The Laws of Wealth Creation

Financial independence or creating wealth is a goal many strive to achieve. However, only a few accomplish this due to a lack of knowledge about wealth creation, while for others, it's often due to a lack of confidence in creating wealth. But this needn't be the case.

No doubt, many of you would agree that a successful strategy for creating wealth is to cut your losses short and let your profits run. However, many still invest in assets that lose money rather than financial assets that generate growth and income. That's why, in this comprehensive guide, we will explore the three laws of wealth creation to help you create a plan of attack that will unlock your potential for financial success.

What is meant by wealth creation?

According to the Free Dictionary, wealth creation is the "accumulation of assets (especially those that generate income) over a long period". In other words, it's about generating long-term wealth by making informed decisions and saving and investing your money to achieve your short, medium, and long-term financial goals.

Despite what some may like to think, wealth creation is not a get-rich-quick scheme; it’s a lifelong journey that requires patience and perseverance. By developing good financial habits and a growth mindset, you can steadily increase your net worth over time to achieve your financial goals.

Stop losing and start making money

Interestingly, many people are willing to spend years studying to gain a formal education, expecting to gain a job that will pay enough to help them sustain their desired lifestyle. Yet, when it comes to educating themselves about creating wealth, they never quite find the time. Instead, the majority seem willing to live from pay cheque to pay cheque, which means they have to work harder and longer to create the income that will satisfy their needs.

The desire for individuals to have whatever they want now and pay for it later means that many forego the required planning to ensure they have sufficient wealth in retirement. But this needn't be the case, as there is always time to get your investments in order.

Based on my experience, most people don’t give enough time or thought to the laws of wealth creation. They take it for granted that they do not need to give them the attention they deserve because they already understand them. But let me ask you, how many of you are genuinely building a nest egg to ensure you are financially secure in your retirement years?

The three laws for successful wealth creation

The three laws to successful wealth creation will enable you to stop losing and start making money. Many only give these principles a fleeting glance, believing they already understand them; therefore, they do not need to give them the attention they deserve.

But let me ask: are you on your way to achieving financial independence? If the answer is no, then please pay attention. These principles provide the foundation for reducing your losses and increasing our profits. The three laws of wealth creation include:

• Spend less than you earn, 
  
• Invest your surplus wisely, and
  
• Leave your investments alone to grow.

Ask yourself, which wealth creation rules do you follow consistently?

Do you have what it takes?

Of the many people I have helped in the investment industry, the majority do not get past the first rule of spending less than they earn. These people are unable to move on. Of those who do follow this rule and go on to invest their surplus cash, many fail to do their homework and, consequently, through lack of knowledge, do not invest wisely. Finally, even having invested wisely, some cannot leave their investments alone long enough to compound.

I assure you that following these rules is the fastest way to stop losing and start making money. After all, if you do nothing, that is precisely what happens—nothing. If nothing happens, you are losing—as inflation will steadily erode the value of your money.

Law No.1: Building wealth is about spending less than you earn

Many people have asked me to show them how they can create wealth. In most cases, they expect that I will give them the “holy grail” of investing that will make them millions. Instead, I ask them, "Do you have a budget?” You know—that excellent wealth creation vehicle many suggest you should have to help you become financially independent.

If you're like most people, you probably think that having a “budget” will restrict your spending, hamper your lifestyle and generally make you miserable. However, none of this is true; a budget is simply a financial plan that helps you to succeed and makes a massive difference in your life.

What is a budget?

A budget lists your income and expenses and lays the foundation for how you invest or spend your money. The thing is, without a budget, how do you know:

• How much you are spending or, more importantly,
  
• How much you can save?

I have never met anyone who could not save at least 10 per cent of their income after completing a budget. Most people can save 20 to 30 per cent of their income and maintain a good lifestyle.

Budgeting is like a roadmap to financial independence, providing a plan to achieve your financial objectives and create your preferred reality. This rule is an important starting point for any investor as it allows you to free up cash flow, so you have more to invest in financial assets that will enable you to create more freedom, security and wealth.

Law No.2: Invest your surplus cash wisely (at least 10% of your income)

Investing your surplus cash wisely is the next rule in your wealth creation journey. A wise investment must provide both capital growth and income. If an investment does not have both components, then someone else benefits from the component you are not getting. Investments that do not have both components are considered average investments in which you have to accept average returns, such as cash or bonds.

