“You have to spend money to make money.”
“The best way to get rich is to use your money to make money.”
How familiar are these phrases? If you’re like most of us, you’ve heard them over and over again as you’ve attempted to build your businesses, pay down your debts, fund your retirements, etc. These phrases are nice, but what do they really mean? How does money make more money?
First: A Story
Melanie, a character we’ve made up for this article, has an average income. She pays her bills on time, she’s paying down her debt and she’s ready to start investing for the future. So, after learning the basics of how investments work she decides to buy into some small company stocks. To her shock and happiness, those stocks do incredibly well and after six months she has tripled her initial investment. What should she do?
The Easy Route
Maybe you think that she should take some of that windfall and use it to pay off her debts. Or maybe you think that she should use it to purchase something awesome for herself, like a vacation or a new car. Neither of these is the best plan. Sure they give you an initial burst of happiness, but that happiness has a short shelf life.
Yes, you could argue that if she uses the windfall to dramatically reduce her debt she could take the money she had been paying toward her bills and invest that, but here’s the problem with this method: what she spends each month on bills doesn’t equal the amount of money she has earned via her stock profits. It would take many months to re-invest what she’d used on her debts.
The best thing Melanie can do is take the profit from her initial investment and reinvest it. This is something every mentor, every book you read, every finance teacher will tell you. If you want your money to earn more money, you need to keep investing it. Use your initial profits to fund new investments. Use those profits to fund more investments or to beef up the current residents of your portfolio.
Why is this the best route when it is so much harder to do?
This is the best way to go because it allows you to make better and more profitable investments. Take our rental investment for example. Instead of just using the rental income for fun stuff every month, we’re stowing it away to buy more rental properties. This will result in more equity and income all at the same time.
Sure getting a windfall from a small investment is awesome. But if you spend that profit, you’ll only ever have that initial small investment working for you. By investing the profit, you aren’t spending any more of your earnings to keep investing. Your budget stays the same but your investment portfolio grows. The bigger and more diverse your portfolio, the higher your net worth and the better your chances of a solvent retirement.
Real World Budget Investing
This is all fine and good, but how do you apply this advice to your own life? As an example, maybe start with some basic investments that present little risk, like bonds. After a year you’ll have your initial investment as well as whatever interest the bond has earned. Re-up your bond with your initial investment and use the interest to buy another bond. Use the profit from both to invest in some small business stocks. As those increase in value, use the profit to buy stock in large companies. Eventually you might roll some of your profit over into real estate or buy into a mutual fund. Work with your financial advisor to figure out which path is right for you.
If it helps, think of it this way:
Your initial investment is the money you spend to make more money.
Using the profits from that initial investment to make better investments is how your money makes more money. (If you constantly have to spend money on your investments, you need a new investment strategy.)
Yes, investing your profits feels boring. It isn’t nearly as exciting as a flashy vacation, a new car, etc. Even so, it is what is best for your long term. Happy investing everyone!
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.