The Laws of Wealth Creation

Financial independence, or creating wealth, is a goal many people strive for. 

However, few achieve it, often because they lack the knowledge or confidence to do so. But that doesn't have to be the case.

One of the most important principles of successful wealth creation is to cut your losses short and let your profits run. Yet many people do the opposite, holding onto poorly performing investments while selling profitable ones too early. 

In this guide, we'll explore the three laws of wealth creation and how you can apply them to develop a practical approach to building long-term wealth.

What is wealth creation?

According to the Free Dictionary, wealth creation is the "accumulation of assets (especially those that generate income) over a long period". 

In other words, it's about generating long-term wealth by making informed decisions, saving and investing your money to achieve your short, medium and long-term financial goals.

Despite what some may think, wealth creation is not a get-rich-quick scheme. It's a long-term process that requires patience, discipline and perseverance. 

By developing sound financial habits and learning how to manage and invest your money wisely, you can build your wealth over time and work towards achieving your financial goals.

Why earning money isn't the same as creating wealth

Interestingly, many people spend years studying to gain a formal education, expecting to secure a job that pays enough to support their desired lifestyle. Yet, when it comes to educating themselves about creating wealth, they never quite find the time. 

Instead, many live from pay cheque to pay cheque, working harder and longer to meet their financial commitments.

The desire to have whatever they want now and pay for it later means that many forego the required planning to ensure they have sufficient wealth in retirement. 

But this needn't be the case. Regardless of your age, taking steps to manage your money and investments now can help improve your financial position.

In my experience, most people don't give the laws of wealth creation enough time or thought. They assume they already understand these principles and therefore don't need to give them the attention they deserve. 

But let me ask you: how many of you are genuinely building a nest egg to ensure you are financially secure in retirement?

The three laws of successful wealth creation

The three laws of successful wealth creation are simple to understand, yet putting them into practice requires knowledge, patience and discipline.

Let me ask you: Are you on your way to achieving financial independence? If the answer is no, then it's time to take a closer look at how you're managing and investing your money.

These laws provide the foundation for protecting your capital, reducing unnecessary losses and building long-term wealth: 

• Spend less than you earn 
• Invest your surplus wisely 
• Leave your investments alone to grow 

Now ask yourself: which of these wealth creation principles do you follow consistently?

Do you have what it takes to create wealth?

Of the many people I have helped in the investment industry, most don't get past the first law: spend less than they earn. 

Of those who follow this law and invest their surplus cash, many fail to do their homework and, because of a lack of knowledge, do not invest wisely. 

Finally, even if they invest wisely, some cannot leave their investments alone long enough to benefit from compounding.

I assure you that following these three laws is one of the most effective ways to stop losing money and start building wealth. 

After all, if you do nothing, that is precisely what happens: nothing. And when it comes to your money, doing nothing can mean going backwards, as inflation steadily erodes your purchasing power.

Law No. 1: Building wealth is about spending less than you earn

Many people have asked me to show them how they can create wealth. In most cases, they expect me to reveal the "holy grail" of investing that will make them millions. 

Instead, I ask them a simple question: "Do you have a budget?"

Now, if you're like most people, you probably think having a budget will restrict your spending, hamper your lifestyle and generally make you miserable. But nothing could be further from the truth. 

A budget is simply a financial plan that helps you manage your money, control unnecessary spending and free up more money to invest in building long-term wealth.

What is a budget?

A budget is simply a plan that outlines your income and expenses, helping you understand where your money goes and how much you can put aside to invest. 

After all, without a budget, how do you know:

• How much you are spending?
• How much you could be saving?

In my experience, I have never met anyone who couldn't find a way to save at least 10 per cent of their income after completing a budget. I've also found that many people can save between 20 and 30 per cent while still maintaining a good lifestyle.

Think of budgeting as a roadmap to financial independence. It helps you take control of your finances, set realistic goals and free up money to invest. 

By consistently spending less than you earn, you can begin building the capital needed to create greater financial security and long-term wealth.

But don't forget about your superannuation. After all, it's your money, and for many Australians, it will be one of their biggest investments outside the family home. 

