Step 1. Time: There is really no shortcut to getting rich. The sooner you begin saving and investing (steps # 2 and 3 below), the faster you get there. If you cannot begin soon enough, retire late – the idea is to give your money enough time to grow.

Step 2. Save: Money does not grow out of a vacuum. You need to start somewhere, and the more you save – by cutting spending, or increasing income, or both – the better.

Step 3. Invest: Locking away your money in a vault will lose its purchasing power to inflation over time. Putting it in a low-interest bank account is not enough either. You should have a smart investment plan, so the interest you earn outpaces inflation.

This just restates one of the most basic formulas of investing, as shown here. “S” is the money you have today, which comes from your saving (step #2). “I” is the annual interest your investing earns you (step #3), which must exceed inflation that typically averages 2.3%. “T” is the time in years (step #1). Raising any one of these three, preferably all of them together, will get you that first million dollars quicker.

Read the CNN Money article here.

An interest rate is the monthly rate you pay as a borrower, or receive as a creditor/lender. If you save money in bank, or invest in a money market, you are indirectly lending money to a borrowing corporation (or the government). If the interest rate goes up, the borrower must pay you more, which makes them unhappy but you happy (your bank balance soars). The mood swings the other way when interest rate goes down.

Here we are talking about a real interest rate, which is the rate after adjusting for inflation. So, for the purpose of this topic, just assume inflation does not exist (hard, I know, given the reality, but it simplifies our discussion).

Demand and supply influence the real interest rate

There are almost as many different types of interest rates as the investing and borrowing choices available to us (your bank pays you one rate, and you pay another rate to your credit card company). But they all respond to three fundamental market forces: supply of funds, demand for funds, and occasional government interventions.

Households supply funds via their invested assets, whereas corporations and the government borrow these funds to finance their needs (see this post on the interaction between investors and borrowers). This dynamics of supply and demand determine how all these different rates arise. It is easy to think in terms of a single abstract rate, as the picture below illustrates, which plots real interest rate against available fund.

The supply curve (solid blue graph) goes up from left to right, because with increasing interest rate the households save and invest more. By contrast, the demand curve (solid red graph) falls as more fund is available. The intersection of these two curves, point A, determines the equilibrium real interest rate.

Now suppose there is an increase in the budget deficit, which will raise the government’s borrowing demand. This pushes the demand curve to the right (dashed red graph), and lifts the interest rate to point B, which in turn may discourage businesses from further borrowing and slow the economy down. The government may then intervene by releasing more fund from the central bank (Federal Reserve). This action pushes the supply curve to right (dashed blue graph), and brings the interest rate down (to point C).

So, again, the fundamental market forces that set the interest rate, and run the investing world, are the demand and supply of funds.

You have bought a 1-year CD for $10,000 at 5% interest rate. After one year you collect $10,500 – a gain of $500. What is your real gain? This depends on what $10,000 can buy one year later, compared to what it does now.

Inflation, the rate at which the prices of goods and services grow with time, will reduce the purchasing power of your original $10,000 investment after one year. Changes in the consumer price index, or CPI (computed as the average price of consumer items purchased by a typical urban family of four), is the standard measure of inflation .

At the current annual inflation rate of 2.5%, you will pay $10,250 after a year to maintain the purchasing power of $10,000 today. So, in effect, what you really gain is $250 (=$10,500-$10,250). In other words, your real interest rate, which defines the growth of your purchasing power, is 5 – 2.5 = 2.5%. The original 5% is the nominal interest rate, which determines the growth of your asset.

Suppose the real and nominal interest rates are r and R, and i is the inflation rate. If the invested amount is a, then the nominal increase after one year should equal the real increase multiplied by inflation. That is, a(1 + R) = a(1 + r)(1 + i), which gives r = (R – i)/(1 + i). When i is much smaller than 1 (like in our example, where 0.025 << 1), we have the approximate relationship

r = R – i.

This is a formal way to present our example. So, higher the inflation, less is the real gain from a fixed-income type investment. Interest rates offered by both the money market and bond market securities are only nominal rate, which you should keep in mind while estimating your asset growth.

Go on to what determines the real interest rate.

There are two things that make inflation so invisible. First, it reduces the purchasing power of your asset, not its absolute amount. Red flags do not usually go up if there is no actual drop in the asset value. Second, inflation works slow. The longer you invest, the bigger is its bite on your asset. Because things do not move fast, we cannot see it early enough.

Take an example. It is generally suggested that you will need between 70 and 80% of your current paycheck to live as comfortably after retirement. So, if you earn $80,000 a year today, in order to sustain your current lifestyle after retirement, you will spend about $60,000 a year then. (On the good side, your mortgages may be paid off, kids may be out of college so no tuition cost, social security and Medicare benefits will kick in. On the bad side, medical expenses may hit the roof, among other things.)

How does inflation figure in this estimate? It does not. Assuming you have 20 more years to retire, and a fixed yearly 3% inflation during this time, what $60,000 can buy today will cost you $108,370 (=60000×1.03²⁰) then! So, you will in fact need 135% of your current salary to maintain the same buying power after 20 years.

What if you retire after 10 years, instead of 20? At the same 3% rate of inflation, you will need $80,635 a year then, about the same as you earn today. So, the longer the wait, bigger is the impact of inflation. Money Magazine has recently discussed these issues in this article.

