“It is not the mountain we conquer but ourselves.” – Edmund Hillary
This is the third and final part of our Building the Bridge series. We will bring together our ultimate objectives in Part One, with an understanding of the financial landscape in Part Two, and now in Part Three, we will give to you a simple, practical formula for true wealth creation.
Why a Formula?
Some might ask, why a formula? A formula does four things. First, it simplifies. Second, it looks beyond complexity and gives us objectivity and universal principles. Third, it links key variables, and shows us how they relate. Fourth, it gives us practical steps we can take to move towards true wealth creation.
The formula I have created for true wealth has been derived from many years of experience and research-
W = PICLAT
Where, W = True Wealth; P = Purpose; I = Income; C = Channelling; L = Leverage or loans; A = Assets, and T = Time. You will see T is a superscript, this is because the other variables are ‘to the power of time’, particularly the Asset variable. For instance, in the investing context, Time and compounding gives us exponential growth.
The formula is easy to remember and apply. Let’s now examine each of the variables. It is better to see them not strictly in a mathematical sense, but as simple true wealth steps.
True Wealth Steps
i) Purpose (P)
We saw in Part One of our series, that our ultimate objectives of wealth creation will have two parts. First, Financial Independence (FI), and second, a non-financial purpose that drives us to succeed and gives us meaning. For example, this might be a specific philanthropic cause. We saw earlier this fits better with a broader idea of wealth. That is True Wealth: Financial Independence for Lifestyle and Legacy (FILL).
ii) Income (I)
Income is regular net cashflow. In the personal context it is disposable income, that is Net Income After Tax. Your net cashflow gives you the a regular amount you can then save or channel into assets, such as stocks, property and modern instruments, such as Exchange Traded Funds (ETFs). The goal then is simple: maximise your income stream/s, and minimise expenses, to maximise net income for investing. In recent years, particularly through mass advertising, many lose sight of this simple approach. You cannot consume your way to wealth creation.
We learnt in Part One to see money or wealth like water. It needs to be respected. It needs to flow. From our net income we then channel our savings into our portfolio of assets. Many people have a psychological aversion to saving. Yet it is one of the key steps. Many fail to do properly, especially over the long term. I have addressed this issue through what I call a True Wealth Machine. A series of spreadsheets and regular processes that automate channelling. Simplicity and automation breed consistency and control.
iv) Leverage (L)
Leverage or loans can be considered when acquiring assets. Here I am talking about ‘good loans’, that is loans or margin-like instruments used to acquire assets. Leverage is often over-sold by lenders. For the astute investor, we always have a preference to use our own funds. This limits risk, and uncertainties. For example if the credit provider changes its lending policy. It also guards against fluctuations in the markets, for instance if a margin loan is used for stock investing.
v) Assets (A)
Many of us still do not distinguish clearly between an asset and a liability. Assets have two core characteristics. First, they can Grow (G) over time. Second, they can provide leveraged income (L). For example, the car you own is a liability not an asset. Similarly your boat, or perhaps your home. When objectively examining any asset that is investment grade, we are trying to bridge uncertainties, project into the future, and then decide if we have a strong probability of maximising G and L over the long term.
Let’s look at a quick example from property investing, for which Australians have a particular affinity. Sadly there have been many salespeople over the years confusing many of us. When analysing a particular investment property, ask yourself:
- Growth. What is the probability of strong, average net capital growth (G) for this property, say over at least one market cycle, 7- 10 years?
- Net Yield. Similarly, what is the probability of strong, average net income (I), that is Net Yield, not Gross Yield, which often appears in marketing materials.
- Total Return (TR) Adding G and I together, what then is the average net Total Return (TR) as a percentage of your capital base?
- Comparing. How does this compare to the net Total Return of other assets, for example, stock market index funds or property ETFs?
- Other Considerations. Then weigh TR against other issues, including your time, maintenance, uncertainties such as climate change, and other broader forms of risk, all of which need to be managed. For instance, can you create a portfolio to balance these risks, as we can easily do in the stock or futures markets?
vi) Time (T)
Time gives us the compounding of capital and income. We all know about the power of compound interest on simple savings returns of say 2% to 5%. But if we apply compounding to say a stock index fund purchased through an ETF that does an average long term net TR of 10%, then we see we can build a capital base sufficient for Financial Independence quite quickly.
Recent advances in technology, such as online brokering, mean too many investors confuse what they are doing with trading. There needs to be a brick wall between the two. Investing works if we carefully select sound assets, manage risk often through portfolio structures, and then hold for the long term. If we regularly trade stocks, say, we add to costs, and we minimise our long term average Total Return.
Universality and Perpetuity
We conclude this series with two insights. We have learnt that much of the apparent complexity in finance is unnecessary. We have found simple, universal principles of true wealth creation. These principles anyone can do with a little committed effort. Second, if we apply the True Wealth formula consistently over time, we build perpetual wealth creation. That is, the capital base of our assets can continue to grow and produce income, even if we draw down some of the Total Return in our years of Financial Independence. This is like the water cycle in nature. Universality and perpetuity give us a means to rise and lead inspired lives of service.
By Lee Spano, Creatness International www.creatness.com