Choose investments that keep your risks low and your profits high

If you get up early and make good use of your time, you will have a higher-than-average income. If you commit to saving a significant portion of that extra income and check your net worth every month, your net worth will grow quickly. How quickly depends on three things:

1. how much you invest

2. how long you keep it invested

3. what rate of return you can get

The traditional idea about investment returns is that the more you want to earn the more risk you have to take. Today, I’d like to talk about how to get a higher-than-average return with much-less-than-typical risk.

Let’s start by assuming that you begin a 20-year wealth accumulation program with monthly savings of $1,000. Saving $12,000 a year should not be a problem for you even if you are starting out. It’s just a matter of doing what I told you to do yesterday.

Let’s make another assumption. Let’s figure that by working hard and smart you are able to increase that $12,000 by $3,000 a year. That is well within the reach of anyone committed to wealth building.

And finally, let’s assume you are 45 years old and have 20 years of income-producing years in your future. (If you are younger than that, the numbers I’ll show you will turn out to be much, much more favorable.)

Over a 20-year time period, putting away the savings mentioned above, the total “extra” income you’ll have socked away will be about $800,000. That’s not bad. It shows you the power of consistent savings.

Now let me show you the power of boosting your savable income. Let’s assume, again, that you started by saving $12,000 a year. But instead of increasing that amount by $3,000 a year, let’s say you add $6,000 — a modest $500 a month. In that situation, your accumulated savings will amount to about $1.4 million.

But let’s say you do better than that. Let’s imagine that your financially valuable skill allows you to increase the amount of money you can save each year by $12,000 ($12,000 the first year, $24,000 the second year, etc.). In that case, your 20-year saving spree will total $2,520,000.

Two-and-a-half million dollars is a lot of money. It would put you among the solidly wealthy. Not revoltingly rich, but financially independent.

You can definitely do that well by sticking to a straight money-building program. But the numbers we’ve cited so far do not include the effect of compound interest. They show what you’d get if you hid all that extra money in your mattress.

If you put all that extra money in the bank and earn an average of 3% interest over time, you’d have about twice the amounts cited above. If you could do better than that — say, 5% — you’d end up with four times that much. 7% would give you about five times that much. And 10% would give you about six times that much, or between $5 million and $15 million.

This demonstrates something you already know: If you can get your return on investment (ROI) up into the double digits and keep it there, you can get rich — even very rich,

It’s not easy to get 10% over time, but I believe it can be done if you invest in businesses you know.

Start by dividing your assets into four categories:

1. your home

2. secured loans

3. passive investments

4. active investments

You know what “your home” means. “Secured loans” include Treasury bonds, municipal bonds, mortgages (that you give, not take), and highly collateralized private loans. “Passive investments” cover the kind of things that most people think of when they think of investing. This includes individual stocks, mutual funds, options, futures, etc. The final category, “active investments,” identifies any investment you make in a business in which you play an active, often controlling, role.

Because I’m a strong believer in “diversified” investing (balancing your investments so that you don’t have too much money in any one area), I make it a personal habit to try to have a substantial amount of money in each of these four categories. In fact, if you want my recommendation, I’d say you should have no less than 10% and no more than 40% of your money in each category. For planning purposes, you might want to start off with the idea that you’ll have equal value in each category.

For each of these categories, you need to reduce your risk and increase your potential return. The way to do this is the same for all four categories: Invest in what you know and keep learning about what you are investing in.

Let’s see how this applies to your home. To be sure that your home appreciates in value, don’t buy a house until you really know the local real estate market. Spend the time you need to scout around, to speak to people, to watch what’s going on. When you are confident you know the good neighborhoods, the up-and-comers, and the overvalued properties, do what the real estate pros recommend: Buy a modestly priced house in an good or up-and-coming neighborhood. (We’ll talk more about this tomorrow.)

The next category — secured loans — is an important but usually overlooked part of any wealth builder’s investment portfolio. Secured loans are wonderful because they pay a decent rate of return — higher than bank savings accounts — with virtually no more risk. To make things simple, I recommend tax-free municipal bonds. If you go for the safe ones — triple A — you’ll get about 4.75% return today. That equates to about 7% to 8% before taxes.

Next, you’ll want money in the stock market. For reasons I’ll tell you about later, I recommend that you select a balanced mutual fund that is meant to “track” the Dow Jones Industrials. Don’t mess around picking individual stocks or timing your investments (pulling them in and out of the market depending on economic conditions and other factors). Just put your money in and let it enjoy the historic 9% return stocks have given investors for 70 years.

You can expect your home to appreciate at least 5% a year — twice that much if you’ve done your homework and have gotten to know your local real estate market. You’ll get about 7% on your muni bonds (before taxes) and 9% from your mutual funds. That means that three-quarters of your wealth probably will be appreciating at an average of 7.5%

Figuring that rate of return into each of the savings levels we talked about before, here’s how your 20-year nest egg would grow:

• If you start with $12,000 a year, increase it each year by $3,000, and get a 7.5% return on 75% of your investments: You’d have about $1.5 million.

• If you start with $12,000, increase it by $6,000 a year, and get a 7.5% return on 75% of your investments: You’d have about $2.5 million.

• If you start with $12,000 and increase it by $12,000 a year with a 7.5% return on 75% of your investments: You’d have between $8 million and $10 million.

What that means is that 75% of your savings will give you a 20-year net worth that will be higher than what you would have had if you had simply hidden your money away — and yet your risk would have been just as low. (Remember, hidden money can be stolen.)

What you do with the other 25% of your savings (the subject of tomorrow’s message) can make the difference between being financially comfortable, enviably wealthy, and disgustingly rich.

[Ed. Note.  Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]