The Golden Rule of Wealth Building: Part 2

wealth building machineBuilding wealth is not rocket science.  In fact, the process can be explained in one simple but powerful formula, an equation I like to call “The Golden Rule of Wealth Building.”  Believe me, I’ve seen The Golden Rule in action many times during my career as a professional wealth planner, and it still amazes me.  So if you are curious on how to get on the right path to financial success, read on.

In a previous post (The Golden Rule of Wealth Building) I explained the story behind how I came across the magical Golden Rule.  Now I am going to show you how the formula works, and why it is the basis of all wealth building strategies.

To me, the Golden Rule is the Holy Grail of finance.  Once you truly understand it, the process of creating wealth becomes clearer. The greatest power of the formula is its ability to tie lots of good financial advice together. In fact, much of today’s financial wisdom comes directly from the Golden Rule.

 

Many Wealth Building Sources Repeat.  What Gives?

If you are a fan of personal finance (like me), you may have noticed the handful of themes that keep coming up. If you take time to listen to a few financial experts, you’ll see that even though their styles may be different, they all say pretty much the same thing. (To paraphrase Mark Twain: They don’t exactly repeat, but they sure do rhyme.) That’s because all wealth building boils down to just a few key components. The Golden Rule cuts out the noise and focuses on those key elements of wealth building.

So here is the Golden Rule again:

[heading style="1"]FW = CW  ×  (1 + R)  T

Where FW=Future Wealth, CW=Current wealth, R=Return, T=Time[/heading]

For those who hate math, don’t worry. My focus here is to translate this math equation into PLAIN ENGLISH. And for those who have seen this formula before and are unimpressed right now, I totally understand.  I once thought the same thing myself!  Trust me; the more you think about the Golden Rule, the more you will appreciate its power.

 

Multiplication is the Fuel in the Wealth Engine Tank

So let’s take a closer look at the actual formula.  Translated into English, the formula says your future wealth (FW) depends on your current wealth (CW), your rate of return (R) and time (T). Probably the most important thing to notice is the formula is based on multiplication. In other words, wealth doesn’t simply add up over time, it multiplies.

It is important to understand that wealth building is based on multiplication. Not only that, magic starts to happen when your multiplied wealth starts to multiply, a process known as “compounding.” Compounding (or compound interest) is an amazing concept and a crucial piece of the wealth building process. It is rumored that Albert Einstein said, “Compound interest is the eighth wonder of the world.” Whether or not Einstein actually said that or not (a debate on the author of the quote continues) I’m sure the brilliant physicist understood that the fuel that runs the engine of wealth is multiplication.

 

Only Three Ingredients in the Recipe for Wealth

Now let’s take a look at the three main elements of the formula. You can find a mountain of material on each component, which is probably why many people find wealth building so intimidating. I’ll try to keep things high level and simple, so as not to lose the forest through the trees:

  • Savings and Your Current Wealth: To get on the path to riches, you need to start somewhere. Many people start by saving a small amount of money. Your current wealth (CW) is the accumulation of past savings and investing. Saving is an important part of building wealth and probably the easiest concept to understand. Most of us were introduced to the idea of saving as a child. (I’m sure many of you remember having a piggy bank jammed with birthday money, spare change, maybe a button or two.) Again, everything has already been written on the different ways to save. The bottom line is to regularly set aside some money and add it to your existing pile of savings or investments. Now, although saving is a necessary part of wealth building, very few people have made a fortune by squirreling away a part of their pay check every year. To build significant wealth, you need to mix in the other two ingredients: return and time.
  • Return: Your return is the money you earn on your long term savings or investments.   As far as the formula goes, return (R) is undoubtedly the most unstable element.  That’s because return always has risk unpleasantly glued to it.  There is an almost an infinite amount of investment ideas out there, with outcomes that range from slow and steady to crash and burn.  Conservative investments are typically more stable, but returns are lower. Aggressive investments offer the chance of higher returns, but you have to stomach the rough ride and face the possibility of losing all your money. The key to a successful investment strategy is to choose the one that has the best return for the amount of volatility you are willing and able to take.
  • Time Horizon: The last main element of the formula is time (T). The goal here is pretty straight forward: Start saving and investing as early and consistently as possible.  The earlier you start investing, the more heavy lifting the Golden Rule will do on your behalf.  In other words, compounding will work more in your favor the earlier you start.

Now we are ready to see how the different parts mesh together to demonstrate the trade-offs inherent in wealth building. For example, it is possible to be conservative (low R) and build wealth; you just need to save more (increase CW) or start saving earlier (increase T). If you start saving and investing later on in life (lower T), you have to save more (increase CW) or rely more on returns (increase R).  Practically every investment strategy out there today is the result of someone adjusting the levers of the Golden Rule machine.

So there you have it. The most powerful concepts in finance boiled down to one formula with three main ingredients.  Again, the power of the Golden Rule is its ability to cut out the noise and have you focus on the key components of wealth building.

In practice, the formula explains the success story behind every wealthy client I have worked with over the years. The Golden Rule is the common thread among all successful investors. In future posts I will show you some examples of the formula in action.  I’m sure you’ll be amazed by how simply the Golden Rule works, just like I still am.

