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Real Wealth Creation Strategies - What Cycle are You in? |
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Understand the cycles to put your mind at ease |
What is wealth creation? It is a word that is widely used and very poorly understood. Many people believe that
wealth creation is about making more money. This is part of the process, but wealth creation has a much wider
definition. There are five aspects of wealth creation to consider:
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Generate Income
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Manage Expenses
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Maintain and Increase Assets
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Manage Liabilities
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Manage Risks
Wealth creation is ultimately about lifestyle. It is about improving your lifestyle by having the financial means
to do this.
Generate Income
Increasing your income is often seen as the way to having more money. While this can be true an
increase in income for many people does not solve their problems. I am sure you know someone that earns over
$100,000 per year and they say it is really hard to save on their income. Often what happens is as their income
increases their expenses also increase. It is of no advantage to earn $1 million dollars a year if you are spending
$2 million.
The best way to increase your income is to generate multiple streams of income, or to have money coming in from
lots of different areas. Then if one of your income streams stops for any reason you still have other income to
rely on. Many households however have one source of income and that is their job. If something was to happen to
this income stream then this can create financial difficulties. Wealthy people do not rely on income from one area
as a successful business does not rely on income from selling only one product. Start investing into shares,
property or cash to increase your sources of income.
Manage Expenses
While focusing on increasing your income it is also important to manage your expenses. There is a very simple rule
for creating wealth. Spend less than you earn and invest the rest. This is easy to say but not so easy to do. If
you had 10 minutes to calculate how much you earned last year it is very likely that you could do this very
accurately. However if you were given 10 minutes to calculate how much you spent last year then many people would
be unable to do this and very few would be able to accurately record their spending. How do you know if you are
spending more than you are earning? If you don’t how do you know if you are getting wealthier or poorer. Keeping
track of where your money goes is an important part of wealth creation. For more background reading there is a
great book called the Richest Man in Babylon which details the process of accumulating wealth.
What is the biggest expense that you will face in your lifetime? Many people respond that it is their house, their
children or their partner. All of these are expensive items but not the biggest expense that people will face. The
biggest expense that most people in the developed world are subject to is tax. If you are paying the highest tax
rate in Australia then almost half of your money disappears before you see a cent of that income. That is before
you pay GST, petrol or alcohol taxes. Tax is by far the largest expense that you will face during your lifetime. It
is important that you spend time focusing on reducing your tax. Many people will drive across town to save one cent
on their petrol, or visit many different supermarkets to save a few dollars on groceries. If they spent as much
time focusing on reducing their tax then they would be in a much better financial position than saving a few
dollars here or there. We will take a look at different structures that you can invest in to minimise your
tax.
Maintain and Increase your Assets
The goal of a person looking to create wealth is to increase their assets so they can generate an
income off their assets. The starting point is to recognise what is an asset. The true definition of an asset is
that it puts money into your pocket. Anything that takes money out of your pocket is considered to be a liability.
Many of the things that people consider to be assets are in fact liabilities as they cost them money.
Assets can be classified into two categories lifestyle assets and investment assets. The car the house and the boat
are all lifestyle assets, while rental property, shares and cash are considered investment assets. The middle class
make a critical error when they aim to achieve wealth. They strive to have the nice house, the nice car and the
nice boat that the wealthy have, but miss a critical link on the path to creating wealth. They get a high paying
job and buy the house, the boat and the car that the wealthy drive. The link that they missed was the wealthy
person bought investment assets to pay for the house, the boat and the car. They did not buy them out of their
salary.
Manage Liabilities
Debt is not good or bad. It is how the debt is used that will determine whether the debt is of benefit
to you or detrimental to your financial well being. If you were to borrow $10,000 and spend it on an overseas
holiday, how much would it be worth in a year’s time? You would have memories and photographs maybe, but no money.
If you were to borrow $10,000 and buy a car how much would it be worth in a year’s time? The car would possibly be
worth $5,000 and certainly less than $10,000. If you were to borrow $10,000 and buy property or shares then how
much would it be worth in a year’s time? The exact amount is unknown however it is likely to be worth more than
$10,000. So borrowing to buy an asset makes the debt “good” or of benefit to your financial position and borrowing
to spend makes the debt “bad” or detrimental to your financial position.
Manage your Risk
If you are a proponent of Murphy’s Law then anything that can go wrong will go wrong. Managing risk is
about reducing the impact on your financial situation when things do go wrong. Risks fall into two categories,
insurable risks and uninsurable risks. Most people have insurance for their house, car and contents, but fewer
protect the things that can have a huge impact on your financial well being. Most people’s major asset is their
ability to earn income. This can be protected with income protection insurance which will replace an income if you
are unable to work for any length of time. Life insurance becomes important if you have children or a partner that
depend on you for their lifestyle. Health insurance may be of benefit to you to cover large medical expenses that
could occur.
Insurance can be used to minimise the impact of unforeseen events, however there are some things that cannot be
insured against. Insurance is not as readily available against your business having a severe downturn or being sued
because of a traffic accident. To protect your assets and income in the situation where you are uninsured requires
the use of structures to isolate different activities and to hold assets away from creditors.
Wealth Creation Life Cycle
There are four phases of wealth creation that occur during most peoples’ lives. Phase 1, Broke from 0
-20 years old, Phase 2, Financial Survival from 20 - 40 years old, Phase 3, Financial Stability from 40 -60 and
Phase 4, Financial Freedom from 60 years onwards. Obviously the ages are a guideline and this will vary from person
to person.
Phase 1, Broke
Most people are born into this world with nothing. Very few people arrived with a wallet attached when they were
delivered and most people do not have significant income during the early years of their lives. In this phase of
life income equals expenses as the majority of the money earned is spent. The person has no significant assets or
liabilities.
Phase 2, Financial Survival
Phase 2 is often worse than being broke. The person now has a regular income and he or she can borrow
to buy a car or a house. At this stage he or she is also setting up their life by purchasing furniture, appliances
and often having children as well. There are many expenses to pay and often the young person borrows to cover these
expenses. This can generate a downward spiral when a person’s expenses are greater than their income. The only way
this is sustainable is if the person borrows more to pay their debts. If this stays out of control for a long
period of time then the person can end up bankrupt as they are no longer in a position to pay their
debts.
Phase 3, Financial Stability
As people get older their income increases and their expenses drop away. It is during this phase of
life that people are in the best position to accumulate assets. The assets that they own are increasing in value
and adding to their income allowing the person to reduce their debt levels and add further to their asset
base.
Phase 4, Financial Freedom
Financial freedom occurs when a person’s income from their assets is greater than their expenses. At
this point in time the person is free to stop work if they choose to and live off the income generated by their
assets. In Robert Kiyosaki’s game, Cashflow, the hardest professions to get out of the rat race are the doctor, the
lawyer and the airline pilot. Their expenses tend to be very high so a large income is required from their assets
to get out of the rat race. The janitor, teacher and truck driver find it much easier to exit the rat race as they
have far less expenses to cover. This is backed up by a book called the Millionaire Next Door that studies the
profiles of millionaires. The majority of them own their own businesses and do not drive expensive cars, or live in
expensive houses. They focus on investing their money to increase their wealth.
Everyone is at different stages on the path to financial freedom. It is important to identify where you are on the
current path. If you do not know your starting point it is very difficult to set out in the right direction to
achieve your financial goals.
Jeff Cartridge
LearnCFDs.com
3 January 2009
Source: http://www.learncfds.com/
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