Wealth – What is left
In this, the last part of the three part blog (You can read part 1 HERE, and part 2 HERE)on the wealth equation we are going to look at the one we are all most interest in, wealth. Just to recap, the equation goes like this : Wealth is what is left after you have consumed your income – Not higher grade maths, but if you can simplify something that is infinitely complex into a simple concept, there is a better chance that more people will understand, and, more importantly, make the small changes that can have a huge impact on their wealth.
To start off with let’s look at what wealth is, and what it isn’t. Your primary residence is not an asset. In time, it may reduce your consumption that comes from rent but you have to have a roof over your head in the long term. If push comes to shove in your retirement years, you can realise the capital and live off it for the rest of your life, but obviously a chunk of that is now going to go into rental. Your brand-new-every-three-years-car and holiday-home-that-is-hardly-ever-rented are also not assets or wealth. In part one and two we focussed on one thing – increasing the amount that is left after you have consumed your income – so that you can invest and grow your wealth. One question I often get is “Should I pay off my debt or invest the money?” The easy answer is pay off your debt. The even easier answer is, apart from your mortgage, don’t have any debt. Mortgages are usually the lowest interest rate you can get. What about cars I hear you shout… My answer? Read part 2. If you pick right the first time, and you look after it, a car should last ten years. That gives you 5-7 years to put that repayment into an investment when you have to replace it – and pay cash. Before you buy a car find out what the out-of-plan maintenance costs are like – the variety by brand might shock you into making a longer-term choice. With our slower investment market and high interest rates, putting excess money in a bond is the best ‘return on investment’ you are going to get. However… whether you should or not is going to depend on your personal financial behaviour. Far too often I have seen pensions being cashed out (and taxed) to pay off debt or go into the bond, only for the debt to rise up again quickly. Fess up to your financial behaviour – you don’t have to share it with anyone – but if you know how you behave you are well on the way to really growing your wealth.
So, let’s just recap from Part 1 (which you can read HERE if you missed it). Wealth is what is left after you have consumed your income. In part one we looked at the income component. I debunked some of the myths around passive income before you think that is going to answer all your problems. I also emphasised that the working world is changing and it is not cool to be clueless, especially when it comes to technology. If you don’t keep learning and making yourself relevant, you’re going to come short. Nobody wants the money to run out before they do. You might not want to hear it, but it is the consumption component of your wealth equation where you can make the biggest difference, and most of it immediately. There is no point in scrabbling around to reduce the fees on your investments if you’re living large and beyond your means, making those few basis point saving on your investments fade into insignificance.
Most of our spending is a result of years of habits. Some of those habits, or perceptions, about money were laid in childhood. If you really want to make a difference to your wealth mind-set, you need to let go of blaming everyone else for your behaviour and own it. Sure, you might not have been set the best example in the world, your parents might not have been able to afford the best education, but as soon as you are an adult and have control over your own money it is time to stop blaming your parents or teachers and claw back that power. There are so many resources out there (including this one) that will help you do that. Irrespective of what you earn you should know, almost on a daily basis, what money is coming in, and what is going out and where. Fortunately there is an app for that. If you gave a huge sigh of frustration at that comment perhaps you need to go back to Part 1. It is not cool to be clueless, embrace technology, and not demonise it because you’re too lazy to learn. (Harsh and not politically correct I know but now, more than ever before, simple apps will save you massive amounts of time.) The app I like best for this daily money management is 22seven (free on Playstore and iStore). Why? It pulls all your transactions from all your accounts and most investments. You can then decide on your own categories and once done, all the transactions from that place (say Pick n Pay or Builders warehouse) will go into that category. You can then set the limits for each category. After a couple of weeks it is very clear where your weak points are. If you rarely look at your bank statement, then you might find long forgotten debit orders. It is those day-to-day expenses, accumulated over years that erode your wealth.
The wealth equation part 1 : Income
Is it possible to boil the secret of wealth down to a simple formula? I think it is not only possible, it is necessary. It is so easy to over-think wealth. Our relationship with money is extremely complex. We unwittingly give it different meaning and power way beyond its value. There is no other ‘concept’, with the exception perhaps of religion, that can stir up so much passion in a person that they are willing to kill for it.
We all know of people who will throw every single value they have ever held out of the window in the pursuit of the almighty buck. To be more exact, in pursuit of more income. But that is wealth isn’t it? Nope. Wealth is what is left after you have consumed your income. Even an ecosystem can be boiled down to some very basic elements so that they can be understood better. Inputs minus outputs equals growth. In an ecosystem the Inputs are numerous; sun, water, elements, oxygen, carbon dioxide, soil, food. Outputs include energy, pests, elements, oxygen, carbon dioxide, harvest, offspring and consumption – to name a few. The growth is the increase, of the plant, the animal, the population. If the outgoing is more than the incoming there is no growth. For dinosaurs (and millions of other species) they become extinct.
