How to get rich

I regularly teach an undergraduate finance class at university, and I spend the first few weeks of lectures on personal finance. In this article, I provide some tips for getting rich. I learned these tips from reading countless books and articles on personal finance as well as making economic decisions such as consumption, saving, and investment over a few decades. I believe that for most people living in developed countries, getting rich (say, becoming a millionaire) is not particularly difficult. You don’t need special skills or luck. However, you do need a lot of discipline, which explains why not everybody is rich.

Getting started

Let me first explain what I mean by being “rich”. I use “rich” synonymously to “wealthy” (having a high net worth). Of course, there is no objective wealth level that defines being wealthy. What I mean by someone being wealthy is that the person is able to live comfortably without working or relying on family members or the government. In other words, being wealthy simply means being financially independent, and I am assuming that is our objective.

To become rich, we need to understand a few equations. One of them is the budget constraint, which looks like \[ W’=R(W+Y-C-T).\] Here, \(W\) is your current wealth, \(Y\) is your current income, \(C\) is your current consumption, \(T\) is your current tax bill, \(R\) is the gross return on savings, and \(W’\) is your wealth next period. Looking at the budget constraint, we see that there are only five ways to become rich.

1. Start rich (high \(W\))
2. Increase income (high \(Y\))
3. Reduce consumption (low \(C\))
4. Reduce taxes (low \(T\))
5. Earn a high return on savings (high \(R\))

I will not discuss how to start rich, because you cannot choose your parents and it is not easy to marry somebody rich. I also do not discuss how to increase income, because I don’t know how to do it other than working hard, which is obvious. (However, you may want to look at some data before deciding college major.) My tips discussed below falls into one of the remaining categories.

Avoid high-interest debt

Taking a high-interest loan such as credit card debt is one of the most stupid things you can do. As I discuss below, historically, you can expect to earn an annual return of 6% on investment. Credit cards often charge more than 20% interest, which eclipses the gains from investments. Therefore, you should never take a high-interest loan. If you already have one, you need to pay it down first. If you can’t manage your finances without taking a high-interest loan, it just means your lifestyle is wrong.

Pay attention to mortgage rates and refinance if necessary

Most people buy houses with 15- or 30-year mortgages. Because the amount borrowed is typically substantial, even reducing the mortgage interest rate by 0.5% will make a big difference. Pay attention to the long term interest rate and consider refinancing when the rates are sufficiently low. When refinancing, consider choosing a shorter term (say 15-year instead of 30-year) because the interest rate tends to be lower.

Optimize credit card usage

Although you should never take credit card debt, that does not mean you should not use credit cards. To the contrary, credit cards are useful for accumulating points and deferring payment interest-free by one month. Different cards provide different benefits, so it is important to choose which cards to use. See here for what I do, though it may not be for everybody.

Stay away from big houses

I must admit, when I drive my kids to their friends’ homes and see a big, nice house with a big yard, I feel some envy. However, real estates are bad investments because you need to pay property taxes, they are not liquid (you can’t easily buy or sell when you want and transaction costs are high), and you need to pay maintenance costs such as insurance, air conditioning, landscaping, home owner association fees, etc. Even without those costs, with a big house you have more furniture to buy and space to clean. Just be happy with the space and quality you need and don’t go for more than that.

Recall that most real estate agents or property management companies don’t own many properties themselves. They know that it is more profitable to charge home owners transaction fees or management fees than investing in real estate on their own.

Own as few cars as possible

Just as real estates, cars are also bad investments. Car dealers often say “investment” but it is really consumption. Furthermore, as long as you own a car, you need to pay property taxes, insurance, gas, maintenance costs, parking, etc., and the car also depreciates.

Eat out strategically

Never order drinks when you eat out unless your host covers it for you. When I pay myself, I just order tap water if it is safe to drink. (In some European countries like Germany, if you just say “water”, they will bring bottled water that costs a few euros. Do your research in advance how to order “tap water”.)

I like to drink coffee, but I usually drink coffee at home. Sometimes I go to Starbucks, but it is not for drinking coffee but to have a place to sit down with wifi.

I like to drink beer, but I usually drink beer at home. There are a few exceptions, though. When I travel, it is fun to try local beer in a pub. When I go to the burger place Chicago Fire Grill at University City, I often have a beer because they are ridiculously cheap ($2).

When you choose a restaurant, think about your purpose. Is it to have a nice meal with family and friends, or is it to just satisfy your hunger? If the purpose is to have a nice meal, and if you can afford it, you can choose whatever you want. But sometimes we need to eat out just because you are hungry, for instance during a road trip. In those cases, one of my top choices is to go to the Costco food court, where you can feed a family with less than $10 by buying their $1.5 hotdog. It’s far cheaper than going to, say, McDonald’s. Another option is to buy the $4.99 rotisserie chicken at Costco and eat it at a park or the hotel room. When I go to Atlanta, I try to eat at either the airport lounge (free) or the Emory dining hall ($11.5 all-you-can-eat with the meal plan).

