How do you make money and build wealth over the long term? In this article we talk about some theory but it is mostly about actions.
The key point of this article is not only the action but the fact that it isn’t dependent on what the market is doing. The results depend mostly on your actions and not what financial markets are doing. Over the long term, financial markets do matter and will increase your wealth, but this is secondary.
What we talk about here isn’t just theory or book knowledge, but from a practical view. This discussion is about what we actually do.
Nonetheless, there actually is a book worth reading on this topic. It answers the questions: who are the wealthy and how did they do it? This was answered in great detail in the book, The Millionaire Next Door (MND) by Tom Stanley. This book is highly recommended. It’s been around a long time, I read it more than 20 years ago.
In this book, the wealthy are identified by overriding traits, some of which are:
- Older than the general population.
- Don’t drive flashy cars or spend extravagantly.
- Didn’t inherit their money.
- May own their own business, but not required.
Let’s focus on the first one, why are the wealthy generally older? It’s because they have saved and invested over long periods of time. Wealth doesn’t come overnight, it takes time.
Fortunately, you can do the same things to build wealth that they do and get the same results. The hard part isn’t in the explaining, it’s in the doing. But for now, let’s start with the explaining.
We took this book to heart over 20 years ago and took action. These are the results that we came up with.
First, Some Accounting Knowledge
To further your understanding, you need to know a little bit about accounting. I promise this will not turn into an accounting class. This is a brief discussion on what you need to know in order to understand what data points to focus on and how to track them.
We can take knowledge from how companies track their finances. We can use this knowledge to help us in our own personal finances. For companies, their financials are broken up into three main statement sections:
- Income Statement
- Cash Flow Statement
- Balance Sheet
The reason why I bring this up is that these statements can be reworked for your personal finances.
These can be described simply as the following:
- Income Statement – The income you earned.
- Cash Flow Statement – Where your cash went.
- Balance Sheet – Assets you own/Debt you owe.
At the highest level view, you are trying to use your cash flow to buy assets that generate cash or build value over the long term.
The first building block is that you have cash leftover each month. If you aren’t generating excess cash each month (after paying your expenses), this will be more difficult. Don’t fret, what can do instead is to first pay down debt until to get to the point that you are generating excess cash.
This is the view of our cash flow each month from employment. These tables have been simplified and the numbers rounded, but the basic result is the same.
This is the first important number, your Take Home Pay (THP) which is what you put into your pocket from your employer. In this table, note that some of the money which is deducted is money that is gone forever (such as taxes). However, there are other deductions that we keep the money in another account (such as the Health Savings Account – HSA).
But, THP reflects what you can actually spend that month.
Cash Flow – Employment | ||
Income | Wage Income | 12,000 |
Deductions | 401(k) | 2,000 |
Dependent Care/Commuter Expenses | 700 | |
Health Savings Account | 300 | |
Health Care | 1,000 | |
Taxes | 3,000 | |
Take Home Pay | 5,000 |
The next set of cash flows are what we can be called Free Cash Flow. This is money left over after paying mandatory expenses. These are monthly costs that must be paid such as: mortgage, utilities, and your credit card bill. These are paid out of your Take Home Pay.
Cash Flow – Employment | ||
Income | Take Home Pay | 5,000 |
Deductions | Mortgage | 2,000 |
Credit Card Bill | 1,000 | |
Utilities | 500 | |
Insurance | 100 | |
Free Cash Flow | 1,400 |
Free cash flow is simply the money you have leftover after all your required expenses.
From a monthly cash flow point of view, we generate free cash flow of $1,400 after paying all expenses. This is a good position to be in. Note that this has been dramatically simplified. One additional detail that should be added is the amortization of one time expenses. This simply means that you split up, say an annual bill into 12 pieces to account for the expense. We have included one expense in this table labeled “Insurance”. So, the $100 accounts for the the fact that we will spend that on car insurance (total $1,200) at some point, not necessarily during the month.
If you stopped right here, you would come away with the view that you put $1,400 into your pocket each month. If you are able to create “free cash flow” each month like this, you will be able to create wealth over time.
Tracking your wealth comes down to looking at your assets each month.
This is what you might call the “accounting view” of your wealth. The reason is that this is how your balance sheet improves each month that isn’t all tied to the cash flow you generate from your employment.
Over time, your assets will generate more income and may eventually exceed your regular income.
In the table below we summarize assets that we own and in fact anyone can own. We provide a value for each one as well as an estimate of how the value changes each month.
These assets are:
- Money market account
- 401(k)
- Health Savings Accounts (HSA)
- Taxable Investment Account with Charles Schwab
- Home Mortgage
Asset Impact – Monthly | ||||
Asset | Investment | Total Value | Impact | Value |
Bank Account | Money Market Account | 50,000 | Added Money | 1,400 |
Income (4.5%) | 175 | |||
401(k) | Index Fund | 200,000 | Added Money | 2,000 |
Income (2%) | 300 | |||
Stable Value | 50,000 | Income (4%) | 200 | |
HSA | Money Market Account | 10,000 | Added Money | 300 |
Income (1%) | 10 | |||
Home Mortgage | Equity | 300,000 | Added Principal | 800 |
Investment Account (Schwab) | Index Fund | 100,000 | Income (2%) | 150 |
Stable Value | 25,000 | Income (4%) | 100 | |
Credit Card Debt | N/A | 1,000 | Payoff | 1,000 |
Total Assets | 735,000 | Asset Change | 5,435 | |
Total Debt Reduction | Credit Card + Mortgage | 1,800 |
Let’s walk through this statement.
First, the boxes noted in red are assets that are market priced. This means that the actual value of these assets varies based upon what others would pay for them. This is not unexpected since it includes assets such as a home and stocks.
