The Laws of Wealth Creation

By Dale Gillham | Published 16 September 2008 | Last Updated 26 October 2018

Financial independence is a goal many strive to achieve, yet only a few accomplish. In my experience, the most common reason why people fail to achieve this is due to a lack of knowledge in how to create wealth, while for others, it is often due to a lack of confidence in their abilities to apply their knowledge.

I think the following quote from American social writer and philosopher Eric Hoffer explains why many people fail to be successful in creating wealth not only with their investments but in other areas of their life:

eggs in a basket

“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 to gain a formal education 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 that many forego the required planning process to ensure they have sufficient wealth in retirement. But this needn't be the case, as it is never too late to get your investments in order.

Based on my experience, I feel that many people do not give enough time or thought to the laws of wealth creation. They take it for granted that because they already understand them, they do not give them the attention they deserve.

But let me ask you – how many of you are truly building a nest egg to ensure you are financially secure in your retirement years?

Understanding the laws of wealth creation

The 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 people do not follow the first rule of spending less than they earn and are therefore unable to move on. For those who do follow 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 do not 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 wealth creation to get you on track.

Spend less than you earn

It is usually the first rule that creates considerable angst amongst people. This is because many people do not have a budget and without a budget, 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 when 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, budgeting is like a roadmap to financial independence, as it provides you with a plan of attack that allows you to create your preferred reality.

It is this rule that is a crucial starting point for an investor.

Invest your surplus wisely (at least 10% of your income)

The second rule to creating wealth is to invest your money wisely. All too often people do what is simple or easy rather than what is wise when it comes to investing. However, a wise investment 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.

plant being watered

Once you invest, it is also important to consider how you will manage your investments. In other words, you need to consider your exit strategy before you invest. Most investors do not consider this because when they invest they expect the asset to rise.

Even though there is a likelihood the asset will 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 evident throughout 2008, with many retirees and prospective retirees watching their nest egg erode by 30 to 50 percent or more. Therefore, it is important 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 percent 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 percent) and only one makes a loss (also by 20 percent).

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 percent 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 percent 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 percent or $500, meaning the unrealised net profit changes to only $300 ($800- $500 =$300) or 6 percent profit on my $5,000 capital. By allowing the falling share to fall below 20 percent halved the return on my portfolio.

The point is 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.

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 earn interest, dividends and capital gains. When you reinvest these earnings, it yields additional income because of the compounding effect. I also apply this rule to any income received from my tax rebates as a result of investing. So, my rule is whatever income is derived from investing, must be reinvested as this will compound your returns.

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.

Educate your clients

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. This is what prevents many from becoming financially independent.

As a share trading educator and fund manager, I have learned that one can attract and retain more clients by adopting a proactive approach towards educating clients. You can also develop stronger relationships and create like-minded synergies with the client.

Many advisers mistakenly believe that if they impart any knowledge to their clients, the client will want to control their own investments rather than utilise their services. However, I have found that the more I educate my clients the more they trust what I do and the more they benefit from my services.

So there you have, I encourage you to take heed of the three laws to wealth creation as they will have a profound effect on your life. 

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