Chapter 5 / The Formula for Riches / The Difference Between Rich and Poor / by Dr. Hannes Dreyer.
Chapter 5.
The Formula For Riches:
Where:
$ = The desire to become and remain wealthy
S = Surplus
G = Growth on your surplus
R = Risk involved in the investment or business Re = Responsibility to manage the growth and risk nm = Time and personal effort
Interpretation of The Formula For Riches
$ = The desire to become and remain wealthy.
The greatest gift which we have received is the ability to decide. Unless you make up your mind that you want to do something, nothing is going to happen. It starts with an idea. Unless you decide to be happy, successful, or rich, nothing is going to happen.
The same is true of becoming and remaining rich. Unless you decide you are going to become rich you will not. But a decision alone will not help you to achieve your goal. You must act. You must do something.
But most people do not have a plan or a strategy or a way to reach their goals. The reason why I developed The Formula For Riches is to give you a guideline that will help you to achieve this specific goal. But I cannot help you unless you want to become rich!
If they want or need is strong enough, a person will do the seemingly impossible. For most people, it is impossible to become rich. I can say this based on what the statistics tell us. It is impossible, not because they are not capable, clever, or hard-working. It is impossible because they do not follow the right system, or know the truth.
So what you as a Wealth Creator want to achieve, will be impossible for the majority of people.
You cannot apply The Formula For Riches unless you have the desire to become rich and are willing to do whatever it takes. In the process you liberate yourself from the trap of having to earn a salary every month, feeling insecure in case you get retrenched, etc.
This is a wonderful bonus because the rewards come early! Within hours or days or weeks you will start to feel more in control of your life, more the master of your own destiny. Life’s possibilities open, you are happier, less stressed, more relaxed, and enjoying the buzz of growth and discovery!
Once you have made up your mind you can take action. The only guaranteed way to become rich is to follow The Formula For Riches and to put its principles into action.
Without action, an idea will stay an idea. It is the doing that gives the idea wings.
S = Surplus.
What is a surplus?
It is excess money that you have left after you have paid your living expenses. It is this surplus that you need to build your financial wealth.
There are two classes of surplus.
Before the income can vest as capital, all taxes must be paid. There are different forms of taxes and the tax laws of the different countries will dictate how much of your income or capital will become or will stay capital.
After all, if taxes have been paid on the surplus income, it becomes capital. It is, therefore, possible, with the right financial structures and entities, to create more surpluses.
It is also possible with proper tax planning to create a bigger surplus, even if your income and living expenses stay the same because you can find ways to legally pay less tax on your total income.
We can therefore also say that a surplus has two natures. The first being income and the second being capital.
The formula does not state what the nature of the income must be. It can be either capital or income or even a combination of the two.
It also does not state how big a surplus you must have, in order to start with The Formula For Riches.
This is contrary to what most people believe to be the truth. They believe it takes money to make money and the more money you have the better it will be. This is not according to The Formula For Riches.
What is the function of the surplus?
The first and foremost reason why you need a surplus is to offset the risk which you may have in any business or investment.
The second function is to determine the pace at which to grow. Normally with a business or investment, if you grow too fast in proportion to the surplus that you have available, you will grow your business or investment into a position whereby, if market conditions change, you will lose everything that you have built up or created.
So by managing the surplus against the growth and risk, you will get the optimum pace at which you can grow your investment or business.
So by managing the surplus against the growth and risk, you will get the optimum pace at which you can grow your investment or business.
Each individual or financial entity will have its own optimum growth rate.
This growth rate will be determined by the availability of income and capital surpluses.
G = Growth on your surplus.
Unless you can measure how hard your money is working for you, it is impossible for you to know if your money is really working for you – it may even be working against you!
Most people do not know if their money is working for them because they do not know how to calculate the growth on their investment. Most investments are based on emotion. People buy their cars, houses, insurance policies, and shares, based on emotion.
I have taught tens of thousands of students how to invest in property. Less than one percent of them were in a position to tell me before the course what method to use in order to calculate the growth in property investment. Less than FIVE PERCENT of THE ONE PERCENT actually had a system for calculating the growth.
The rest bought their investment property based on emotion.
To overcome this very risky business of decision-making on emotion, you must find a system (program) to determine the growth of an investment or a business.
Measuring growth/yield/return.
In order to measure an investment's growth such as an endowment or a retirement annuity, 401(k) plans, mutual funds, or any fixed contribution, one uses the compound interest calculation (also known as future value). This is a formula that calculates the percentage return you will get.
The formula only works if there are these three variables:
So it assumes that you are going to pay say $1,000 into the plan every month for a fixed period – no irregular payments and no withdrawals. The compound interest is the difference between all the money you put in (over the entire period) and the final lump sum that you receive. In other words, you put lots of little bits in, and you get one huge chunk out at the end.
The problem with compounded interest.
When any of the three above-mentioned variables change, the compound interest rate calculation is inadequate. One has to use another mechanism.
One way to overcome this problem is to use the Internal Rate of Return (IRR).
Internal Rate of Return (IRR).
According to the help function in the Excel spreadsheet “The IRR is the returns for a series of cash flows represented by the numbers in values. These cash flows do not have to be even, as they would be for an annuity. However, the cash flows must occur at regular intervals, such as monthly or annually.
