-up Business Ventures: 
This scenario involves either starting small businesses or investing in small businesses- a risky proposition.  Let’s assume you keep your businesses growing and continue to start new ones to get a 30% return over time.  This would be a very impressive rate of return and would take dedication, hard work, and good fortune to achieve.  The business could be anything that could achieve a 30% rate of return, for example investing in and running a growing franchise fast food or service business.  It will require both cash and active participation of the investor to achieve a high rate of return.



Shows how many years it takes to reach $1 million with given monthly investment amount
Years to Reach 1 Million Dollars through investment
Source: Dr. Penny Pincher

The table above shows the number of years that it would take to acquire 1 million dollars through investment with the average rate of return indicated.  You can see that even with a small monthly investment of $50, you could become a millionaire in 24 years- if you can sustain a very high rate of return.  Unless you have good investment skills and are willing to be an active investor, the 8.8% annual rate of return is a more reasonable expectation.  At this rate of return with an investment of $1000 per month, you would reach 1 million dollars in 25 years.

Effects of Inflation


Table showing years of investment required to reach $1 million, with inflation
Years to Reach 1 Million Dollars through investment, adjusted for 3% inflation
Source: Dr. Penny Pincher

Considering that prices tend to rise over time, you will need more than $1 million in the future to buy the amount of goods and services that would cost $1 million today.  If we factor inflation at 3% (the long term average), we can see how this impacts how long it takes to get rich.  With our stock market investment of $1000 per month, it will take 32 years rather than 25 years to reach $1 million of purchasing power.


How do you get money to invest?

It takes money to make money through investment.  The easiest way to get money is to simply not spend the income you have coming in.  Through frugal living and careful budget planning, you may be able to use more of your income for investments rather than spending it on expenses.  Penny Pincher Journal has some great ideas to help you save money.  Another possibility is to get a second job to earn additional money to invest.

One way to accumulate ownership in an investment without cash is to use “sweat equity”.  Sweat equity is contributing labor rather than cash investment to gain equity in a business.  For example, an angel investor may invest $100,000 cash in a start-up to gain 50% equity, and the entrepreneur who runs the business day-to-day would put in $20,000 cash and full time labor for one year to gain 50% equity.

How to Get Rich

Like many things, getting rich sounds simple but is hard to achieve.  If you had $100,000 right now, would you invest it, or would you spend it?  Most people would be tempted to buy a new car or bigger house.  People on the way to becoming rich would likely invest the money and grow it into a larger asset.

Really, there are only 2 steps to  how to get rich:

  1. Establish a budget so that you have money to invest every month.  You may need to reduce your expenses or obtain additional income.
  2. Make regular investments over time that maintain a good rate of return.  This may require active investing to make adjustments to your portfolio.


How long it takes to get rich will then depend only on the rate of return and the amount you invest each month.


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