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.

Investing, on the other hand, is a different ballgame. It is based on deep scientific theories and strategies (a few Nobel Prizes have been given out on them), but the kind of science that impacts our everyday life. Investing in practice is about growing our financial asset with time, so that we have enough funds available for later years when we can no longer work for a living. This is something all of us must face, whether a seasoned investor or average Joe (like me).

Unfortunately, no school curriculum yet offers a mandatory course on finance and investing. We are on our own when it comes to learning how to manage our money. In this learning process (as in any other), it helps to know the basic concepts. In a series of posts over the next few days, I am putting together some of the most frequently used terms and concepts in finance and investing. Much of the material here is taken from the excellent textbook “Investments” (5^th ed.) by Bodie, Kane and Marcus. The list will grow as more posts are added:

1. Why should we invest?
2. What is an “asset”?
3. Players in an investing environment.
4. Banks, Investment companies and Investment banks.
5. What is a “market”?
6. What is a “security”?
7. What is a “money market”?
8. What is a “bond”?
9. What is a “stock”?
10. “Real” and “nominal” interest rates.
11. What determines the “real” interest rate?
12. Efficient Market Theory vs. Fundamental Analysis – Part I.
13. Efficient Market Theory vs. Fundamental Analysis – Part II.
14. …

We begin with Why should we invest?

69-year old Earl Crawley, while making $20,000 a year as a parking-lot attendant, still amassed over $500,000 in investment asset. His secret? Two, in fact. The first is his good old habit of saving every “nickel and dime”, and the second is his lack of investing knowledge, summed up in his quote that I borrowed above.

Saving and investing, in that order (you must save to invest), are the two essentials for building wealth slow and steady. Saving is common sense, and to people like Earl, almost an instinct. Investing, by contrast, requires some learning. But, knowledge plays a self-limiting role in our investing decision, which in turn affects investing performance.

The two fundamental things of investing are where to invest and how to invest. That is, the assets that make up our portfolio, and the proportions in which these assets are allocated. Unfortunately, there are as many different answers to these two questions, as there are books written about them. The more we know, the more confusing they get, and even drawing up the simplest asset mix can become a difficult task.

Keep it simple.

Solution? Keep it simple. Beyond the basics, knowing more does not help much. It is a bit like the picture here. At first, the return of your investment (solid blue graph) goes up with your knowledge level, but after you are past the basics, your return hits a “saturation point”. After this point, more knowledge causes information overload, and the payoff does not show a commensurate increase; in fact, the return can even decrease, depending on the specifics of your portfolio (in investing, more knowledge is not necessarily better knowledge).

Know the basics

What are these investing basics? There are four steps to it:

1. Depending on your risk tolerance, build a portfolio with the right proportions of risk-free (money market, treasury bills etc.) and risky (stocks and bonds) assets.
2. For your risky assets choose among those that do not move in lockstep with each other (for example, stocks+bonds, domestic+foreign stocks, etc). This way, you can spread out the risk of market downturns, and reduce its impact on the return of your portfolio.
3. Build your portfolio with manageable number of assets. Adding too many stocks and mutual funds is an example of information overload; if you do not understand them, you do not know their return potential, and your portfolio return itself can suffer.
4. Once you set up your portfolio, hold on to it. Do not tweak your asset mix each time the market does something unexpected. As I said in an earlier post, there is no get-rich-quick scheme in investing; a “buy and hold” strategy is the only way to smooth out short-term market fluctuations, and gain from the long-term economic growth.

Again, keep it simple. Earl does exactly that. He is open to suggestions and stock tips, but uses his own common sense and gut instinct to make decisions on which stock to buy. He is a self-made investor. Why can’t we all be like him?