Why you need more risk

You're being way too cautious with your money.

It may seem an odd thing to say, but most people simply don't take nearly enough risk when it comes to their money.

Let me explain. Just chatting with folks generally about investments, listening to financial phone-ins, not to mention the other weird (money-related) activities that we Fools engage in, it's pretty clear most of us have very set views when it comes to managing our money.

You'll hear things like "I want the best return over the next five years, but I don't want to take any risk with my capital" or "I don't trust those crooks in the stock market, I lost money on some shares in the 1980s. Never again!"

It's pretty clear many people reckon that cash is good, while investing in shares is considered deviant bordering on evil.

So when it comes to talking about money, there tends to be a lot of focus on how to enjoy the best rate from a savings account. More often than not, the remainder of the conversation will be filled with complaints about the level of interest rates, and the fact you can't beat inflation! And you'll also hear a lot of attention being paid to making sure everything is tax-efficient.

Focus too much on the short term…

It's not surprising that people are scared of losing money. We've seen a succession of financial scandals. We've also seen shares plunge in value by 50% twice in the last 10 years.

Economists even have a name for being scared of losing money. They call it loss aversion. We all have an aversion to losing money of course, but it's reckoned that a loss has twice the psychological impact as a gain of a similar amount. This means we tend to favour steadier assets such as cash and bonds, and steer away from the stock market.

The fact we concentrate so much on taxation is also understandable. Naturally, no one wants to pay more tax than they need to.

And you'll miss out on the real long-term gains

However, in the long term, and it's the long term that counts, these fixations with safe assets and tax-efficiency can cause real, lasting damage.

Cash won't lose you money in the short term, but over decades, an over-dependence on savings accounts is likely to decimate your wealth due to the effect of inflation. Riskier assets, on the other hand, have much more ability to grow. And those gains can compound over time, slowly at first but more and more significantly with each passing year.

By concentrating on the short-term fact that we might lose money in the stock market, we expose ourselves to the much more destructive effect that inflation has on cash.

It's a similar thing with tax. So much effort goes into making sure your money is invested in a tax-efficient fashion, there's very little time to investigate whether the underlying investment is any good in the first place! You shouldn't ignore tax efficiency completely, but it should just be the icing on your investment cake.

A 5-step plan for investing

So, if you're keen to build real wealth, how should you begin? Here are five points to bear in mind for starters:

1. Start early: The longer you have to invest, the more likely you are to be successful. Ignore those who think you shouldn't invest in your 20s, because they believe you should have more important things to do with your money. Your 20s are arguably the most important years of your investing life. It's a time to learn good habits, plus you have much more time to recover from any initial mistakes (and we all make mistakes).

2. Little and often: Rather than trying to time the market, resolve to put smaller amounts away on a regular basis (Indeed, I started with savings schemes for investment trusts). I still find it amazing how quickly a small monthly amount can build up to, and how little you miss the contribution from your bank account.

3. Watch your costs: Costs eat into your returns. Overtrading and high-charging funds can cause the most damage. If you can't work out what the charges are on any particular investment, then the chances are they've been well hidden because they are absolutely horrendous.

4. Learn about the market: Watch the market and get used to its ups and downs. It's amazing how it all evens out in the end. A fall of 3% may make the headlines one day, yet as little as a month later, no one will remember it ever happened. Long-term trends are important — short-term movements are irrelevant.

5. Learn about business: Take an interest in the businesses you use on a regular basis. How do they make their money? What factors impact their profitability and cash flows? Consider the impact of long-term trends that may benefit (or harm) their prospects.

All told, I am convinced you must take on greater risk, through the stock market, to have any chance of becoming independently wealthy and giving up the drudgery of the daily 9-5.

In fact, I can't ever recall reading about somebody creating a seven-digit fortune from a simple savings account, but there are plenty of online stories highlighting share investors becoming millionaires!