Editor’s note: This article was first published in August 2015; the figures it uses, such as fixed-term deposits paying about 2% and salary examples of 40,000 and 17,000 euros a year, are from that time, and interest rates may have changed since.
If we had to simplify the process of building personal wealth, or financial freedom, we could sum it up in 4 basic pillars that anyone can understand.
These 4 pillars work like the ingredients in a recipe: putting in more of one particular “ingredient” reduces how much you need of the others.
(See also: 5 truths about financial success and building wealth that will rile your friends)
The 4 basic pillars of financial education
1. The money you earn
All financial health starts with the money you earn. If you aren’t generating income, or your income is too low, we’re really getting nowhere. So the starting point is to earn money. If you already earn money, the next step is to earn more, which leads us to look for alternative sources of income.
(Read: 7 incredible ways to make your first million)
2. The money you don’t spend
The money you earn isn’t always proportional to your personal wealth, because if you earn a lot but spend everything you earn on a high standard of living, we’re getting nowhere.
So the person who earns €40,000 a year doesn’t always have more money than the person who earns €17,000. This is where the need to live frugally comes in, spending less than you earn. In the end, your finances won’t depend on your income but on how much of that income stays with you (the money you can save once all your expenses are paid). And the secret (hardly a secret at this point) lies in widening the gap between the money you earn and the money you spend.
For people starting a financial plan, one goal is to widen that gap a little more every month. Ideally, you should save at least 30% of your income. Even so, financial progress would mean raising that percentage over time. If at some point you manage to save as much as 60% of your income, that would be a sign that you’ve found the optimal balance.
(Read: 11 ideas for saving a large amount of money every year)
So the most basic pillars of financial education begin with earning more money and saving more money.
3. The return you get on your money
Clearly, to keep the money we earn and don’t spend from being eaten up by inflation, to multiply it and, ultimately, to make it work for us, we’ll have to invest it.
And we’re not only talking about investing in the stock market or real estate, but even investing in our own business if that’s your mindset, once we’re clear about what kind of business would be ideal for us.
When we hold cash, it’s just money saved. The idea is to turn that money into an asset. When we talked about diversifying assets, we looked at which diversification is the most profitable: the investments that have made the most millionaires so far have, without doubt, been their own businesses, followed by real estate and equities (shares).
However, for someone who is an executive at a company, or an ordinary salaried employee who doesn’t want to take on any business risk, the most profitable option is probably a diversified stock portfolio.
See also: Why do 50% of entrepreneurs’ projects fail?
(Read: How to invest when you’re young or have no experience)
For everything to work properly, we should try to earn at least 8% a year on our money. Many people will tell you that’s very hard and that you should settle for a 2% return on risk-free investment products (fixed-term deposits), but the truth is that with share price appreciation plus dividends, it isn’t crazy to achieve even more than a 10% average annual return over 10 or 15 years.
And if you decide to invest in your own business, that kind of investment carries risk, but the profits can be unlimited.
(Read: Financial education in 15 points that are very easy to follow and understand)
4. Time
Time is a fundamental factor in financial education, and, as we’ve explained in previous articles, compound interest becomes the most powerful weapon in our finances.
The sooner you start earning money, the sooner you start saving more of it, and the sooner you start investing more of it, the less time you’ll need to reach your financial goals.
Forget about getting rich overnight, because whoever looks for quick formulas for wealth finds the direct road to poverty.
How do these basic pillars work?
Each simple pillar, and each step, can change the rest. Investing €5,000 isn’t the same as investing €1 million: if we were investing €1 million, we would probably change the way we invest and might be happy with a 5% annual return instead of chasing 10%.
See also: Profitable business ideas: generating a profitable asset with little investment
That’s because once we earn more money and save it, in our quest to multiply it, the principle of preserving wealth must always stay intact. In other words, we must invest our money, not gamble it.
(Read: 5 questions about your money you should be able to answer)
To reach our goal in less time, we need to get a higher return on our money, or else earn more money so we can settle for a lower return. If we save more, we’ll have more money available, and so on. In other words, doing more on each of these pillars reduces how much we need from the others.
It may be very obvious, but it never hurts to be reminded.
Featured image: Michael aus Halle, CC BY-SA 3.0, via Wikimedia Commons.
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