The equation is simple. Income minus consumption equals wealth. That means there are 3 components of your financial life you can tweak to grow your wealth. You can increase your income, decrease your consumption and manage your wealth.
Investment Diversity is as important as Biodiversity
One of the constant features of us complicated humans is the desire for diversity. We get bored quickly. We want new tastes, new experiences, new ‘stuff’. As soon as anything becomes repetitive we lose interest or get stressed. Repetitive jobs, reruns of old TV shows, repetitive ads, poor menu choice at your favourite restaurant. Fashion is a direct result of our need for variety. In nature this variety is called biodiversity.
Biodiversity is extremely important for the planet. It allows for flexibility when change happens to an environment. That change may kill one or two species, but something will always survive – even if it is just a cockroach or Trump. When it comes to our wealth, diversity is just as important. You cannot afford to put all your retirement eggs in one investment basket.
So let’s look at the various components of wealth and see where the diversity can come from:
There are 5 asset classes: Cash, Bonds, Equity, Property and Currency (not a classic asset class but a multiplier for offshore investments).
Cash is pretty self explanatory. It is ‘boring’ and gives you a below inflation rate of return. It’s importance to your wealth however cannot be underestimated. Cash-flow is king, not just for businesses but for individuals too. If you have cash available you can weather unplanned expenses without taking out expensive debt. You can also take advantage of other wealth opportunities quickly and without eroding your other wealth caches. If you put your cash with a major financial institution or in a product that spreads the risk across a number of institutions you are going to be okay. You are unlikely to lose the capital. What percentage of your wealth portfolio should be in cash? This is going to vary according to the economic environment but 3 months, after tax household expenses plus 10% is a reasonable rule of thumb. This is right across your wealth portfolio. Your retirement fund for example will have at least 10% in cash – but is ‘unavailable’. If you have a ‘blended’ unit trust (a flexible or moderate mandate for example) then there is probably a cash component there too.
Highlighting problem areas to save you heartache later
Financial advisory is highly complex and it is far too easy for the man on the street to get hoodwinked. These are the questions to ask your traditional broker that has given you the advice on an insurance or investment product. Be aware that call centres are allowed (by the FSB) to operate on a ‘low or no’ advice model and you probably won’t get an answer to these important questions and you are going to have to do the homework yourself. Over the last decade the regulatory environment has reigned in many of the dodgy practices that used to be rife in the financial advisory industry, but there are still some practices (allowed by the FSB) that can hurt your wealth. Here are some questions to ask your broker before signing up to new life cover or investment:
What are the differences between the benefits on the new and old policies? You need to ask this to protect yourself from a broker that is just churning a policy for more commission. There must be a compelling reason to change, and not just because it is ‘cheaper’. It is way to easy to manipulate a premium to make it look cheaper, often with an aggressive premium pattern or less comprehensive benefits.
How much is your “loyalty bonus” costing me and what are the terms and conditions? A number of traditional and call-centre insurance products offer some sort of payout after a certain amount of time but it is never ‘free’. Not only do they come with golden handcuffs (making it difficult for you to move to a better product in the future) but cost an additional premium that might be hidden in the small print.
Is the life premium “level” or “age-rated” and please can I have a graph comparing them? An age-rated premium is going to be much cheaper now but could well be unaffordable post-retirement when you need it most (because the prices are incremental and exponential) and when there is the biggest chance of having to claim.
Is the dread disease pay-out severity based and what are your alternatives? A severity based benefit pays you out a percentage of your cover depending on how severe the diagnosis is. The medical costs aren’t proportionately lower and it may make sense to have a product that pays you out more sooner.
It’s in their behaviour, not luck
1. They know their limitations. Investment is complicated, even new financial advisors will shy away from giving investment advice or recommend safe, well known funds. The more you know about investment though the scarier it becomes – but that is way better than thinking you know everything. There is nothing like being unconsciously confident. Unless you’re prepared to spend a considerable portion of your week keeping up with the global trends, tax implications, regulatory changes, economic indicators etc get a trusted advisor to give you a hand. That advisor can do due diligence on the Unit Trusts or Shares that you buy, investigate the fees on the platforms you use, investigate the investment philosophy of the asset managers you want to use, divert your funds into the right types of investment and alert you to macroeconomic changes. I know that paying your advisor a fee is a grudge, but regulations are changing to make it a win-win. In return for that fee you are entitled to feedback and ongoing monitoring of the appropriateness of that investment. As much as a fee will erode the investment, believe me, a park-and-leave approach to investing can be even more dangerous. I continually come across investments that have been in place for 20 years or more and not even keeping up with inflation.
2. They know that you can’t buy respect: Keeping up with the Joneses is probably one of the most toxic behaviour traits when it comes to wealth accumulation. Wealth is what is left after you have consumed your income. It is as simple as that. There is no point in seeing yourself as a smart investor if you don’t leave yourself anything to invest with at the end of every month. If you worry what people will think about the car you drive or the house you live in, perhaps you need to spend some time with a shrink or a coach and not on property.com or going for test drives? Read more