4 Steps to Becoming a Millionaire

05/10/2011 12:16 pm EST

Focus: MARKETS

Roy Ward

Chief Analyst, Cabot Benjamin Graham Value Investor

Save early, invest wisely, and don’t let the market get you down, counsels J. Royden Ward, editor of Cabot Benjamin Graham Value Letter.

The American Association of Individual Investors (AAII) divides the investment life of an individual investor into four phases.

Starting Out
Phase 1 begins as soon as you become employed for the first time.

As soon as your income begins to exceed expenses, establish a cushion for emergencies. Your cushion will need to grow to the equivalent of six months of your income. You can fund your cushion by investing in no-risk vehicles, such as savings accounts at your bank or money-market funds at a brokerage firm.

One of the cornerstones of wealth building is being frugal. You should set reasonable savings goals and live below your means. Individuals gain financial independence by budgeting, controlling expenses, and saving a reasonable portion of their income.

When you have accumulated the equivalent of six months of your income—and if you haven't piled up a lot of debt—you are ready to move on to Phase 2. If your debts from college loans, car loans, credit cards, etc., are excessive, you will need to reduce your debt before moving on to Phase 2.

Phase 2 gets exciting. Any savings above your cushion can now be invested in mutual funds, exchange-traded funds (ETFs), stocks, or bonds.

Some advisors encourage investors to invest in mutual funds and ETFs first, and then stocks when your portfolio reaches certain levels. I recommend investing in whatever interests you the most, because you will probably be more motivated to learn about what appeals to you.

Building a Great Portfolio
Phase 2 is the most important step in your investment career. You need to establish a solid foundation of investments that you can build on in future years. I believe investing in a combination of ETFs and common stocks is a prudent approach for many new investors.

Your initial investments should be growth oriented, but conservative. I recommend low-risk companies with reasonably good growth prospects for the next five years.

The best route to financial independence is slowly accumulating wealth. Don't expect to double your money every year. According to AAII, the average annual return for common stocks is 10% to 12% per year during the past 85 years.

Nevertheless, an individual who invests $10,000 at the age of 27, adds $2,000 every year to his or her account for 35 years, and can average 11% annual returns (including dividends), will end up with a cool $1.069 million at age 62.

The following list includes a dozen companies that I believe will get you started in the right direction and provide a solid foundation for your investment portfolio. Invest approximately the same dollar amount in each stock.

  • Barrick Gold (ABX)
  • BlackRock (BLK)
  • Caterpillar (CAT)
  • Google (GOOG)
  • MasterCard (MA)
  • McDonald's (MCD)
  • PepsiCo (PEP)
  • Research in Motion (RIMM)
  • Stryker (SYK)
  • Teva Pharmaceuticals (TEVA)
  • TJX Companies (TJX)
  • Walgreen (WAG)

All of these companies pay dividends with the exception of Research in Motion and Google, which instead offer exceptional growth potential.

The list includes a diversified cross section of industry leaders, which is important because you will want to keep your risk low while you build for the future. Buying stocks in many different industries will reduce your risk.

Phase 3 begins after your initial investments start to show noticeable profits. Your initial stocks should be held for the long haul, unless the industry or the company falters badly.

NEXT: Follow Your Muse

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Follow Your Muse
Assuming you haven't accumulated a lot of debt, you are ready to start adding investments to your core portfolio. Stocks and ETFs are a good way to go, but mutual funds are also appropriate.

Rather than staying conservative, now is the time to start investing according to your personal preferences. If you are a gambler, invest aggressively, but not foolishly. If you are conservative, stay with low-risk stocks and mutual funds.

I advise adding stocks that are grossly undervalued and stocks with exceptional growth prospects. In addition, you might want to add to some of your smallest core holdings, but be sure that each company's outlook remains robust.

I also recommend offsetting your aggressive investments with bonds or defensive ETFs. You should be prepared to jettison risky stocks that underperform and sell stocks that become overvalued.

The following list includes three stocks selling at bargain prices, followed by three stocks with great growth potential, and one defensive choice to hedge against unforeseen market declines.

Selling at bargain prices:

  • Computer Sciences (CSC)
  • Reinsurance Group (RGA)
  • SkyWest (SKYW)

Great growth potential:

  • Gildan Activewear (GIL)
  • LKQ Corp. (LKQX)
  • TAL International (TAL)

Defensive choice:

  • Templeton Global Income Fund (GIM)

As your investment funds grow and you invest in more stocks, you will need to decide how many stocks, mutual funds, and ETFs are reasonable to follow. When you reach your limit, add to stocks that you already own.

A Time to Play Defense
Phase 4 begins about five years before your retirement. At this point in your life, you should start to reverse your investment strategy. Initially, start selling some of those risky stocks. Invest the proceeds in ultra-conservative investments such as certificates of deposits (CDs), money-market funds, bonds, or bond ETFs.

Your goal in Phase 4 is to get back to owning very conservative stocks (your core holdings). I advise selling stocks that aren't paying dividends. If you need to be ultra-conservative, sell almost all of your stocks and invest in shorter-term bonds, CDs, and money-market funds.

When you are retired, your main goal should be to not lose money, and to invest conservatively.

One of the most important attributes that an investor must acquire is patience. The stock market can be a very frustrating place because of its unpredictability. Expect to lose money from time to time. Have confidence in your investment decisions.

"If a business does well, the stock eventually follows. Our favorite holding period is forever," states Warren Buffett, one of the greatest investors of all time.

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