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Thursday, 19 July 2007

The simple steps to creating wealth

by Scott Francis

A lot of financial planning focuses on important decisions that have to be made about 'financial planning strategy' (eg salary sacrifice contributions to superannuation) and 'investment selection' (eg index funds vs actively managed funds vs direct shares). Perhaps not enough focuses on the simple disciplines that lead to a person becoming wealthy over time. Outlined is a 5 step guide to how you can become wealthy over a life time - a 'get rich slow' recipe. We are starting to see in the media that the Henry Kaye style 'get rich quick' property seminars and the 'get rich quick' share trading programs don't work. The power of this get rich slow recipe is that it has worked for many people, and it will work for many more.

1/ Spend less than you earn. As simple as this sounds, clearly many people don't get past this first rule. Statistics on the level of debt that we have in Australian show that it is reaching record levels, no longer measured in billions of dollars, it is now measured in trillions.

Most of us face an average tax rate of about 25%. That means that we are working the first 25% of the year - 3 months - just to pay our tax bill. The last thing anyone should be doing is taking on consumer debt, so that part of our future income is promised away in the form of repayments to finance companies as well as the tax office!

2/ Invest the surplus in growth assets (Australian shares, international shares, listed property trusts). All these asset classes have expected returns of about 7% above inflation - say 10% in the current 3% inflation environment. This is better than the expected return from cash, which is about 3% above inflation (6% total). Earning a long term rate about 7% above inflation increases the purchasing power of your investments over the long term.

Investing in a portfolio made up of all three growth asset classes helps smooth the overall volatility of the portfolio. If one investment asset class has a terrible year, the returns can be smoothed by the returns from the other investment classes. Sure, some years they will all have bad returns, accept that as part of investing. Some years - such as in recent years - they will all have great returns, accept that as part of investing as well.

3/ Do this over a long period of time. Make this a habit.

Investing additional money regularly over time is very powerful. As markets go up you can say, 'great, my investment returns are strong and are creating wealth for me'. As markets go down you can say, 'great, here is an opportunity to invest more money at lower prices'. When markets turn and go up again - and they will - you will be in great shape.

Regular investing lets you benefit when markets rise or fall. You simply can't go wrong.

4/ Accept that part of the strategy is investing in growth assets is that while they have a higher expected return than investing low risk cash investments, they also have a greater volatility: that is there will be periods of ups and downs. Don't try and outguess these ups and downs, just accept that they are the reason you will get a higher overall return, and accept that there will be volatility. This is the biggest mistake that people make - trying to pick and choose when to buy and sell in and out of asset classes. There is overwhelming evidence that professionals can't do this. If the professionals can't, then we should not be so arrogant as to try.

Dalbar, a US research company, track the actual returns that investors get from US managed funds against the overall market return. For the 25 year period to the end of last year they found that they average US share investor made 4% a year, while the market return was 11%. This was because investors' panicked and sold investments when they went down in value, and got excited and bought more when they went up in value. Don't try this and get left with these terrible returns. Accept the ups and downs as part of the strategy, and don't let this distract you.

Don't dismiss the importance of this rule. Trying to 'time' markets is the number 1 mistake investors make. Don't make this yourself.

5/ Remember that compound interest is a very powerful force. However you won't see the real benefits of compound interest for some time - don't expect too much too soon, or you will be disappointed. (Compound interest is the effect where as your investment earnings increase, these investment earnings will return their own investment earnings, and these earnings will have more investment earnings and so on. It is very powerful effect in a portfolio; however it takes quite a few years to really see it happen.)

I often wonder how often investors read or hear about the power of compound interest, get very excited about the examples offered, but never actually realise that the power of compound interest happens at the back end of an investment strategy. Compound interest is exciting, it is powerful, however it takes a while for the effect of investment earnings on investment earnings on investment earnings to kick in and be visible. So don't be discouraged when you don't see this happening in the first 5 or 7 years - stick with the plan over time.

So there you have it. You now know how to become wealthy. It's not that hard and you can start today.

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