Wealth Extractions: Investing a lot with a little

In our “Wealth Extractions: Taking inventory of your investments,” I addressed the importance of starting to save as early as possible, even as you establish your career. Like encouraging your patients to practice good dental hygiene from the beginning, early savings help prevent “wealth decay” over the long haul. Once saved, you also want to put those savings to work by investing in ways that generate interest and dividends, then allowing the proceeds to reinvest and reinvest again until, voila, you’ve built some real wealth. But there’s a paradox. You know the old saying, “It takes money to make money”? Well, sayings don’t become popular unless there are grains (or boulders) of truth to them. Like it or not, the more wealth you’ve got, the easier it is to build more. Economies of scale increase, which can translate to decreased costs. Plus, you expand your ability to fully apply the tenets of efficient investing. (Of course, you also expand your opportunities to blow it on spectacularly unsound investments. But I digress.) So, how do you take relatively modest savings and build future wealth? Invest according to a few timeless essentials, whether we’re talking $10,000 or $10 million:Plan If you haven’t clearly defined your financial goals, how will you know if you’re on track to achieve them? You should make plans for short-, mid-, and long-range milestones, and write them down. Take stock of your current financial circumstances, and write that down. Combined, you can better determine where you are today, where you want to go, and what it’s realistically going to take to get there. The documented results are what we refer to as an Investment Policy Statement — your financial treatment plan. Diversify Investments are expected to earn more than savings and inflation, but to do that you have to expose them to market risk, which is part and parcel of expected market rewards. One huge way you can manage that risk is to avoid piling all your chips into too few bets. Diversification is a key ingredient to help minimize (not eliminate) the risk involved. For true diversification, you’ll want to diversify across a wide spectrum of “asset classes,” which is a fancy way of saying 1) stocks and bonds, 2) safer and riskier stocks, and 3) worldwide. Control costs Many of the so-called gurus on Wall Street would like you to think otherwise, but after diversifying there’s actually not much more you need to know besides seeking out the most cost-effective solutions for getting the job done. According to the academic evidence on the subject, if you’re invested as efficiently as possible (via globally diversified asset allocation), any added costs aren’t expected to add value, rather, they simply take away from the wealth you would otherwise get to keep. Two key ways to control cost are as follows: Select low-cost investment vehicles — Among the lowest cost vehicles for achieving efficient diversification are index or index-like, no-load mutual funds that track various asset classes rather than trying to “beat” them. Also, don’t overlook the value of establishing your retirement funds within IRAs, SEPs, and SIMPLEs for added tax savings opportunities. Don’t get too fancy. It may seem counterintuitive, but when your assets are limited, you can actually achieve smarter, more efficient global diversification by investing in a single fund that specializes in tracking asset classes and reduces the cost of doing so, than if you invested in a dozen higher-cost funds or a bag full of individual stocks. (One example of such a fund is Dimensional Fund Advisor’s Global Equity Portfolio, DGEIX). Stay the course — Just as you don’t want the funds you’re invested in to try to outfox the market, you should avoid the costly mistake of trying to outguess the market by moving in and out during bears and bulls. To best capture the market’s long-term returns, simply stay the course according to your plan. (Remember that plan I mentioned above?) Congratulations! Simply by adhering to these simple tenets throughout your investment experience, you’re well on your way to being a financial expert. In my next Wealth Extractions, we’ll build from the platform of these themes, and introduce additional concepts you can apply as your wealth accumulates. None of the essentials change one bit. But greater wealth does begin to afford enhanced opportunities.Editor's Note: To read more of Werhan's "Wealth Extractions" series, please click here.