When I “decided” to get rich, I didn’t know the first thing about creating wealth.
I was an editor. I wanted to be a novelist. I’d never taken a course in finance or economics. Plus, I was broke.
But I had a great advantage. I was working for a human wealth machine – a man who, at 43, had already created three hugely profitable businesses.
He adopted me as a surrogate nephew/son and taught me everything he knew about making money.
I retired 12 years later with a net worth well in excess of $10 million.
Why am I telling you all this?
Maybe because I’d like you to think that when it comes to the subject of building wealth, I have some insights that might be useful to you.
Many commonly accepted “facts” about wealth building are, in fact, fallacies.
Take these six as examples:
- Risk and reward are inversely correlated. If you want to acquire great wealth, you have to be willing to take great risk.
- Wealthy people are stingy for a reason. Pinching pennies is a necessary part of building wealth.
- The most important factor in building wealth is ROI – the rate of return you get on your investments. When investing in stocks and bonds, therefore, look for high ROIs.
- A well-balanced investment portfolio is composed primarily (80% to 90%) of stocks and bonds, with the rest (10% to 20%) in cash or cash equivalents.
- The surest way to acquire enough money to retire on is to buy the most expensive house you can afford and gradually pay off the mortgage.
- Asset allocation is the single most important factor in building wealth.
Those are the fallacies. Here are the facts:
1. Safety grows wealth, not risk.
The intelligent wealth builder takes advantage of safe bets and avoids risky ones. He does this as an employee, a business owner and an investor. He understands that smart financial decisions are cautious decisions. When he must take a risk, he does so with some sort of loss limit in place. He never loses more than he is comfortable losing.
2. Being cheap doesn’t make you richer.
Spending money prudently is an economic virtue, but being stingy – i.e., paying less than market value for goods or services simply because you can – is a flaw. The rich man who undertips does so not because he has learned the value of money but because he is a cheap bastard. It’s as simple as that.
3. The most important factor in wealth building is not ROI.
Rather, it is the accumulation of net investable assets, the amount of money you’re able to devote to investing after you’ve paid for all your regular expenses – your car, home, debts and loans. Plus, individual investors chasing yield typically get ROIs that are less than half those of market averages. This is why the astute wealth builder devotes the lion’s share of his wealth-building time to increasing his income and setting realistic goals for his stock and bond portfolios. By “realistic,” I mean market averages plus or minus 10%.
4. Diversification is key.
The typical portfolio of stocks, bonds and cash, however allocated, is an inadequate approach to building and safeguarding wealth. The savvy wealth builder will also include other assets, such as income-producing real estate, tangible assets, alternative fixed income investments and direct investments in cash-generating private businesses.
5. Buying bigger isn’t better.
Buying a more expensive home every time you get a big raise is a great way to ensure that you will never get rich. What you want to do is find the least expensive house you can “love long term” and keep it. The longer you keep it, the more net investable income you will have to invest in income-producing assets that will eventually make you rich.
6. There’s a proper way to manage risk.
Asset allocation is indeed very important, but it is only one-third of a larger strategy that truly is most important. I’m talking about risk management. Risk management has three parts: asset allocation, position sizing and loss limitation. The intelligent investor pays equal attention to all three.
Okay, those are six facts that dispel the common fallacies. Got a few minutes more? Here are four more facts, some of which are very basic but often ignored.
1. The biggest mistake retirees make is giving up their active income.
Yes, I know that’s exactly what you hope to do. But to keep your wealth for a lifetime, you need multiple streams of passive income. Your goal should be to build each stream of income to a level where you can live on that and that alone.
2. Compound interest also applies to knowledge.
The “miracle of compound interest” applies not just to money but also to skill and to knowledge. If you want to get rich and stay rich, you need to invest as much of your spare time as possible in acquiring financially valuable skills and learning about your business.
As a general rule, buying makes you poorer, whereas selling makes you richer. If you want to develop a wealth builder’s mindset, develop the habit of asking yourself every time you buy or sell anything: Is this making me richer or poorer?
3. Don’t expect more. Or less.
Every type of financial asset has its own unique characteristics in terms of growth potential, income potential and risk. Expecting more growth or less risk than “normal” from any investment is a bad idea. That is why 90% of ordinary investors have results that are far worse than market averages.
4. There are two ways investments can build wealth.
One is by the generation of income. The other is through appreciation – an increase in the value of the underlying asset. Asset classes are inherently structured to increase value, preserve value or do both. Investments that provide both income and appreciation are generally superior to investments that provide only one or the other. But in developing an overall strategy of wealth building, the prudent investor will incorporate all three types of investments.
You may find some of these facts instantly sensible. Others you may disagree with, be confused by or see as unimportant. But don’t just read them and dismiss them. Give yourself time to think about them.
For me, they are useful and important because they have worked for me and people I mentored – and they’ve worked over and over again. Which means, of course, that they might work for you.