Let me ask you, do you know how your superannuation is invested and whether it's working towards achieving your financial goals? If you don't, perhaps it's time to find out.

Law No. 2: Invest your surplus cash wisely (at least 10% of your income)

Investing your surplus cash wisely is the next rule in your wealth creation journey. A wise investment must provide both capital growth and income. 

Investments that lack both components are considered average investments, where you must accept average returns, such as cash or bonds.

Investing in shares vs property is the best method that delivers income and capital growth. 

While investing wisely in these assets is higher risk, the reward is worthwhile if you gain the required knowledge and skill to lower your risk and minimise your losses, especially if you want to learn how to profit from share trading.

Develop an investment strategy

Given how hard you work for your money, it makes sense to invest the time and money learning how to trade stocks or invest in property to increase your probability of making confident investment decisions.

If I work one hour to earn $50 and put that money into a share hoping to make a profit but instead I lose it, that $50 represents an hour of my life I can never get back. 

I can earn another $50, but I can never work that same hour again. So why would I risk my hard-earned capital unless I had a high probability of success?

That's why it's important to develop an investment strategy that considers your financial goals, risk profile and timeframe. You also need to understand why you're investing. 

Is it to generate income, build long-term wealth or achieve both?

To improve your probability of success, your investment strategy should satisfy two important criteria:

• You must have a clear rationale for investing in a particular asset.
• You must have an exit strategy.

Let's examine these in more detail.

The rationale for investing in a particular asset

If you don't understand what you're investing in and the risks involved, you increase the likelihood of making poor investment decisions and losing money. 

For example, many investors got caught up in the hype of the technology boom in the late 1990s, investing large sums of money in the hope of making a fortune.

Media hype and speculation fuelled the belief that traditional "blue chip" shares were outdated and that technology or "dot-com" stocks were the growth stocks of the future. 

This speculation created enormous excitement and greed, driving share prices to levels that were difficult to justify based on their underlying value. 

Many investors ignored the basic economic fundamentals of successful companies, including the fact that numerous dot-com businesses had yet to make a profit.

When the technology bubble burst, many investors suffered substantial losses, setting back their plans to build wealth. And history shows that speculative behaviour doesn't disappear. 

Look at the extraordinary price swings and speculation surrounding Bitcoin and other cryptocurrencies. While the assets may be different, the danger of investing based on hype rather than knowledge remains the same.

That's why you need to understand the potential consequences of your investment decisions before committing your hard-earned money. Otherwise, you may be better off choosing a lower-risk investment, such as a bank term deposit. 

While the potential returns may be lower, you're not exposing your capital to the same level of risk associated with highly speculative investments.

Why diversification matters when building wealth

One of the biggest mistakes I see investors make is putting too much money into one share or spreading their money across so many shares that they can't keep track of what's happening in their portfolio. Neither approach is particularly wise.

Think about it. If you invest half your money in one company and its share price falls by 40 per cent, you've just wiped 20 per cent off the value of your entire portfolio. 

That's a substantial loss from one investment, even if your other shares haven't moved.

Now, you might think the solution is to buy as many different shares as possible. But that's not necessarily the answer either. 

The more shares you own, the harder it becomes to monitor their performance and make informed decisions about when to buy, hold or sell.

In my experience, a portfolio of around five to eight carefully selected shares is generally manageable for an active trader, while eight to twelve shares can provide reasonable diversification for a longer-term investor. The key is ensuring your capital isn't overly concentrated in one company or sector.

Remember, diversification isn't about how many shares you own. It's about spreading your risk while maintaining enough control over your investments to manage them effectively. 

While ETFs have become a popular way to invest, don't assume that owning an index ETF means you're fully diversified. 

For example, an ETF tracking the ASX 200 gives you exposure to 200 companies, but you're still exposed to the movements of the broader Australian share market, which is heavily concentrated in certain sectors. 

And depending on your investment goals, that may not be in your best interests. To understand why, I encourage you to read my article on investing in shares vs ETFs.

