A quick internet search will return thousands of articles claiming to share the secrets of building your wealth, but you need to be careful where you get your advice. Some pervasive myths about growing your net worth could do you more harm than good. Here are three of the most common misconceptions and the truths behind them.
1. You need to take big risks to get big rewards.
Some people think the secret to becoming rich is to gamble on the right investment. While there are some people who have made their fortunes that way, many more have lost a sizable chunk of their savings. It may sound boring, but you're usually better off investing in established companies that you know something about.
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Warren Buffett has long advocated sticking to your circle of competence, or the subject area that matches your skills and expertise. For instance, if you work in energy, you might invest more heavily in companies within that sector. You could also invest in large retail chains or online businesses that you're familiar with as a consumer.
If you aren't confident in your ability to invest your money responsibly, consider hiring a financial advisor to do it for you. Be sure to choose a fee-only financial advisor, instead of a fee-based financial advisor. Fee-based advisors earn commissions for recommending certain investments, which creates conflicts of interest. Always ask for a copy of the advisor's fee schedule, whichever type you choose, so you understand what you're signing up for.
2. Saving money is the best way to become wealthy.
Saving money is certainly a better way to grow your wealth than spending money, but investing is better than both. The average savings account annual percentage yield (APY) is 0.09%. If you invest $1,000 in a savings account with a 0.09% APY, you'll have only $1,000.90 after one year and $1,009.04 after 10. High-yield savings accounts are better, but even the best of these only offer between 2% and 2.5% APY.
By contrast, inflation has historically averaged 3% per year. While the inflation rate for any given year may be higher or lower, the odds are good that over time, the money in your savings account will lose value as inflation outpaces its growth.
It's smart to keep the money you intend to spend within the next three to five years in a savings account, and you should also keep your emergency fund there as well. This should contain at least enough to cover three to six months of living expenses in case you experience a financial emergency. But you should invest the rest of your money in the market so it can grow over time. Historically, large stocks have generated a 10% annual rate of return since 1926, according to Morningstar, and even long-term government bonds average a 5% to 6% annual return -- enough to beat inflation.
3. The investment rate of return is all that matters.
Rate of return is important when it comes to investing, but the fees you pay matter just as much. Your broker may charge brokerage fees, and the investments you choose may come with their own costs too. Mutual funds charge all shareholders an annual fee known as an expense ratio, typically a percentage of your assets, so as the value of your investments rise, so does the amount you pay in fees. If you're buying and selling assets often, you can also expect to incur transaction fees.
Check your broker's fee schedule to see what kind of fees it charges and review the prospectus for your investments to find any fees associated with them. You want to keep your fees under 1% of your assets, and lower if possible. A 1% fee on a $1 million portfolio is $10,000 per year.
If you're paying more in fees than you'd like to, look for ways to reduce your costs by moving your money to investment products with lower costs like index funds. These are mutual funds that passively track a market index like the S&P 500. Because the investments within the fund largely stay the same, there's less buying and selling and less work for fund managers, and they pass the savings along to you in the form of lower expense ratios.
It's easy to get started investing, but it takes time and practice to become good at it. Understanding the truth behind common misconceptions can help you avoid beginner's mistakes that are discouraging and expensive. Never hesitate to reach out to someone who's more knowledgeable than you if you need help. Your life savings isn't something you want to gamble with, so it's worth bringing in a professional to help you invest appropriately for your needs and goals.
