How Money Works

I have to preface all of this by saying that it's more of a hypothesis based on observation and experience than a supported theory. I'm not insanely wealthy, but I do okay. I don't come from money, and I've only been at this for a few years.

This advice is for people in their teens, twenties, and early thirties, who want to retire in their 40s and 50s to do whatever they like. It is a “get rich slowly” scheme, but the advantage of this compared to any “get rich quick” scheme is that it should work reliably for anyone. It is not necessarily easy to execute, but it is straightforward. It does not require any special skills other than patience.

My goal in writing it down is in producing a repeatable and testable method for average people to accumulate wealth. I'll add updates here over time, based on what I learn.

1. It Takes Money to Make Money

This old adage is true, and what it really means is that, if you have no money at all, you need to get some. Ignore all of the get rich quick schemes in the universe, though! Just go get the best job you can, and keep your expenses extremely low. If you don't have any money right now, then that's good because you're already used to not spending much. When you have your job, continue not spending much. Don't fall into the trap that everyone you work with falls into, of spending their money. Keep living like a poor person.

Some people scoff at this; they say “what's the point of earning money if you can't spend it?” That doesn't sound so dumb, but those people are idiots, because their income will always be tied to the time they put in at their job. If you can have some self-control now, you'll be able to make money without working later.

The key to this step, besides living like a poor person for a while, is getting the best job you can. This could easily be its own essay; for now let us just say that this does not entail becoming an astronaut or a medical doctor. If you're young, it is worth extending your timeline somewhat by investing in education for a profession, but not if it introduces a whole bunch of debt. Truthfully this plan could be executed on a janitor's income.

Your goal should be to save more than 50% of your after-tax income every month. Yes, this is quite difficult, especially if you have a family to house and feed*, but again: a relatively short-term sacrifice now will result in long-term benefits later.

* If you are housing your family through property that you own rather than rent, then a portion of that 50% can go toward your mortgage, which will make things slightly easier.

2. Patience is a Virtue

As alluded to above, you have to be patient. When it comes to your finances, you should be thinking in 1-year, 5-year, and 10-year increments, not month-to-month. Stop trying to get rich quick! People have a very poor understanding of how entirely straightforward it is to get rich slowly by following basic steps over a 10- to 15-year timeline. Trying to get rich quickly gets in the way of this, and relies on a huge amount of luck.

3. Understand Your Goals

Understanding what you're after is important. It will change over time, and that's fine. But write down what your starting goal is, and when you reevaluate, don't let yourself raise the bar just because you can—sincerely contemplate what circumstances in your life have changed which are causing you to want more. Ultimately you will find a balance that works for your needs.

A simple way to define your financial goals is:

a) How much money would you like your primary residence to be worth? (You will own it outright at the end of this plan.) b) Once your residence is paid for, how much after-tax income do you want to earn every month to cover food, miscellaneous expenses, and leisure?

If your answer to (b) is more than you currently earn after-tax, it may be a sign that either your goals are unrealistic or that you need to re-visit step 1.

If your answer to (a) is more than 50x your monthly after-tax income, it may be a sign that either your goals are unrealistic or that property prices in your area are grossly inflated. If the latter is true, it will make it almost impossible to execute the rest of the steps without relocating, since owning real estate is an important component of this plan.

If your goals are unrealistic, don't be dismayed! That doesn't mean they're impossible by any means, but it does mean that you will need to find a way to either increase your income, increase your timeline, or decrease your expectations. I strongly suggest that you try some of all three: you should seek to increase your income at least once a year anyway, and learning to be happy with less is an important life skill. However, increasing your timeline is another interesting option! What if, instead of working on a 10- to 15-year timeline, you break this up into two 10-year plans? Keep your ultimate goal, but turn that into your 20-year goal while also creating an interim 10-year goal that is closer to your current reality. Work hard at it for 10 years, following the steps laid out here, and then re-evaluate and repeat. It may take 20 years instead of 10 or 15, but you will be much farther ahead than if you had given up altogether.