1. Ridgewells Diner (Bethesda, MD) serving 40 people: Now costs $9795 – up 31% from last year.
2. Lenox, Williamsburg Shell pattern silverware, 4-piece place setting for 12: Now costs $6960 – up 28% from last year.
3. Natural Russian sable coat, Maximilian at Bloomingdale’s: Now costs $225,000 – up 18% from last year.
4. Nautor’s Swan 70 sailing yacht: Now costs $4,771,550 – up 17% from last year.
5. American Academy of Facial Plastic and Reconstructive Surgery: Now costs $17,000 – up 17% from last year.
6. Men’s black calf wingtip shoes, custom-mad, John Lobb, London: Now costs $4566 – up 11% from last year.

Not that I am worried about such a list (hey, if I want a boat ride, I’ll get myself a $20 ticket to one of those “sea screamers” down in Florida, rather than pay $4,771,550 for a yacht).

Do you think the ultra-rich will zip up their money-belt now? Hardly so – their earning grows at way more than 6%, whereas our salary barely keeps up with inflation.

The short answer to this question is that we should invest to be able to shift our purchasing power from the high earning phase of our life to the low earning phase. Many of us earn more than we need to spend in our working life (note the italic – some of us spend more on our wants rather than our needs). It is the exact opposite when we retire – we spend more on our needs than we earn. Therefore, we must have adequate funds available when we retire to live out the rest of our life.

It used to be easy before. Most employers offered pension schemes that guaranteed a steady paycheck for their ex-workers as long as they lived. This concept has almost become a thing of the past. Instead employers today offer various “retirement plans” that encourage workers to sock away a portion of their payment for the future. In short, the burden of supporting yourself in retirement has shifted from your boss to you.

The primary objective of investing is then to have a reasonably comfortable life after retirement. (Increased longevity extends our retired life, not the working life. With the average life expectancy of 78 years in America today, we are talking of almost 20 years in the sunset, and even longer for some.) One way to achieve this goal is to store the “excess fund” during our working period as financial assets, such as stocks and bonds. After retirement, we sell these assets to meet our consumption needs.

We are talking of shifting the purchasing power of money, not the money itself. With inflation steadily eroding the value of a financial asset with time, a dollar 30 years later will buy a lot less than it can buy today (I bet you won’t begin your breakfast with a 99¢ cheese burger then.) So, our asset must at least grow apace with inflation just to preserve its purchasing power. (From the recent CPI data, this means the return of our investment should be at least 2.5%.)

Merely compensating for inflation is not enough, though. Remember that our paycheck reduces drastically after retirement (it vanishes altogether for most). We must have enough assets accumulated by that time to be able to steadily draw out from them for many more years, without facing the risk of outlasting them. So, the derivative goal of investing is to implement a strategy of growing our asset as fast as the prevailing market conditions allow.

I have used the words “asset” and “financial asset” a few times here. In the next post, we will see what they really mean.

1. Rising oil prices. High energy cost triggers fear of inflation, and Federal Bank typically counters by raising short-term interest rates, which deflates stock prices. Oil price has soared 20% so far this year.
2. Rising Treasury yields. As the yield of 10-year Treasury notes rises sharply, investors often turn away from stocks in favor of the security of notes and bonds. The yield has not changed much this year yet.
3. Falling number of growing stocks. If the broad indexes are being pulled up by only a few large company stocks, while others are falling around them like ninepins, that cannot be a good sign. Over the last few weeks, almost four times as many stocks hit 52-week lows as highs.
4. Falling consumer spending. If we buy less, it stands to reason that the product-oriented industry will suffer. Retail sales dropped almost 1% in June, and the continuing housing market crunch can force consumers tighten their money-belt even further.
5. Falling corporate earning growth. If corporate earning slows, the market will slow down as well. Low productivity growth, inflation fears, high long-term interest – all of them dissuade companies from borrowing money. We won’t know till 2007 earning reports are out.

In short, we do not know. Even though this type of analysis is better than those based on charts alone (the so called “trend analysis”), predicting the future based on past events is still notoriously difficult, if not impossible. The only certainty about the market is in its past, a classic example of “hindsight being the perfect science”.

Now you know why I do not like paying extra thousands of dollars for a new car, when a reliable used care can do just as fine. Looking at the larger picture, the used car industry in America is twice the size of the new car industry in terms of the number of vehicles sold each year. Most of these buyers choose a used car because of budgetary reasons. For those of you who can easily afford a new car, I am going to argue in the next couple of posts that it still makes better investing and practical sense to own a used car instead.

If you already made up your mind to buy a new car no matter what, here is a short list of some excellent resources that will hold your hand through the process step-by-step. For the rest of you, picking the right used car demands some time. (We often spend a week planning a $200 vacation; we can surely spare a weekend researching a $10,000 car.) This guide will hopefully make the process easy and relatively painless. It is divided in the following eight posts, and I recommend reading them in sequence (at least from step #3):

1. A close look at car depreciation.
2. Why should I buy a used car?
3. Picking a budget.
4. Making a list.
5. Researching your car.
6. Checking the car out.
7. Wrapping it up.
8. A note on extended warranty.

Let us begin by taking a close look at car depreciation »