Golden rules to success

Published in Empower Magazine, May 2009

by Dale Gillham

Understanding the foundations of wealth creation is the key to successfully share investing, writes Dale Gillham. Here he explains the three basic rules.

Before we embark on series of articles outlining ways to create wealth in the share market, we first need to look at the bigger picture of wealth creation.

There are three laws of wealth creation that have been around for thousands of years that go hand in hand with any investments you may make in your endeavours to become financially independent. In my experience, the most common reason people fail to achieve financial independence is due to lack of knowledge. For others, it’s probably due to a lack of confidence in their abilities to apply the knowledge. However, I think the following quote from American social writer and philosopher Eric Hoffer explains well why people may fail to be successful not only in investments but in other areas of their life:

“They who lack talent expect things to happen without effort. They ascribe failure to a lack of inspiration or ability, or to misfortune, rather than to insufficient application. At the core of every true talent there is an awareness of the difficulties inherent in any achievement, and the confidence that by persistence and patience something worthwhile will be realized. Thus talent is a species of vigor.”

Interestingly, many people are willing to spend years studying, with the expectation that they will obtain a job that will pay enough to enable them to sustain a desired lifestyle. Yet when it comes to educating themselves about how to create wealth, they never quite find the time. Instead, the majority seem willing to live from pay cheque to pay cheque, which means they have to work harder and longer to create the extra income that will satisfy their needs.

The desire for individuals to have whatever they want now and pay for it later means many forego the required planning process for their retirement years. But this need not be the case, as it is never too late to get your investments in order.

By simply educating yourself on the ‘three laws to wealth creation’ below you can build a solid foundation and ensure you have a sustainable income during retirement.

Based on my experience, I feel that many people do not give enough thought to these time proven principles. So, let me ask you this – are you truly building a next egg to ensure your financial independence during your retirement years or are you treating your financial independence as a ‘nice to have’?

Three laws to successful wealth creation are:

Spend less than you earn;
Invest your surplus wisely (at least 10% of your income); and
Leave it alone so it can grow.

Unfortunately, the majority of Australian’s do not obey the first rule of spending less than they earn and are therefore unable to move on. For those who do obey the first rule and move onto invest their surplus cash, many also fail to do their homework beforehand. As a result of their lack of knowledge in this area, they either don’t invest wisely or are unable to leave their investments alone long enough to compound over time. So, here’s a breakdown of the three laws to get you on track.

1. Spend Less than You Earn

It is usually this first rule that creates considerable angst for people. This is because many do not have a budget or spending plan. Without one, how do you know:

How much you are actually spending; or
How much you can save?

Usually, it is not until the end of the financial year that people realise just how much they have earned. But when spending habits are quantified, only then we do we know how much we can save. Indeed, a spending plan is like a roadmap to financial independence - it provides you with a plan of attack that allows you to create your preferred reality.

I won’t go into budgeting here as there are many good books and computer programs that can assist you, but this essentially this first rule is a crucial starting point for an investor.

2. Invest Your Surplus Wisely

The second rule to creating wealth is to invest at least 10% of your income wisely. All too often people do what is simple or easy rather than what is wise when it comes to investing. A wise investment, however, must give you capital growth and it must give you income. If an investment does not have both of these components, then someone else is benefiting from the component that you are not getting. The share and property markets give you both capital gain and income, making them two of the best investment vehicles for you to create wealth. Given the expense of investing in property, those that are looking to start building wealth are wise to use the share market until they have sufficient capital built up for property.

Once you invest, it is also important to consider how you will manage your investment. In other words, you need to consider your exit strategy before you decide to invest. Most investors do not consider this because when they invest they expect the asset to rise. Even though there is likelihood for the asset to rise, the value of the asset is not realised until you sell. Consequently, this is considered unrealised profits as the asset could fall in value. This was highlighted throughout 2008 with many retirees and prospective retirees seeing their nest eggs eroded by 30 to 50 per cent or more. Therefore, you need to consider how and when you will exit if your investment turns sour or does not perform as expected.

Unfortunately, many investors mistakenly believe that if they have not sold a share that is falling in value then they are not losing. But let me demonstrate why the opposite is true.

If I buy a blue chip share that is rising, I know with high probability that the stock will generally rise a minimum of 20 per cent in price over the next 12 months. Let’s assume I invest in five stocks throughout the year. Four of the stocks rise in value (all by 20 per cent) and only one makes a loss (also by 20 per cent). Now let’s convert this into dollar terms. If I invested $1,000 in every stock then I would have made $200 on each of the four shares that went up and lost $200 on the share that went down; therefore I would make $800 and lose $200, which would give me a net profit of $600 or a 12 per cent return on my capital of $5,000.

Now let’s assume I decide to hold onto the stock that was falling in value, because I believe there is a chance it will turn around and start to rise. However, by the time it has decreased by 50 per cent in value I realise that this is not going to happen. So what is the effect of this on my portfolio? On the falling share, I lost 50 per cent or $500, meaning the unrealised net profit changes to only $300 ($800- $500 =$300) or 6 per cent profit on my $5,000 capital. Allowing the falling share to fall below 20 per cent halved the return on my portfolio. This failure to sell falling shares in 2008 has seen many people’s portfolios drop to levels from which it will take 5 or more years to recover.

The main point here is that, the longer a stock continues to fall, the greater the effect on your overall profitability. In essence, allowing your losses to run into bigger losses turns a good investment strategy into an average one.

3. Leave It Alone So It Can Grow

The third rule to wealth creation is to leave your investments alone to grow. When you invest wisely, your money will normally earn you income and capital gains. When you reinvest these earnings, it yields additional income and capital gains because of the compounding effect. This also applies to income received from any tax rebates you might get as a result of investing. The rule is that whatever comes from investing must be used to invest more, or compound. Consequently, it is this rule that is the real key to wealth creation. Therefore, once you embark on your investment journey you should leave your capital alone to allow it to grow. Only when your investments are generating income and growth that is equal to or better than what you earn from working should you consider using your investments or income for lifestyle purposes.

Regrettably, the lack of knowledge about wealth creation for the average investor has the effect of intensifying the emotions of fear and greed, causing investors to react and at times over react to market conditions such as we have experienced in the past year. In essence, this prevents many from becoming financially independent.