5 Rules to Invest Money Wisely and Build Wealth

Investing Money Wisely Takes Patience, Discipline, and Risk Management

Getty Images

At its core, investing money wisely comes down to a handful of behaviors in which you, as an investor, can engage to harness several powerful forces to build wealth for your family. You win the game, so to speak, when your passive income reaches a point where it, by itself, gives you financial independence. This means that the finish line for every investor is different because everyone has different lifestyle goals, objectives, and plans.

Some people truly want nothing more than a few acres in view of a mountain, a log cabin, a hunting rifle, a faithful dog, and a good book to read on the porch. Others want fast cars, oceanside villas, expensive watches, and trust funds stuffed with so many stocksbondsmutual funds, and real estate properties, their great-grandchildren won't have to worry about anything.

I have five general rules for investing money wisely — things that, if followed, can make the journey to fiscal affluence a lot easier. Keep them in mind when thinking about how to handle your own financial concerns, taking what works for you.

1. Investing Money Wisely Means Never Owning Something You Don't Understand

If there is one rule that could save tremendous amounts of financial heartache it would be this: Do not buy or hold anything you can't explain to a kindergartener in three sentences or less —  how it makes its money, what its potential pitfalls are, and how that money finds its way into your hands.

This sounds so simple — and it is — but few people seem to follow it. The moment a bull market starts raging somewhere, otherwise perfectly reasonable people who have enough common sense not to walk out into the rain without an umbrella suddenly get it in their heads they should be buying collateralized debt obligations, even though they couldn't tell you what they are.

Or giving up their safe cash deposits and swapping them for auction rate securities, even though they can't explain how they work.

Do you know the difference between a share of stock and a master limited partnership unit? No? Then don't buy MLPs through your broker. They look like stocks, trade like stocks, but are most definitely not stocks. You can be in for an unpleasant tax surprise if you start collecting them without knowing what you're doing. Do you know how preferred stock differs from common stock and corporate bonds? No? Then don't buy them. The same goes for everything from convertible shares to REITs. There's plenty of time to learn about these securities and you can always buy them tomorrow. Jumping in before you are ready, well-informed, and aware of the dangers is like a non-swimmer deciding his first foray into the pool should be from the the high dive board of an Olympic facility. It's probably not going to end well and if it does, it's luck, not skill.

2. Investing Money Wisely Means Protecting Yourself Against the Downside By Proactively Managing Risk

Risk is ever-present when managing your money and investing wisely requires you to respect it while simultaneously reducing it.

If you don't, you can wipe out years, maybe even decades or a lifetime, of savings; savings for which you swapped part of your life expectancy (quite literally — you sold hours of your life in exchange for that cash; hours you could have been sitting on a beach, writing a novel, learning to paint, sailing off the coast of Florida, or pursuing your favorite hobby). There are  different  types of investment riskliquidity risk, inflation risk, market risk, counter-party risk and fraud risk. On and on it goes. This is one of the reasons it is so important to focus not on absolute returns, but on risk-adjusted returns; to actively, constantly, strive to reduce risk.

For most investors, dollar cost averaging into a diversified portfolio over many decades is, statistically, the most successful way to drastically reduce risks of all kind. Couple this with large cash reserves to provide a cushion in the event of a job loss, recession, stock market closure or collapse, natural disaster, or other non-expected situations and you are on the right track. This might sound counter-intuitive but rich investors are actually obsessed with maintaining high cash balances. Of the 115,610,216 households in the United States, an estimated 1,821,745 have investment portfolios worth more than $3,000,000 and much of this money is parked in liquid greenbacks. How do you think the wealthy are able to buy up assets on the cheap when everything goes south? Perhaps nobody embodies this concept better than billionaire investor Warren Buffett. His holding companyBerkshire Hathaway, has an estimated $60 billion in cash and cash equivalents sitting on the balance sheet. He piles up money, sometimes for years on end — there was a period spanning much of the 1980's, in fact, when he didn't buy a single stock at all — waiting for the right opportunity to pick up incredible enterprises that he then sits on for decades.