When you eat out with friends or coworkers, volunteer to pay the bill and ask the others to reimburse you in cash or Venmo. That way, you can accumulate more credit card points and defer the payment by one month.

If possible, avoid rideshare

Uber and Lyft are convenient but expensive. Before you travel, do a bit of research whether public transportation is available. My sample is limited, but for Atlanta and Washington, D.C., taking the train from the airport is quite cheap and convenient. Emory gives a free MARTA pass to faculty members not requiring parking (see here), so when I go to Atlanta, I just ride the train and bus to get around, which is fun.

Embrace a minimalist lifestyle

In my opinion, you don’t need that much money to have a decent lifestyle. For instance, to play tennis at the time you want, you need a club membership and equipments (racquet, strings, shoes, balls, etc.), which will likely cost no more than $1000 per year. It’s easy to spend ten times of that by having a membership at a fancy club with showers and a gym or by taking lessons, but I would rather save the difference of $9000. (My club just has courts but my family can reserve courts pretty much any time for $550 per year; I used to take lessons but I no longer do because I realized I don’t have time or talent.) The same applies to living in a small house versus a mansion, flying economy class versus business class, or watching Youtube videos versus going to cinema.

Avoid paying taxes as much as possible

Tax avoidance is different from tax evasion. Both seek to pay less tax, but avoidance is legal, while evasion is illegal. Do your research on tax avoidance. I have already written on this subject here. There are many things you can do to save taxes, such as

• invest in a health savings account (HSA) to pay for healthcare bills,
• invest in Roth IRA accounts,
• live in a smaller house to save on property taxes,
• own fewer cars to save on property taxes,
• avoid living in high-tax states such as California, Hawaii, and New York,
• donate stocks with capital gains to charity instead of cash,

and so on. My impression is that, the more complex the tax code is, the more loopholes there are, and the more homework pays off.

Invest in stock market index funds

According to the mutual fund theorem, under some assumptions, investors just need one mutual fund and a risk-free asset to achieve their preferred portfolio. But every stock needs to be owned by somebody, so market clearing (demand equals supply) forces that that one mutual fund must be the stock market index. Of course, there are many assumptions to this result (which I teach to students), but as a first approximation, I think most people should just invest in the index fund (say, Vanguard’s Total Stock Market Index Fund but there are many alternatives), forget about it, and do whatever they want with their life. That’s what I do with my investments (though I own both U.S. and ex-U.S. index funds). In theory, risk tolerant investors can borrow to invest in stocks, but that is not practical because the interest rate would be too high. Similarly, risk averse investors may want to invest more in bonds. This is just my opinion, but I don’t think you need any bonds in your portfolio if you are working because the present value of your future income is already like a bond investment. Furthermore, bonds are nominal assets that get eaten by inflation, coupons are taxed at ordinary income tax rate, which is not efficient, and above all, you can’t trust the government. So, my portfolio is pretty simple: other than my house, mortgage, and cash to cover monthly expenses, I invest everything in stock index funds, and I tell my kids to do the same.

Index funds are boring, but they are also amazing. In ordinary activities, like studying, doing research, or playing tennis, if you don’t put any effort, you will be pretty bad. But the amazing thing of index fund investment is that you get the average return of the economy with zero effort. All the hard work is done by the managers and employees of firms that create value, and all you need to do is to own the stocks to get paid the capital gains and dividends. I view index funds as one of the greatest inventions of the 20th century. Historically, the average return has been 6% per year after adjusting for inflation and volatility. This is why I claim that it is easy to become rich. Imagine that starting at age 20, you open a Roth IRA account, contribute to the max (assume $7000 per year, which is the current IRA contribution limit), and invest in an index fund that yields 6% real return per year. Then after 40 years, your investment grows to \[ 7000\times(1.06+1.06^2+\dotsc+1.06^{40})=7000\times \frac{1.06-1.06^{41}}{1-1.06}=1,148,334,\] so you are a millionaire. Invest a bit more or longer, and you can be a multi-millionaire. This is the power of compound intrest: in this example, even though you have invested only \(7000 \times 40=280,000\), due to compounding, investment becomes significantly larger. One of my favorite books on personal finance, The Richest Man in Babylon, explains compound intererest as “Learn to make your treasure work for you. Make it your slave. Make its children and its children’s children work for you.”

Conclusion

You don’t really need a high income to be rich. You don’t need special skills or luck either. The difficulty of becoming rich is that you need a lot of discipline: you need to resist temptations, establish wise spending habits, avoid paying unnecessary taxes, and consistently invest in a stock market index fund. The reason why most people are not rich is simply because they lack discipline: they either don’t save enough or don’t know how to invest.