If you're considering managing your own share portfolio, I also recommend reading my Four Golden Rules for Investing in Shares.

An exit strategy must exist

Once you invest, it's important to understand how you will manage the risk vs reward. 

This means having an exit strategy in place before committing your money. Yet many investors overlook this because they expect the value of their investment to rise.

While an investment may increase in value, any profit remains unrealised until you sell. And just as an investment can rise, it can also fall, potentially wiping out those gains. 

That's why you need to know how and when you will exit if the investment doesn't perform as expected.

Unfortunately, many investors mistakenly believe that if they haven't sold a share that is falling in value, they haven't lost anything. But let me explain why this thinking can be costly.

Example of the impact on your portfolio when shares are falling

When I buy a rising blue-chip share that meets my trading criteria, I'm looking for a high probability that it could rise by at least 20 per cent over the next 12 months.

Let's assume I invest in five stocks throughout the year. Four rise by 20 per cent, while one falls by 20 per cent. Now, let's convert this into dollar terms.

If I invest $1,000 in each stock, I make $200 on each of the four shares that rise, giving me a total gain of $800. 

On the share that falls, I lose $200. Therefore, my net portfolio profit is $600, representing a 12 per cent return on my original capital of $5,000.

Now, let's assume I hold onto the falling share, hoping it will turn around and start rising. Instead, it keeps falling until it has lost 50 per cent of its value. 

So, what effect does this have on my portfolio?

The falling share has now lost $500 rather than $200. 

This reduces my net portfolio profit from $600 to just $300 ($800 minus $500), representing a return of only 6 per cent on my original $5,000 investment. 

By letting one share fall 50 per cent instead of limiting the loss to 20 per cent, I've halved the return on my entire portfolio.

The point is that the longer a stock falls, the more it can hurt your overall profitability. Allowing small losses to become large losses can turn a sound investment strategy into an average one.

That's why I teach traders to use a stop loss as part of their trading plan. A stop loss helps manage downside risk by establishing when to exit an investment if the price moves against you.

Law No. 3: Leave your investments alone to grow

The third law of wealth creation is to let your investments grow. This is where the power of compounding, often called the world's eighth wonder, comes into play.

When you invest wisely, your money has the potential to generate interest, dividends and capital gains. By reinvesting your earnings and allowing your capital to grow, you can generate additional returns through compounding.

This is why the third law plays such an important role in building long-term wealth. Two key factors influence how effectively compounding works:

1. Time: The longer your money remains invested and generates positive returns, the greater the opportunity for interest, dividends and capital growth to accumulate. As these earnings are reinvested, they can generate further returns, allowing your wealth to compound over time.
2. Rate of return: The higher the rate of return on your investments, the faster your capital can grow through compounding. This occurs because each positive return increases the amount of capital available to generate future earnings.

Let's look at an example of how compound interest works.

The power of compounding

If you invest $10,000 and earn 10 per cent interest in the first year, you would make $1,000. If you reinvest that $1,000, your capital grows to $11,000, which now earns 10 per cent interest. 

This means you would earn $1,100 in the second year, equivalent to 11 per cent of your original $10,000 investment, even though the annual interest rate remains at 10 per cent. 

Imagine what happens when you keep reinvesting your earnings.

As the table below shows, after five years of compounding at 10 per cent annually, your earnings in the fifth year increase to $1,464.10, or 14.64 per cent of your original capital. 

As the table below shows, your original $10,000 investment has grown to $16,105.10 over five years. 

This represents a cumulative return of 61.05 per cent, assuming a constant 10 per cent annual return with all interest reinvested and no fees or taxes.

How reinvesting dividends can help build wealth

One of the mistakes I see investors make is taking the dividends they receive from their shares and spending them rather than reinvesting the money. 

Now, there's nothing wrong with enjoying the income your investments generate, but if your goal is to build long-term wealth, you could be missing out on the benefits of compounding.

Think about it. If you receive $1,000 in dividends and reinvest that money into more shares, you're increasing the number of shares you own without having to contribute additional money from your income. 

