There are three key factors that govern the rate at which you can increase your future wealth. If you can improve on any of these, you will be better off.
The three determining factors to your future wealth are:
1. Your ability to increase your income in real terms;
2. The amount that you can save (and, in turn, invest) from this income; and
3. The real return you can achieve on your investments.
Clearly, these three factors – income growth, the ability to save / invest and the performance of financial investments – differ from person to person. Even if two people earn the same salary, one may well accumulate far more wealth than the other.
If you want to calculate how much you can accumulate over time, you need to assess your financial situation. Firstly, evaluate (in today’s terms) your income potential over the rest of your working life. Secondly, assess how much of that income you can save. And finally, determine what return you can get on these savings and investments.
Boost your earnings
There are natural limits to this process. For instance, low income earners cannot increase the proportion of their income that they are able to save to the same extent as top income earners, nor are they able to invest at top earners’ rates. However, top earners can still find themselves paupers if they live excessive lifestyles and make bad investment decisions – and there have been several high-profile examples of this.
No-one has ever become truly wealthy earning just a salary. In other words, no-one has become really rich selling their time. To achieve this you need to harness other sources of wealth generation, beyond the constraints of your own personal resources of time and energy.
If you are limited to earning a salary, look at ways to enhance that salary, such as acquiring additional skills through taking courses or studying for a degree or even an additional degree. Find ways to move up the salary scale in order to boost your income-earning ability.
Save as much as you can
The amount that you are able to save depends directly on your income. As you know, a large chunk is deducted by your employer before you even receive it. The largest deductions are normally for tax, retirement funds and medical aid.
After deductions, however, what happens to that money is up to you. A home loan and car loan, an expensive hobby and a large family are usually sufficient to ensure that many people are permanently cash strapped. We often hear people say they are saving when, in fact, they are just setting money aside to buy something in future. This is simply delayed consumption.
It is important to note that research published by Thomas J. Stanley in his book “Stop acting rich and start living like a real millionaire” shows that the size of your pay cheque is only responsible for 30 percent of the reason that people accumulate wealth, 70 percent is based on your ability to spend less than you earn and invest the balance.
While you could consider all saving to be deferred consumption, this type of saving will never make you financially independent. The savings we are talking about here are long-term savings that go towards building up a capital base that you could ultimately live off; a capital base that will generate a passive income for you. As John Kehoe said: “First you work for money and then money works for you.”
Most people face an uphill battle for the first 20 years of their working life. Even top earners cannot make major financial savings during this period because they are faced with the high costs of raising and educating children while big ticket items such as a home, a car, furniture and so on absorb most disposable cash.
For most people, their savings ratio only starts to rise meaningfully in their forties or fifties.
One way to increase your financial fitness is to get the payments on the big expense items out of the way as early in life as possible. The sooner you are out of debt, the sooner you can make meaningful increases in your savings ratio.
Get the best returns
Historically money has worked the hardest in equities (shares). Over the long-term, equities have outperformed all other investments everywhere in the world. but if you ask people “Do you invest in shares?” most say: “No!”
Why not? The common answer is: “Shares are too risky. Look at what’s happened repeatedly all over the world; just look at how volatile the market has been recently, it’s far too risky.”
What does the smart money do? It invests consistently in global share markets through its ups and downs, knowing that the markets ultimately spend more time rising than they spend falling. If that’s what the smart money does, shouldn’t all of us be doing the same thing, at least in part? Shouldn’t we all be investing at least a portion of our money in shares if they give you the best potential returns in the long run? This is the third factor in wealth creation.
Increasing your basic understanding of investments will make you more comfortable with the managed risks involved in well-diversified investments and give you the opportunity to share in the growth of the economy. As the saying in the share markets goes, “What goes down must come up”.
By increasing any of the three main determinants of wealth creation, you can become wealthier and more financially fit. And if you really want to be rich, then you should work on all three.
* Paul Leonard is a CFP and regional head: Eastern Cape at Citadel. His views are not necessarily those of IOL.
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