Building 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.