Many people don’t understand the nature of wealth building. They think rich people were either born into money or possess some mystical skill that is unattainable for the average Joe. While in some cases this is true (the Paris Hiltons and Katy Perrys of the world), the vast majority of wealthy people got that way through saving and investing over long periods of time. In fact, there is only one simple formula for building wealth:
FV = ( (1 + i)n ) * PV + PMT * ( ( (1 + i)n - 1) / i )
|PMT||Periodic Payment Amount|
|i||Interest (growth) rate per period|
|n||Number of Periods|
Ok, so maybe it’s not quite elementary math, but luckily you don’t have to worry about calculating your future net worth by hand. Here is the online calculator I use:
Using this calculator, you just need to provide input to 4 easy fields and click the button under the remaining one of which you’d like to calculate. For example, if you want to find out how long it will take you to become an inflation-adjusted millionaire if you start from scratch, contribute $2000 per month and maintain a 7% inflation-adjusted ROI from an S&P 500 index fund, you’ll find out that it will take just under 20 years. Not so bad right? But this is an early millionaire extreme blog, so we are not satisfied on waiting until we are middle aged to become millionaires.
This brings us to an important conclusion. All people who have ever accumulated any amount of money did it in this way. There is no way around it. Since time is the same for everyone, and you can’t control how much money you start with, if you want to get wealthy, you only have to worry about two things: your monthly contributions and your capitalism coefficient (ROI).
Monthly contributions can be broken down into skill value and frugality level. Some people like Brad Pitt have a very high skill value due to a rare talent or luck. For most people the skill value on a monthly basis will be somewhere between $2,000 to $10,000. Of course there are people who make much more (Neurosurgeons, executives, NBA players, etc.) but this range covers > 80% of the population. The frugality level is even more controllable than the skill factor as it is almost entirely based on choices while skill factor is split between choices and other factors (intelligence, access to education, etc.) that you can’t control. This is why frugality is so important to obtaining wealth — it is the only factor that you have (almost) 100% control over. Whatever your skill factor, starting capital, or capitalism coefficient, as long as your frugality level allows you to save money every month you will become wealthy in the long run.
The capitalism coefficient is the most important factor in obtaining mass wealth in the long run. This is because skills are not scalable because there are only 24 hours in a day and no matter how talented you are, there is a cap to how much value you can create to the economy per hour. However, you can achieve a 10% return on your money whether you have $100k or $100,000k. Wealth accumulation is exponential which means that in the very long run, the capitalism coefficient will become all that matters. However, in the short run when you don’t have much capital, it is not very important at all. In order to build wealth the most important path is to first learn a skill that provides you income, then learn frugality skills to save a lot of that income and finally to learn investing skills to make that money work for you.
For a novice, 7% is a very good and easy capitalism coefficient. In the long run, it can be attained with 0 effort on your part by buying an S&P 500 index fund such as VFINX from Vanguard (at least using historic growth levels). This was the number used in the example above showing how an average person can become a millionaire in slightly less than 20 years. However if you are shooting for much more than $1 million like me, 7% will take quite a long time to get us there. So we have no choice but to enhance our capitalism coefficient to beat market returns. My advice is that though possible, it is very difficult to do this through the stock market without substantial leverage (running a fund with other people’s money and taking a percentage of the returns in fees). However, through skilled real estate deals, private equity investments, startups (angel investing or being a founder), and other high-risk/high-reward deals this becomes feasible.
As laid out in a previous post, my rather bold goal is to maintain a capitalism coefficient of between 21% to 23% over the next several decades. Using the parameters of $3,500 monthly contributions, 23% ROI and starting capital of about $10k, you can see that I’m hoping to roughly reach the following net worth milestones at these times:
- $5 MM by age 39
- $50 MM by age 50
- $1,000 MM by age 65
I realize that I originally predicted that I’d become a billionaire at age 90, but I have since changed my goals to a much more aggressive capitalism coefficient. Now, this is all just words until I actually start living up to these frighteningly ambitious goals, so feel free to criticize in the comments.