And if those shares continue to pay dividends, you'll potentially receive even more income in the future.

Some Australian companies make this easier by offering a dividend reinvestment plan, which allows you to receive additional shares instead of taking your dividends as cash.

Of course, dividends aren't guaranteed, and share prices can fall. 

That's why it's important to continue monitoring your investments. 

But when you select quality companies and reinvest their dividends, you give your capital more opportunity to grow through compounding.

How spending your capital and earnings affects wealth creation

Once you begin investing, it's important to allow your capital and earnings time to grow. 

Ideally, you should reach a point where your investments generate sufficient income and growth to support your lifestyle before you begin drawing on them for everyday expenses.

Sadly, many investors prefer short-term gratification and dip into their investments to buy a car, go on a holiday or spend money on things unrelated to building wealth. 

While there is nothing wrong with enjoying the money you earn, repeatedly withdrawing investment capital can set you back years in achieving your financial goals.

The reason is simple. Compounding produces relatively modest gains in the early years, but its effect becomes increasingly significant over longer periods. 

As the example above demonstrates, the more capital and earnings you leave invested, the greater the opportunity for those earnings to generate further returns.

Educate yourself about wealth creation

Unfortunately, a lack of knowledge about wealth creation can intensify the emotions of fear and greed, causing investors to react, and sometimes overreact, to changing market conditions. 

This often leads to poor investment decisions that can prevent them from achieving financial independence.

That's why educating yourself about wealth creation is so important. With the right knowledge and skills, you can make informed decisions, manage risk and avoid costly mistakes. 

Let's look at four reasons why education matters when building long-term wealth.

1. Improved financial decision-making

Education gives you the knowledge and skills to make informed financial decisions instead of relying on speculation, market hype, or tips from others. 

It helps you understand investment opportunities, assess their potential and develop strategies that align with your financial goals.

As Charles Givens once said, "Knowledge overcomes the two enemies of prosperity...risk and fear".

2. Risk management

Understanding the risks associated with your investments is essential to protecting your capital and minimising potential losses. 

This includes knowing how to manage individual investments, develop exit strategies and understand the impact of diversification on your portfolio.

Diversifying your investments can reduce your exposure to individual assets and sectors, although it cannot eliminate the risks associated with broader market movements.

3. Increased confidence

Education builds confidence by giving you a better understanding of how financial markets work and the strategies you can use to manage your investments.

As your knowledge and practical experience grow, you're better equipped to make decisions without allowing fear or greed to dictate your actions. 

This can also help you become more disciplined and consistent in applying your investment strategy.

4. Long-term financial success

Building wealth requires more than understanding financial markets. 

You also need the knowledge and discipline to recognise opportunities, manage changing market conditions and consistently apply proven investment principles.

The more you develop these skills, the better equipped you become to make informed decisions and work towards achieving your long-term financial goals.

As a share trader and educator with over 30 years of experience, I've seen the difference education can make in people's lives. 

I've witnessed the success stories of those who have invested in developing their knowledge and skills, and I can't emphasise enough how important it is that you do the same.

Over the years, I've also found that the more I educate people about the market, the more they value the knowledge and experience that professional education provides. 

Rather than creating dependency, education gives people the confidence to take greater responsibility for their financial decisions.

So, there you have it. 

The three laws of wealth creation are simple, but applying them consistently requires knowledge, patience and discipline. 

By spending less than you earn, investing your surplus wisely and allowing your investments to compound, you can build a stronger financial foundation and work towards achieving financial independence.

If you found this article helpful, you may also enjoy reading:  

• Financial Freedom Through Trading: Is Freedom the New Rich
• Why Most Traders Fail

For a deeper understanding of wealth creation and practical investment strategies, you can explore my book Accelerate Your Wealth – It’s Your Money, Your Choice.

If you're serious about building wealth through the stock market, having the right knowledge and skills is essential. 

Wealth Within provides structured trading education, including Australia's only government-accredited share trading qualification. 

Our Diploma of Share Trading and Investment is designed to help you develop practical trading strategies, understand risk management and make informed decisions when trading the market.