Investing in shares and property is the best method that delivers income and capital growth. While investing wisely in these assets is higher risk, the reward is worthwhile if you gain the required knowledge and skill to lower your risk and minimise your losses, especially if you want to learn how to profit from share trading.

Develop an investment strategy

Given that you work hard for your money, it makes sense that you would invest the time and money learning how to trade stocks or invest in property to ensure your investments are profitable. If I work one hour to earn $50 and put that money on a share hoping to win, and I lose, that $50 can never be replaced - I can never work that hour again. So why would I put my hard-earned capital at risk unless I had a high probability of success?

That's why developing an investment strategy that considers your goals, risk profile, and timeframe is important. You also need to have a clear objective for why you are investing. Is it to generate income or build wealth over the long term? And to ensure you are successful, your investment strategy should satisfy the following criteria:

• An exit strategy must exist 
  
• You should have a rationale for investing in a particular asset.
  

Let’s examine these in more detail.

An exit strategy must exist

Once you invest, it's important to consider how you will manage your investment risk. In other words, you must consider your exit strategy before investing. Most investors do not consider this because they expect the asset to rise when they invest.

While there is potential for the asset to rise, the value of the asset is only realised once you sell. Consequently, this is considered unrealised profits, as the asset could fall in value. Therefore, it is important to consider how and when you will exit if your investment does not perform as expected.

Unfortunately, many investors mistakenly believe that if they have not sold a share that is falling in value, they are not losing. But let me explain why the opposite is true.

Example of the impact on your portfolio when shares are falling

If I buy a rising blue-chip share, I know with a high probability that the stock will generally rise a minimum of 20 per cent over the next 12 months. Let's assume I invest in five stocks throughout the year. Four stocks rise in value (all by 20 per cent), and only one makes a loss (also by 20 per cent).

Now, let's convert this into dollar terms.

If I invested $1,000 in every stock, I would make $200 on each of the four shares that went up and lose $200 on the shares that went down. Therefore, I would make $800 and lose $200, giving me a net profit of $600 or a 12 per cent return on my capital of $5,000.

Now, let's assume I hold onto the stock that is falling in value because there is a chance it will turn around and start to rise. However, when it decreased by 50 per cent, I realised this wouldn't happen.

So, what is the effect of this on my portfolio? On the falling share, I lost 50 per cent or $500, meaning the unrealised net profit changes to only $300 ($800- $500 =$300) or 6 per cent profit on my $5,000 capital. Allowing the share to fall below 20 per cent halved the return on my portfolio. 

The point is the longer a stock continues to fall, the greater the effect on your overall profitability. Allowing your losses to run into more considerable losses turns a sound investment strategy into an average one. That's why I teach everyone to place a stop loss on their investments so they minimise their downside risk. 

The rationale for investing in a particular asset

If you do not understand the consequences of your investment strategy, you are taking higher risks, which means there is a higher probability you could lose. For example, many investors got caught up in the hype of the tech boom in the late 1990s, investing large sums of money in the hope of making a fortune.

Media hype and speculation fuelled the misconception in the marketplace that "blue chip" shares were outdated and that technology stocks or "dot com" stocks were the growth stocks of the future. This misleading information permeated the market, causing mass greed that resulted in share prices skyrocketing to many times their true value. Many investors even forgot to consider the basic economic fundamentals of successful companies, ignoring that many of the "dot com" companies were yet to make a profit.

As a consequence, a lot of investors lost money and time in creating a wise investment portfolio. And there is no doubt this will happen again. Just look at the bubble created by the hype and mania surrounding Bitcoin and cryptocurrencies, a form of digital currency that appears out of thin air and then skyrockets in value to many times its worth.

You need to understand the consequences of your investment decisions. Otherwise, you are better off investing your money in an average investment, like a bank term deposit. While your return may be lower, you eliminate the risk of these higher-risk investments.

Law No.3: Leave your investments alone to grow

The third rule to wealth creation is to leave your investments alone to grow. Einstein referred to this as the power of compounding or the world's eighth wonder. When you invest wisely, your money will earn interest, dividends and capital gains. When you reinvest these earnings, it yields additional income because of the compounding effect. Consequently, it is this rule that is the real key to wealth creation due to two key factors:

1. Time

The longer you hold onto your investments, the more opportunity there is for interest, dividends and capital gains to accumulate, generating even more earnings.

