Lessons before you invest Building wealth is all about having a good plan, and sticking to it

BUILDING wealth is all about discipline – the discipline to set a strategy, develop a plan, to implement it and to stick to it.

The foundation of that strategy and plan is anchored around a clear understanding of the fundamental concepts of investing. It’s about clear thinking … the right thinking.

Here is what we think are the basic financial concepts that you need to follow before building your strategy.

1 NET WORTH

Net worth is your barometer of financial health. It’s your total assets minus your total debt. It is the true litmus test of how successfully you are building wealth.

It often amuses us when people tell us the impressive value of their investment portfolio. We usually follow up with “and how much debt have you against that?”

If they stumble around, we know they’ve borrowed up to their eyeballs and it’s not wealth but debt. It’s a bit like the friend driving around in an impressive car when a finance company is the real owner. 2 REAL RETURNS

Inflation is when the cost of living goes up. As prices rise, the same amount of money will buy less … unless your income or investments are rising at a greater rate to compensate.

The inflation rate is now rising at 2.1 per cent a year. So your income and investments need to grow by more than the CPI or you’ll be standing still or going backwards.

The “real return” is the return from your investments less the inflation rate. It is the only measure of how far you’re actually ahead.

3 LIQUIDITY

Liquidity is simply how quickly you can get at your money. Cash in your hand is the most liquid your money can be, while superannuation is probably at the other end of the liquidity scale because the Government has regulated you can’t touch that money until their defined retirement age. Shares and property are at different levels.

Liquidity is a big issue when it comes to investing. Access to your wealth is always an important consideration depending on what you want your money to do. For example, an emergency fund needs to be invested in liquid assets so it can be retrieved easily.

Libby and I rarely invest in direct property because it is such a big ticket item which, depending on the state of the market, can take a long time to sell. Plus the transaction costs (stamp duty, agent’s fees, legal costs) can be really high.

4CYCLES INVESTMENTS MOVE IN

When it comes to investing there is no guarantee: there are no “sure things”. History tells us every investment moves in a cycle … there will be times when values go up and times when values go down.

The key is where you are in the investment cycle and making sure your timing is accurate enough that you invest near the bottom and sell at near the top of a cycle.

Stepping back and looking at the big picture cycles is critical.

5 HOW MUCH RISK IS RIGHT

If we acknowledge investments move in cycles, risk tolerance is how comfortable you are with these swings – whether you understand the cycle and ride with it or stress about it. Your risk tolerance determines how aggressive you can be with your investing.

Risk tolerance isn’t just emotional. It depends on a range of factors such as how much time you have to commit, your future earning potential, and the assets you have that are not invested, such as your home or inheritance.

6 ASSET ALLOCATION AND DIVERSIFICATION

Asset allocation is basically the type of assets you invest in, which is determined by your investment strategy and goals.

The goal of diversification is spreading the risks of investing by spreading your wealth across a range of assets: not putting all your eggs in the one basket.

Hopefully it smooths out returns. An investment that is falling in value is ideally offset by another that is rising.

7 COMPOUND INTEREST

Compound interest is interest that you earn on a “rolling balance,” and not on the initial principle.

If you start off with $100 earning 10 per cent interest annually, after your first year you’ll have $110. The next year, you’ll be earning 10 per cent interest on $110 and not $100 (you’ll earn $11 instead of $10).

It doesn’t sound impressive $10 at a time, but the multiplier effect can super charge returns.