4. Understand Risk

Risk is a difficult topic to teach, but almost everyone who is adept with money understands it. “High risk, high reward” is an oft-repeated phrase, but poor people take that to mean they should earn a greater appetite for risk in order to reap more rewards. That's not really true! In fact, getting rich slowly is all about understanding which parts of our financial system protect you from risk, and how you can take advantage of that. For example, basically the only kind of debt that is smart for most people to use is mortgage debt, since that has a lot of protections built into it which limit your risk exposure. That's why owning real estate is important—it gives you access to credit which is extremely inexpensive (relative to the alternatives) and protected from downside by the property value.

5. Understand the Efficient Market Hypothesis

A good book to read about this is Burton Malkiel's “A Random Walk Down Wall Street.” Effectively, there are not really any secret shortcuts to making quick money in the stock market, or anywhere else, because markets are efficient. What you can do instead, though, is understand how diversification can be used as a tool to maximize returns and minimize risk. (Furthermore, the efficient market hypothesis might cause us to start looking for markets that are structurally less efficient, and therefore provide slightly better opportunity for returns; normally such markets are that way because they're harder to access. This is a legitimate strategy, and worth understanding, even if it may not fit into your 10- to 15-year plan.)

6. You Must Use OPM

“OPM” stands for “Other People's Money.” Basically, saving diligently and even investing wisely does not make people wealthy on its own. In order to do that, almost everyone uses OPM. In the general context, this could mean debt or outside investors, etc. In your case, there's only one acceptable form of OPM: a mortgage from a bank.

Banks lend huge amounts of money at very low rates whenever real estate is involved. You should take advantage of that!

After executing on #1 for a year or two, you should be in a position to make a down payment on a home, if you don't already have a mortgage. Do it! And then continue executing #1 diligently, to pay off that mortgage as quickly as humanly possible. This is where patience will help, but not as much patience as Joe Public, please! “Normal” people take out 20, 25, or 30 year mortgages (and beyond!). You should get terms based on 20 years, but use payment top-ups to pay it off in 10. (This will be possible if the home you buy is less than 50x your monthly income after tax.)

Now, this is where it gets really interesting. You own a home! And it only took 10 years—congratulations. We're not done yet, though! Your next step is to buy a second property. Having paid off a mortgage so efficiently, banks will be happy to lend to you again. However, this time your intention will be to buy a property that you can rent out, so that the mortgage on this property effectively pays itself. (The simplest option is probably to buy a second home that is similar to your first, and find a family to rent it.) Unlike the mortgage for your primary residence, it is completely ok (and even encouraged) to take out a longer-term mortgage for this second property.* It is easy to over-think this step; you simply need to find a property which you can rent out for slightly more than it costs to pay principal, interest, and maintenance on.

* You should not finance anything against your primary residence. Now that your home is paid off, keep that as your nest egg. But taking long mortgages on and/or re-financing secondary properties is fine.

7. Multiply!

Once your second property is in place (this should happen by year 10-12) you have some options:

a) You can wait about 2 years, re-finance your second property (again: never re-finance your primary residence), and use the equity from that property as a down payment on a new one. Continuing this process allows you to multiply the equity you're earning from rent over time. If you repeat this process once a year for 5 years, by the end of the 5th year you will have built up enough equity overall to pay for the initial investment property outright, thus continuing to earn the rent from that property as income. (Not to mention the significant equity it represents!) b) You can re-finance the property every year or two and invest the resulting cash in the public stock market. When you're ready to retire, you can continue the re-financing process to generate cash for yourself every year and supplement it with the interest that you're earning from the stock market, reaching into the principal eventually if you want.

The key in both cases is that you're relying on the bank to keep lending you money which is secured by real estate, and multiplying your cash flow through either the stock market or additional real estate investments. You can also mix and match both approaches to great effect. Your risk is limited, since the loans are secured by the property and (unlike your primary residence!) your goal is not necessarily to maintain ownership of the property long-term.