Principles of Wealth Creation to Follow

Why some people build wealth and a lot of people do not appears to be a great mystery too many. By looking at the number of articles written, books published and TV shows on the topic it looks like most of us have no idea about how to form financial wealth in our lives. And unfortunately for many this lack of knowledge of the basic principles of wealth creation has significant consequences for their lives.

Don’t worry, I’m not writing this from the mountain upon high. I didn’t take this process seriously until my forties … missing out on a couple of decades of the benefits of compounding returns. However, like me, you can only start from where you are right now. And I wish I had taken the time to find these very basic principles, and followed them, much earlier in life.

Spend Less Than You Earn – Creating the Gap

For such a simple concept and one we all know we “should” do, it is interesting how many of us, including my past self, don’t manage this on a regular, sustained, basis. If you want to build wealth … you must spend less than you earn. It’s that basic. It’s that simple.

Nothing in personal finance is as powerful as this principle and that is why it is first in the list. If you did nothing else other than do this, you will build wealth. You may not build as much as you want or perhaps will need for retirement, but you will build wealth.

Sure, you could spend less than you earn and then go and spend those savings; that is true. A nice holiday. A better car. And not build much wealth with this approach. Nice holidays don’t add to your net worth position. They do add to your emotional or relationship bank accounts, but those aren’t financial decisions.

This basic concept of spending less than you earn as one of the principles to wealth creation does seem to be lost these days. The growth in credit cards, pay day loans, lease arrangements for consumer goods, etc all point to people more than happy to spend tomorrow’s income today and hope for the best for tomorrow.

Save the Gap You Have Created

Now that you have a positive gap between your income and spending, you need to save this gap. And when I say save Im really talking about building cash to then go and invest, which is the principle we will come to next. But for the moment you have to save … you have to keep hold of that money. Because what we want to do with it is put it to work so that it starts working for your future self. The present self is demonstrating delayed gratification so that the future self can have a better financial life.

As you progress in your wealth creation and following these principles you are going to want to move into a more sophisticated savings plan. Not complex, but one that better understands your financial needs. So once you have a savings habit built, and build it quickly, you are going to want to save for:

  1. an emergency fund (a rainy day fund);
  2. a goal orientated fund (eg holiday, house, car, education); and
  3. long-term investments (eg retirement funds).

It’s the first and last that appear to be the most difficult in this area. But they are just as important as the second one. Let’s take a quick look at each.

Emergency Fund

As famous as Dave Ramsey is for his avoidance of debt he is perhaps more famous for saving when Murphy arrives; the emergency fund. In the Total Money Makeover your first baby step is to save $1,000. Sell everything not bolted down, “… put the cat on ebay and the dog on craig’s list and the kids think they are next”. Dave’s quote goes something like that. As quickly as possible get together $1,000. Have it in real cash or in a separate “I can’t spend from” bank account.

And then you will want to build this to a balance of three to six months of normal spending. Or what ever number of months you wish, but at least three months. Why three? It gives you the breather between loosing your job, something expensive going wrong with the house or the car or the dog. And getting back on your feet again. My wife and I target 12 months. And I tell you, it makes such a difference in how you feel having that set aside. Now our spending is much more modest compared to most. But this enables us to have a much bigger buffer for when Murphy comes to visit.

Of course once this funding target is set this money can then be redirected to one of the other two savings plans below. If your lifestyle has coped this far without needing that money, why not continue? But as you need to draw down on these funds as life happens, do come back and top it up again.

A Goal Fund

You don’t see this in many personal finance writings, but I think it’s critical to help keeping you on track. In particular if you are operating a budget (yes, you should) putting money aside on a regular basis for the things you want to do or have is important. Obviously the big ticket items like houses will take some time. But if you are disciplined it is surprising how much can be built up over a short period of time.

Please do not confuse saving for and buying a house with your long-term retirement savings. They are not the same because your house is not an investment! Why? Because it is not an asset. Yes yes, I know it is in an accounting sense. But if you haven’t already. go and ready Robert Kiyosaki Rich Dad Poor Dad and then let me know what you think. I agree with him 100%. I do have our house on our balance sheet (the accountant can’t help himself). But it is not an investment and we kept our home to a very modest spend. And paying that mortgage off as fast as we can!

Long-term Savings

The third savings you need to be putting aside for is for the long-term, often focused on retirement. This savings may well be automated, the best way to save, from your pay cheque – like mine is into a pension fund. But what ever method is used, it needs to happen each pay cheque, month-in-month-out, year-in-year-out. And the sooner the better. If you have started “a bit later in life”, as we did, now is going to be the best time to start.

