Build Your Future with Bricks—Not Straw or Sticks

Tuesday, June 3rd 2008 by Shanel Yang

Remember the Three Little Pigs?

They were brothers who each needed to build a house of their own. They had the choice to build their homes out of straw, sticks, or bricks.

The first chose straw, the second chose sticks, and the third chose bricks. Along came the Big Bad Wolf who loved to eat little pigs.

None of the little pigs would let the wolf into their homes. But, the wolf was able to blow down, first the house of straw, then the house of sticks, and eat those two little pigs.

However, when the wolf got to the house of bricks, he could not blow it down. Instead, he finally tried to enter that little pig’s home by climbing down inside the chimney. But, the clever little pig had set a big pot of boiling water at the bottom of the chimney, inside the fireplace, which trapped and killed the wolf, instead.

This is an old fable that was told to children as a way of teaching them to consider the long-term consequences of their decisions and actions. But, I think this is also an excellent lesson for adults—especially when it comes to making money.

FUTURE MADE OF STRAW

A future made of straw is one based primarily on your salary as your major income source for the rest of your working life. This is the weakest possible defense against the Big Bad Wolf of taxes (income, sales, property, etc.). Unfortunately, most Americans rely on this flimsy strategy for their financial security and, consequently, cannot expect to accumulate any kind of wealth with this plan.

Almost everyone believes that doctors, lawyers, and CEOs who have annual salaries of over $100,000 are rich. The truth is, if these professionals don’t have another income-earning strategy besides their salaries, they are more in debt than the plumbers, teachers, and truck drivers living in much poorer neighborhoods. Why?

First, the more you earn in terms of salary, the more taxes you have to pay. Second, the bigger your salary, the more everyone expects you to spend (mostly on credit!) to live up to the image of a highly-paid professional or executive. (No one cares that you have to pay almost half of it in taxes and at least half of that in student loans, home loans, and car loans, leaving you only 1/4 of your salary to spend or save.) Third, many of these high-stress jobs cause marital stress, often resulting in divorce with exorbitant alimony and child support payments—and, these days, more than just one divorce. (There goes the last 1/4 of your salary. Now you’re living paycheck to paycheck, interest rates are rising, and you still want to live the lifestyle you’ve grown accustomed to. You’d better keep getting huge raises and bonuses, or else you won’t be able to make your payments.) That’s a 3-part formula for big-time debt. Often, the bigger the salary, the bigger the debt!

If you want to learn more about the down side of trying to build your future based solely on your wages or salary, I highly recommend Rich Dad, Poor Dad: What the Rich Teach Their Kids About Money—that the Poor and Middle Class Do Not.

FUTURE MADE OF STICKS

A future made of sticks is one based mostly on socking away your after-tax dollars into a savings account, which interest is usually too low to even keep up with inflation. It’s better than a future made of straw because at least you have some savings, but it’s still just a fraction of what you would have by doing just a few things differently. As long as you have the extra cash to sock away in the first place—and if you are at least 10 to 20 years away from retirement—there are far better things to do with that cash than put it into a savings account if you want to create wealth and financial security. Here are a few things you could do.

1. Buy a home. The tax write off for the interest paid on the mortgage is still one of the best available to most salaried employees. Get the lowest interest you can on a 30-year fixed-rate mortgage and never make more than the minimum monthly payments. Why? Because you should use any extra cash you have for investments that you will actually benefit from, whereas, if you just put extra money into paying off your house, you lose out in at least three different ways: (1) the extra money you pay goes to the principal and not the interest so that extra payment is not tax deductible; (2) if you move before you pay off the mortgage, you haven’t really gained anything because the buyer simply pays the bank and, depending on how much you paid the bank, you get whatever’s left; and (3) if you do pay off the entire mortgage a few years early, you will have your house free and clear—but usually little or no money for anything else, including repairs or retirement!