Even though they are market priced, our position in each improves each month. In the case of the house, we are paying down the principal $800/month. For the stock index funds, buying more increases our ownership of the positions. Over time, this will result in higher returns.
The stock funds also pay income. This might be invisible to you depending on how your broker accounts for the income, but it is nonetheless true. The income from the companies in the stock fund also increase your ownership interest.
In our 401(K) and bank accounts, we are earning about 4% investing in money market funds and stable value funds. These are designed to maintain a ‘par value’ so that they are not market priced.
The $1,400 of free cash flow goes directly to a money market account to increase our savings.
Our Health Savings Account (HSA) is an account that is tied to our health insurance at our employer. Depending on your employer and plan, there may be an opportunity to earn income on this account.
Summing Up The Monthly View
This exercise results in three important data points:
Data Point | Source | Amount |
Take Home Pay | Income | 5,000 |
Personal Free Cash Flow | Cash After Expenses | 1,400 |
Asset Value Change | Added Money | 4,500 |
Asset Earnings | 935 | |
Asset Value Change | 5,435 | |
In the case of Take Home Pay, note that we are actually saving more money than this number. The reason is that the Take Home Pay already has deductions that are funding our accounts, such the HSA and 401(k). This additional money shows up on the asset sheet.
Next, the Free Cash Flow (FCF) number gets to the heart of determining if we are actually saving money each month after expenses. For a complete view, you should also account for one time expenses that occur during the year in your analysis. In this example, we split up an annual car payment into a monthly cost of $100.
Taken as a whole, for this month we added $6,800 to our wealth.
What To Do With Extra Debt
In this article you will notice that we haven’t discussed about paying off debt. The reason is that we don’t carry credit card debt month to month. Also, we don’t have car payments because we choose to own paid off cars that are bought used.
Owning expensive cars and keeping large credit cad bills are wealth killers.
We have had car payments and credit card bills in the past. We have worked to pay these off and not get into that kind of debt again.
This of course always depends on your situation. It could make sense to buy a car if you really needed a good one for the job you have. But, if you can you don’t want to spend too much of your money on cars and credit cards because this takes away from money you can use to build wealth.
If you are in a debt situation, use your free cash flow to pay off the debts early. Here’s an example. Lets say that we had a car loan of $15,000 and a credit card bill of $10,000. In the previous tables we used $1,000 of our existing cash to payoff our credit card bill. We reallocate that money to the debt and also all the remaining free cash flow.
Cash Flow – Debt Payoff | |||
Total | Payment | Ending Balance | |
Credit Card Debt | 10,000 | 500+1400 = 1,900 | 8,100 |
Car Note | 15,000 | 500 | 14,500 |
We took all of our free cash flow and allocated it to payoff the two loans more. The reason why you would do this is that the interest rate you pay on the loans will likely be higher than the interest rate you can earn on the cash. Here’s a summary of typical rates as of this writing in 2023.
Account Type | Interest Rate |
Car Note | 6% |
Credit Card Debt | 18% |
Money Market Rate | 4% |
In the table above, as long as the interest rates for the debt are higher than money market rates, it makes sense to pay the debts off first. Given that the interest rate on the credit card is much higher, it makes better sense to payoff that loan faster. So, we pay 500 to the car note and the rest to the credit card.
What Happens After A Year?
If you project out this same plan for a year, the result is more than simply multiplying everything times 12. The reason is that due to compound interest, your earnings go up more than the simple sum. The table below shows what happens to your assets after 1 year.
Asset Impact – Yearly | |||||
Asset | Investment | Starting Value | Impact | Simple Sum | Ending Value |
Bank Account | Money Market Account | 50,000 | Added Money | 69,000 | 69,000 |
Income (4.5%) | 2,250 | 2,750 | |||
401(k) | Index Fund | 200,000 | Added Money | 224,000 | 200,000 |
Income (2%) | 4,000 | 4,300 | |||
Stable Value | 50,000 | Added Money | 50,000 | 50,000 | |
Income (4%) | 2,000 | 2,000 | |||
HSA | Money Market Account | 10,000 | Added Money | 13,600 | 13,600 |
Income (1%) | 100 | 120 | |||
Home Mortgage | Equity | 300,000 | Added Principal | 309,000 | 300,000 |
Investment Account (Schwab) | Index Fund | 100,000 | Income (2%) | 102,000 | 92,000 |
Stable Value | 25,000 | Added Money | 25,000 | 25,000 | |
Income (4%) | 1,000 | 1,000 | |||
Credit Card Debt | N/A | 1,000 | Payoff | 1,000 | |
Total Assets | 735,000 | Asset Change | 801,950 | 759,770 |
There is a lot of detail here, but in summary, we added money to our accounts during the year and the stocks were down about 10%.
This is an example showing that your investments can go down at any given time. In our 401(k), we started with 200K. We added an additional 24K during the year, but ended up with only the same 200K. This means that the stocks were down for the year.
This happens.
With our other assets, we saw increases.
Paying down the principal of our mortgage, resulted in an increase of equity of 9K. Note that the amount paid to equity actually increases each month since more money goes to principal for each payment made.
Our cash accounts made interest and it increased each month as more money was added.
Here is a summary view of what happened during the year.
Asset Value Summary – Yearly View | |
Beginning Balance | 735,000 |
Added Money | 55,600 |
Income | 12,170 |
Investment Loss (Unrealized) | -43,000 |
Ending Balance | 759,770 |
During this year it was a down year, since we had unrealized losses of -43K. However, our balance sheet was actually up overall.
This what we mean by building wealth even in down markets. Over time, markets return and will build the balance sheet to higher values. In this situation, it might be a good idea to also move some more money into stock funds to increase returns going forward.