Invest Your Savings

This was the part I was always really bad at and it made a huge difference in the lack of wealth built over nearly two decades of working and earning. I didn’t understand it. I didn’t spend much time thinking about. I never took onboard the very good advice of making your money work for you, rather than you having to work for it. I never thought about what are the basic principles or steps I should follow to wealth creation.

Despite my “devotion” to the Dave Ramsey baby steps, which we have nearly completed, I had to depart from Dave on his “devotion” to mutual funds. I think this approach going forward has significant risks that the returns and lack of control makes this an unwise “all in” approach. But hey, it has worked well for him – but it didn’t suit me going forward.

We aren’t going to cover here what your investment plan should look like; we’ll leave that to a future article because it needs its very own attention. We need to talk about asset allocation, risk adjusted returns and financial planning. None of this is rocket science, but it’s where people can really go wrong.

Avoid Debt

This is the step where many people probably stop reading and conclude I have no idea what Im talking about. Principles of Wealth Creation? This guy has no idea. OPM (Other Peoples Money) is the way you “make it”. Which still could be true. However, from personal experience, and listening to those much wiser than I, the avoidance of debt has been a great liberator for us. Not only in freeing income from being handed to someone else, but just the freedom from that burden.

I know the numbers. If one can borrow at 3 per cent and earn 7 per cent, it’s a no brainer. And yip, absolutely true. As my friend over at Radical Personal Finance, Joshua Sheets, covered in one of his many podcasts. Mathematically, this will always work; if the earning number is higher than the paying out number you win. But when it doesn’t … you lose.

Of course “getting out of debt” is the cornerstone of the Total Money Makeover by Dave Ramsey And before listening to Dave and reading his material I was with everyone else. The numbers work, so that means leverage always work. But Dave drove home two really good points:

  1. someone without debt has never been declared bankrupt; and
  2. think about what your future income could be doing if you weren’t handing it over to someone today.

And it’s that last point that really hit home for me. I thought about what our monthly income could do, or the less overtime I would have to do, if we weren’t paying off debt. And remember, debt is the commitment of future income to now. You are clawing back money from the future to now. On the assumption that future income will always be available.

From our personal experience the freedom from debt has been a game changer in how we have dealt with money, how we have been able to help others, and how it has helped prepare us for the things that life brings to us all.

Budget and Repeat

I know. You don’t want to budget. You don’t see the need for it. You don’t have time for it. You get by ok without worrying about it. You are not good at numbers, or paperwork, or some other 100 things that could be listed.

But just do it. It’s not difficult. You don’t need software or spreadsheets or a computer at all! Yip, these things can make it easier … but in someways they can actually make the process less effective in that they can make it much more complex than it needs to be.

Budgeting your regular income, be it weekly or monthly, or however often it comes in, is critical to achieving consistent and maximum results from this process. Sure, you can achieve results better than most by not budgeting. But let’s think about that … most people are just dreadful with their money. And why?

Because most people don’t control the person in the mirror” as our friend Dave Ramsey is heard to say many a times on his show. The biggest problem is not the numbers or the logic of a budget process. It’s the guy in the mirror who doesn’t want to control themselves. They don’t want to be held accountable, especially to themselves.

And that is all a budget is … a simple tool to hold your present self accountable to your future self. Remember, it’s your future self who will feel the consequences of your present self’s decisions. In terms of the principles of wealth creation, a budget is the tool that gives your effort the shot in the arm. Over the same period of time I believe that the person with a budget, and who uses it, will always out perform the one who does not. We know this. We know that someone with a plan will generally achieve more in life when compared to someone without one.

Conclusion

If you have made it this far in the article, well done! Most won’t. Although most say personal wealth is important to them, they put little time and energy into understanding it and then doing it.

But as you can see what has been laid out above, the principles to wealth creation are really simple. And yet the guy in the mirror makes it really difficult. The reflection wants its fun and toys now … not caring about the reflection in ten or twenty or thirty years. Just be imposing some control over the now to look after the future can make a huge difference in your personal wealth. It has in ours. Yip, I wish I had started many years ago. But I can’t go back and change that, so all I can change is how I deal with our money now … so that options and choices can be built for the future.

I didn’t mention that at the beginning, so I’ll close on it. What we are talking about here is what the principles are for you to build a greater range of options and choices for the future. For that is what money ultimately provides. What you do with those choices will reflect who you are as a person.

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