What does it mean to “pay yourself first”? How much of your income should you invest? Where should you invest it?
If you want to become financially successful, the most important step you can take is to invest money from every paycheck. That’s the view of David Chilton in his book The Wealthy Barber. When you invest and leave it alone, compound interest will ensure the long-term growth of your assets. Chilton recommends a couple of types of investments that he prefers over savings in the bank.
Keep reading to learn Chilton’s advice on what you should invest in and how much you should invest.
Investing for Long-Term Growth
How much of your income should you invest? Chilton recommends 10%. This means taking 10% off the top of your paycheck as soon as you get paid (before you have a chance to spend it!). Chilton says you should invest that money in index funds or mutual funds, then leave it alone so it has a chance to grow by virtue of what some have called “the most powerful force in the universe”—compound interest.
|What Is Compound Interest, and How Does It Work?|
Although Chilton extolls the virtues of compound interest, he never actually defines it. Compound interest is essentially interest earned on interest. For example, if you invest $100 and it earns 10% interest every year, you’d have $110 at the end of the first year. By the end of the second year, you’d have $121—because in addition to earning $10 on the initial $100, you also earned $1 on the $10 in interest. Over many years, this compound growth adds up, as your money continues to make more money.
Through the “magic” of compound interest, if you invest $500 a month, with a 10% average rate of return, your portfolio will be worth $1.14 million after 30 years. And as Chilton points out, because you’re investing a percentage of your income, as your wages rise over time, the amount you’re investing also increases.
Inflation may put a damper on the power of compound growth, but the fact that prices will rise is all the more reason to save. If you invest your savings wisely, the rate at which your money grows should exceed the inflation rate.
Chilton explains that it’s much more profitable to invest in stocks than it is to leave your money in the bank. In the former scenario, you own your investments, while in the latter, you are loaning your money to the bank. You’ll get higher average rates of return in the long run if you’re an owner, not a loaner.
Nonetheless, it’s not a good idea to purchase common stock on your own or through a stockbroker. Stockbrokers are salespeople, not investment advisers. In addition, most people don’t have enough money or knowledge to properly diversify their portfolio. This is why Chilton recommends investing in mutual funds or index funds, which don’t require you to have any special investment expertise.
(Shortform note: To encapsulate his advice that you should save 10% off the top of your paycheck, Chilton uses the phrase, “Pay yourself first.” While some have credited him with originating this concept, it was likely first articulated in George S. Clason’s classic 1926 book, The Richest Man in Babylon. In fact, The Wealthy Barber and The Richest Man in Babylon share a number of financial lessons, including the advice that you invest your 10% savings to take advantage of compound interest, that you plan ahead for retirement, and that you live within your means. However, Chilton disagrees with Clason’s prescriptions that you should own your own home and make use of careful budgeting as the best way to control your spending.)