2. Contribute the maximum allowed to your 401(k). These are pre-tax dollars so they give you more investment bang for your buck in three ways: (1) your pre-tax dollars are worth more than your after-tax dollars, so you are actually investing more money into whichever accounts you choose; hence, you stand to earn more from it, which, in turn, means more money gets reinvested, and so on; (2) it doesn’t cost you a penny in fees or other charges that you normally would have to pay if you invested in the very same mutual funds with your after-tax dollars; and (3) any employer contribution—if you are lucky enough to get it—is free money!

a. Dollar Cost Averaging

Spread out your contributions into as many payments as allowed to take full advantage of dollar cost averaging. This automatically decreases your overall risk by ensuring that the same amount of money buys less stocks when the prices are high and more when the prices are low. Over time you will have more stocks at a lower cost to you. The longer you do this, the better your bottom line will be.

b. Pick Your Mutual Fund Based on Your Retirement Age

Pick the mutual fund that is most aggressive (100% high-growth stocks) if you still have at least 20 years till retirement (if you can handle more risk, 10 years is good enough). Pick the mutual fund that is medium risk (1/3 high-growth stocks, 1/3 medium-risk stocks and bonds, 1/3 safe bonds) if you have only 10 years left till retirement. And, pick the safest mutual fund (mostly safe bonds) if you have less than 10 years till retirement (if you can handle more risk, 5 years is good enough). Obviously, as you grow older, you need to switch your investment allocations accordingly. But, otherwise, leave it alone. Your money can’t grow if you don’t leave it alone. Never, ever take it out unless it is your absolute last resort in a true, dire emergency! You can never make up for the lost investment growth if you do.

c. The Magic of Compound Interest

The same principle that makes your credit cards almost impossible to pay off also makes your 401(k) grow like gangbusters. It’s called compound interest, and it does seem like magic unless you understand how it increases balances by repeatedly adding interest upon interest. For a great explanation of how it works and how even the poorest among us can benefit from taking advantage of it, click here.

For more information on how to build wealth from moderate incomes, I highly recommend Ordinary People, Extraordinary Wealth: The 8 Secrets of How 5,000 Ordinary Americans Became Successful Investors and How You Can Too.

FUTURE MADE OF BRICKS

A future made of bricks is one based on as much passive, low-taxed or deferred-tax income as possible, preferably more than 50% of your total annual income, but, ideally as much as 80%. Passive income is the money that your investments make for you without your having to do much work to keep earning it. Examples of these are real estate, intellectual property, a stake in other people’s businesses, such as stocks, and anything else that can be bought and sold that tend to go up in value.

Just as the last little pig worked harder and longer to build his house of bricks, if you want to build your future from bricks, you will need to be disciplined because it requires you to be frugal enough to go without most of life’s luxuries even when you can afford all of them. Because you will be taking all the money that you can spare and spending it, not on you but, on your future financial well-being. You are going to take every hard-earned dollar that you can spare and invest it in something you know a lot about. You will know a lot about it because you will have done a lot of research first. You know every investment is risky, and to make money you have to invest money, but you wisely do all you can to lower those risks. You don’t trust what people tell you about how great an investment is. You always do the research yourself, including checking out all property, products, and services for yourself.

If you can work for yourself, you do that instead of working for someone else—not because you want to “be your own boss” but because there are tremendous tax benefits if you own a business, whether as a sole proprietor or as a corporation. But, you check with a good business lawyer, accountant, and financial planner first before you get started on any of this because you know they are the experts who know how your decisions and actions, every step of the way, can affect your future tax burden. The few thousands of dollars you spend on their advice early on will save you hundreds of thousands, maybe millions, down the road. And, you work hard at your business. When it starts to take off, you don’t “reward” yourself with a new car, a new house, or, even, a big party. You keep your nose to the grindstone and realize that there will be lean time as well as green times ahead. You save and plan for those lean times. And, when you have those green times, you invest more, always cautiously. But, in the end, if you want to keep the Big Bag Wolf out of your wealth, you can’t touch hardly any of it. That’s how taxes get you. If you take the cash out of the tax-deferred or low-tax investments, the government gets a huge chunk out of it first. Then, when you go to buy something, especially luxury items, the government takes another big chunk out of it.

So, why go to all that trouble if you can’t hardly touch it? It’s there if and when you really need it. For medical emergencies. For your retirement. For your grandchildren and greatgrandchildren. For your favorite charities. For security.

For more information about how to build your future out of bricks, read The Millionaire Next Door: The Surprising Secrets of America’s Wealthy.

CONCLUSION

I don’t know about you, but the older I get, the more I value the dream of financial security above the short-lived thrill of the finest luxuries. Money, for all the evil that it’s supposed to embody, sure has the power to give a lot of peace of mind. I’ve never known what that feels like, though I’ve been in the finest hotels, worn the most stunning outfits, and dined on outrageously expensive food and wine.

What a price I paid for that fleeting false sense of riches! See “How I Paid of $50,000 of Debt in One Year.” I could have had financial security by now. But, it’s not too late for me—or for you! I am following the last little pig’s plan. And you?

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