3. Investing Money Wisely Means Taking Advantage of the Power of Compound Interest as Early as Possible

Wise investing means harnessing the power of compound interest. The younger you start, the easier it is to amass a jaw-dropping net worth. A college student saving a mere $111 per paycheck, by way of example, could end up with $4,426,000. This is one of the reasons it's so easy for the rich to get richer: When you set up a trust fund for your children or grandchildren, they get to benefit from a lifetime of compounding, watching their money grow while in elementary school. Those extra years are extraordinary in terms of final outcomes.

Perhaps an actual mathematical example might help. We'll use some time value of money formulas. Imagine there are three people — Samuel, Abigail, and Daisy.

  • Samuel begins life with no investments, doesn't save throughout his twenties and thirties. But he starts making a lot of money by the time he is 45, at which point he promptly begins putting aside $5,000 a month. Assuming average rates of return on his equities, he ends up with $3,436,500 before taxes by the time he retires.
  • Abigail begins life with no investments but she was always keen on personal finance and money. At 18 years old, she decides to put aside $100 a week. She maintains this habit throughout her lifetime and never increased the amount by inflation, meaning it progressively became easier and easier to fund. Assuming average rates of return on her equities, she ends up with $4,534,269 before taxes by the time she retires.
  • Daisy is born and from the first breath she takes, her parents put aside $25 a week for her investments. This routine is maintained throughout her entire life, and it is never increased with inflation. Assuming average rates of return on her equities, she ends up with $6,361,819 by the time she retires.

If you want to know how to get rich, there's the secret: Either put a lot of money to work, let it work for a long period of time, or, ideally, both.

4. Investing Money Wisely Means Arranging Your Holdings and Behaving in a Way That Allows You to Minimize Taxes

Having seen how powerful compounding is in the last section, you realize that every dollar is worth a whole lot more future dollars if prudently managed. The more you can save on taxes, the more money you have working for you. Learn how to take advantage of deferred tax liabilities. Figure out how to use a Roth IRA, which is the closest thing to a perfect tax shelter the poor and middle classes are likely to ever get. Have your family structure its holdings so the stepped-up basis loophole can be taken advantage of upon death. Utilize the asset placement technique to minimize tax payments. Form  family limited partnerships to transfer wealth using liquidity discounts to lower gift taxes.

Do not cheat on your taxes, do not get close to the edge of the lines, but definitely take advantage of all of the breaks Congress has given you under the law. Your elected representatives put them there for a reason and assumed you'd avail yourself of them so speak with your advisors to find out what you're missing.

5. Investing Money Wisely Means Controlling Your Expenses

Sometimes, fees can be worth it. For certain high net worth individuals, especially with complex needs (say you worked for a Fortune 500 company and ended up accumulating a concentrated block of highly appreciated stock you need to liquidate in an orderly manner, while minimizing taxes and protecting against a sudden market collapse), a private bank or registered investment advisor charging a 1% or 2% fee can absolutely be worth his or her weight in gold, far exceeding the amount that would have been saved with the attempted do-it-yourself approach. Structuring a portfolio using something like a charitable remainder trust alone can pay for itself in tax savings many, many times over. Setting up a so-called QTIP trust that makes sure children from a first marriage aren't purposely or accidentally disinherited by a second (or fourth) spouse while the latter spouse is still provided for during the remainder of his or her life has value.

There are dozens of situations in which that fee everyone likes to complain is the best money you can spend, provided it is integrated into a broader service package. Real estate developer? You might get access to much better financing terms on your projects by being part of the private client group, the fee you pay on your trust and portfolio assets dwarfed by the interest savings on the debt side. Your teenage son got in an accident, you're out of the country, and you need someone to bail him out of jail in the middle of the night? Your white-shoe private wealth management firm might do it for you but a firm like Vanguard certainly won´t. That's the trade-off. You have to look at the whole picture. What are you getting? Market returns aren't the only variable. Service, risk reduction, access, expanded product offerings, and privacy assistance are all on the menu.

That said, for many small and medium-sized investors, this isn't a concern. They are never going to have enough wealth, nor needs complex enough, to care about the added services and benefits. There are no oil paintings to insure or background checks on nannies to perform. In that sense, costs matter and the costs to which you want to pay the most attention probably include the mutual fund expense ratio. For many, this means opting for something like a low-cost, passively managed index fund from a firm like the aforementioned Vanguard. For others, it's going to be switching to a discount brokerage firm charging $10 or less per trade instead of a traditional bank that assesses a $150 commission on the same trade execution.