2. Rate of return

The higher the rate of return on your investments, the faster your money will compound. This occurs because additional earnings are added to your capital, generating other earnings through compounding.

Let's look at an example.

The power of compounding

If you invest $10,000 and earn 10 per cent interest in the first year, you would make $1,000. If you reinvest the $1,000 on top of your capital of $10,000, you now have $11,000 earning interest at 10 per cent. This means you would earn $1,100 in the second year, and the effective rate of return or yield (excluding fees) on your original capital of $10,000 is now earning 11 per cent. Imagine if you continued to compound your returns.

As you can see in the table below, if you continue to reinvest your capital and earnings over five years, you will earn an effective yield (excluding fees) of 14.46 per cent on your original capital. 

Once you embark on your investment journey, you should leave your capital alone to allow it to grow. Only when your investments generate income and growth equal to or better than what you earn from working in a 9 to 5 job should you consider using your investments or income for lifestyle purposes.

Sadly, many investors prefer short-term gratification and dip into their investments to buy a car, go on a holiday or do something unrelated to building wealth. If you do this, you should know that this will put you years behind in achieving your goals. This is because compounding produces only modest gains over the first few years. As demonstrated by the example above, the real effect of compounding is only seen when your capital and earnings are reinvested and left for more extended periods as they begin to grow much faster.

Educate yourself about wealth creation.

Regrettably, the lack of knowledge about wealth creation intensifies the emotions of fear and greed, causing investors to react and, at times, overreact to market conditions, which prevents many from becoming financially independent.

This is why educating yourself about wealth creation is essential, as it will enable you to build long-term wealth and achieve financial success. Gaining the required knowledge and understanding will allow you to make informed decisions and avoid costly mistakes. So, let's look at why it's important to educate yourself about wealth creation:

1. Improved financial decision-making

Education provides you with the tools and knowledge to make sound financial decisions. It also helps you optimise your wealth creation potential to achieve your financial goals much sooner. There's an old saying by Charles Givens that states, "Knowledge overcomes the two enemies of prosperity...risk and fear".

2. Risk management

Educating yourself about the risks associated with your investments allows you to manage these risks and minimise potential losses adequately. This includes understanding the impact of diversification and how this affects your portfolio returns. By diversifying your portfolio, you can protect yourself against extreme market events and the inherent volatility of individual investments.

3. Increased confidence

An education will boost your confidence to manage your money more effectively, leading to better financial habits. Building your confidence also helps you feel more in control of your financial future.

4. Long-term financial success

Educating yourself about wealth creation contributes to a growth mindset. As you expand your knowledge and skills, you become better at capitalising on opportunities and managing the challenges that will inherently pop up in your investment journey.

As a share trading educator and portfolio manager for over 30 years, I have seen the success stories of those who have chosen to educate themselves about wealth creation. I can't emphasise enough how important it is that you do the same.

Many professionals mistakenly believe that if they impart knowledge to their clients, they will want to control their investments rather than utilise their services. However, I have found that the more I educate my clients, the more they trust what I do and benefit from my services.

So there you have it. Remember, wealth creation is a journey, so I encourage you to follow the six laws in this comprehensive guide, as you will find they will profoundly affect your life.

Others also enjoyed reading: 

• Four Golden Rules to Investing in Shares
  
• Trading the Stock Market - Why Most Traders Fail
  

My latest award-winning book, Accelerate Your Wealth, It's Your Money, Your Choice, is also packed with some simple but powerful investment strategies that will enable you to fast-track your wealth creation goals. If you want to gain the necessary knowledge and skills to achieve consistent profitability in all market conditions, I encourage you to check out our accredited trading courses. You can also gain insights into the success of our graduates in their wealth-creation journey by reading their reviews and testimonials.

Dale Gillham is one of Australia's most respected analysts with over 30 years of experience in the investment industry, including banking, financial planning, share market education and professional trading. He is the best-selling author of multiple books. He is passionate about ensuring clients receive a quality education in the stock market with Australia's most comprehensive trading course to support you to become a confident and profitable trader.