 

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Debt is Probably the Best Tool for Building Wealth

debtDebt sure has a bad reputation these days. Every time I pick up a newspaper, all I see are articles about the “sovereign debt crisis.” When I turn on the television, I’m bombarded with commercials from companies offering to help people with their “debt troubles.” I can understand why many people today see debt as a disease, something to avoid like the plague. That’s too bad, because I think debt is one of the greatest inventions of all time, and probably the best tool we have for building wealth.

There’s no question: Many individuals and even some large governments today are struggling with debt. However, debt is not responsible for all the misery, the individuals who used the debt are at fault. Debt is not something that is good or bad in itself. How debt is used determines whether an outcome is good or bad. Similarly, fire is not good or bad in itself, but how fire is used determines whether an outcome is good (i.e. a campfire) or bad (i.e. a forest fire). Debt and fire also have another thing in common: When used incorrectly, you can get badly burned.

[pullquote align="left"]Debt is one of the greatest inventions of all time, and probably the best tool we have for building wealth.[/pullquote]Let’s look at a definition for debt. In basic terms, debt is a promise between a borrower and lender, where the lender gives money to the borrower, and after a period of time the borrower gives the money back with interest.  Some financial experts classify debt as either good or bad depending on what the money was used for. For example, money that was borrowed to buy something that is expected to appreciate in value (like a house or investment) is considered good debt. Borrowed money used to buy something that depreciates (like a car, TV, or vacation) is typically considered bad debt.

The Wrong Way to Use Debt in Building Wealth

Much of today’s debt problems started back in 2005. At that time, people around the world were using cheap debt to buy real estate at ever increasing prices. Many people thought real estate prices always go up, so the debt they were taking on was “good debt.” However, what most people didn’t see at the time was the housing bubble that was developing. Real estate assets were bought at incredibly inflated prices during the peak of the bubble. When the bubble finally burst and housing prices came crashing down, many people were stuck with large amounts of debt and houses worth a fraction of what was paid for them.

There is a lot of blame to go around after the real estate bubble. Some of the many guilty parties include dishonest lenders, morally corrupt Wall Street bankers, incompetent regulators, and delusional buyers. In the end, as with all financial calamities, the underlying emotion driving all the madness was greed.

Using Debt to Build Wealth

So understandably, many people today see debt as pure evil. However, the ugliness of the real estate collapse should not mask the many benefits of debt. For example, debt is used to finance many public projects like hospitals, schools, roads and bridges. Debt also gives businesses and entrepreneurs the necessary capital to develop new products, expand new markets and grow the overall economy. Without debt as a tool to fund new ideas, innovation would grind to a stop.

Debt is a great tool to move money from those who have it to those who need it. Almost every successful wealth builder has used debt at some point. Here are some examples: The founders of Starbucks had to borrow $5000 from a local bank to keep their first store in Seattle afloat. Starbucks went on to become a Fortune 500 company. The founders of Apple, Steve Jobs and Steve Wozniack, were penniless when they started and had to use credit from a supplier to build the first computers they sold. Apple is now one of the most valuable companies on the planet. There are countless other stories of individuals building successful businesses and creating tremendous amounts of wealth beginning with a small loan.

A New Opportunity for Building Wealth?

Today’s situation may be giving way to a new opportunity for creating wealth. Interest rates are still at historic low levels, stock markets are stagnant, and some companies appear to be cheap judging from their fundamentals. This may explain the slight pickup in merger and acquisition activity recently (see Ernst and Young’s latest Q2 tracker of M&A deals). Strong corporations may be realizing that they can buy quality assets at cheap prices and fund it using cheap debt. The same opportunity may be emerging for individual investors as well. Many quality blue chip companies have come down in price, giving individuals an opportunity to “buy low.”

Of course nobody can tell the future. The sovereign debt crisis could get a lot worse, the stock market could fall further, interest rates could rise significantly, or a new crisis altogether could pop up. But it’s times like these, when fear is running high that many smart investors can buy good assets on the cheap. Using debt is a way to potentially multiply that advantage.

There are always dangers to using debt (as the real estate bubble clearly shows), so anyone considering borrowing to invest should consult their professional advisor. However, using debt to buy quality assets when prices are cheap greatly mitigates the risk, and could lead to a significant increase in your wealth. Don’t get me wrong. It is possible to build wealth without ever going into debt, but if you are serious about building significant wealth, you need to have debt ready and at your disposal.

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The Golden Rule of Wealth Building

Wealth BuildingI am completely convinced that anyone can achieve financial success. Why am I so confident? Because as a wealth planner for well over a decade, I have had the great privilege of working with many wealthy clients. I also learned HOW they amassed their fortunes. The good news: I’m going to share my wealthy client secrets with you. The even better news: The secret to their success is very simple. In fact, wealth creation can be summarized in just one line, something I call The Golden Rule of Wealth Building.

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The Greatest Book on Wealth Building was Written in the 1920s

Greatest Book on Wealth BuildingWealth, like a tree, grows from a tiny seed. The first copper you save is the seed from which your tree of wealth shall grow. The sooner you plant that seed the sooner shall the tree grow. And the more faithfully you nourish and water that tree with consistent savings, the sooner may you bask in contentment beneath its shade.” Arkad from “The Richest Man In Babylon”

 

The best piece of advice I can give anyone who is serious about building wealth is this: You need to read The Richest Man in Babylon. Of all the books on financial planning and personal wealth I have read in my life, The Richest Man In Babylon is by far the best. I just finished re-reading this book for the third time. And here is the kicker: It was first written in 1926!

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