The internal rate of return is the interest rate received for an investment consisting of payments (negative values) and income (positive values) that occur at regular periods”.
Modified Internal Rate of Return (MIRR).
“Returns the modified internal rate of return for a series of periodic cash flows.” MIRR considers both the cost of the investment and the interest received on reinvestment of cash according to the help function in the excel spreadsheet.
How I use the IRR.
I use the IRR and not the MIRR. The reason why I do this is that I want to compare the return (growth) of my investment in property to that of any other class of investment. Because fixed deposits, mutual funds, pension funds, provident funds, endowment policies, etc. are calculated using the compounded interest method, I use the IRR method to calculate the growth on any property or any other class of investment.
Both the compounded interest method and IRR calculate the growth of your investment and therefore you can compare the two.
Property has at least twenty-seven different variables with hundreds of thousands of different permutations. The only logical way to calculate the growth is to determine the IRR.
This can’t be done in property investment unless you have a system that takes into consideration all the different permutations relating to the specific property. Once you have determined the cash flow on a property, it is possible to proceed to calculate the IRR.
Because a property investment can consist of either income streams or capital growth or a combination of both, it becomes important to find a method that can sustain both of these criteria.
Furthermore, some investors may wish to use their income as a pension and do not want to reinvest their income back into the property. Because the MIRR considers both the cost of the investment and the interest received on reinvestment of cash, we cannot use this method to calculate the growth of property investments.
With the IRR the assumption is made that if there is income (positive cash flow) that income will be taken into consideration without reinvesting that income back in the investment.
In property, the IRR is directly influenced by the cash flow and equity in the property at a specific moment in time (time intervals).
In property, the cash flow (therefore the IRR) is mainly influenced by the:
purchase price
market value
deposit
assessment fees
initiation fee,
house owner's comprehensive insurance stamp duties
transfer duties
deed office levies
rental income
inflation-linked or not
vacancy rate
projected capital growth rate
projected inflation rate
bond interest rate
term of the bond
interest only or interest and capital repayments
property management fee
monthly expenses such as rates and taxes
special expenses
repair and maintenance
renovation costs
tax rate
the type of entity that owns the property
If any of the variables change, one cannot calculate the return by any means other than the IRR. It remains the same, valid measurement because it measures everything that you put in and everything you took out, while the compound rate assumes “frequently in and once out”.
The IRR can be used on any venture and any investment, so it is probably a better way to determine the return of your investment in property than working out the compound return.
Because of the way the Property Pro Investment Program™ measures the IRR, it incorporates tax and all other variables related to property, so the ultimate picture is very accurate.
The downside of the IRR.
The question is interim cash flows based toward the start or the end of the project? Unless the interim re-investment rate is correct (in other words, a true re-investment rate rather than the calculated IRR) the IRR distortion will be greater when interim cash flows occur sooner.
This concept may seem counterintuitive since typically we would prefer to have cash sooner rather than later. The simple reason for the problem is that the gap between the actual reinvestment rate and the assumed IRR exists for a longer period of time, so the impact of the distortion accumulates.
Learn how to use the Property Pro Investment Program™
For this reason, it is important to interpret and learn how to use the Property Pro Investment Program in the way that it was originally intended to be used.
If, for example, I make restorations to the property, the restorations can be done either at the beginning of the year or towards the end of the year.
This will lead to a distortion of the IRR or the real growth for that specific year and years to come.
The same applies to all cash flow scenarios. If I am using negative gearing and there is a shortfall in year 1, the program will show the yearly shortfall as well as the monthly shortfall. This may be misleading as the IRR is based on the yearly shortfall (payment) which is done on the last day of the year, but the monthly shortfall leads one to believe that it is on a monthly basis.
The purpose of the Property Pro Investment Program is to compare different strategies and properties to one another.
If you make the wrong assumptions you are going to get the wrong answers.
Ri = Risk involved in the investment or business.
What is the risk?
"Risk" is a very important investment word that is frequently misunderstood. It is the risk that is detrimental to investment. As I have said before, ignorance is the biggest risk there is to any investor or business owner.
Unless you know how to calculate the risk in any investment or business you cannot make an informed decision as to whether this will be a good or bad investment for your portfolio.
If you cannot measure or determine the risk in an investment or business, it is best to avoid the investment until you have the knowledge to do so.
The reason why I say this is because the risk is more important than growth when it comes to investments. Most people firstly do not understand risk and secondly do not know how to calculate it. As long as the investor is ignorant, someone is going to make money out of the ignorant investor.
Investments are done based on emotion because investors do not know how to calculate the risk in the investment or the growth on the investment. They invest because it feels right. I believe that the main reason why people do not calculate the risk is that they don’t know how and then they rely on their emotions.
The qualities they think are important about an investment or business are excitement, popularity, intuition, it feels right, being recommended by “experts”, neighbors, friends, colleagues, etc. They think that if they then throw themselves into it, heart, soul and overdraft, the recipe will be complete and they have the best possible chance of success.
This is conditioning. This is reading too many “rags to riches” stories. Anybody who gives it any thought will see how risky this approach is.
During the last three years, I have taught thousands of students how to invest in property. Not a single one of them could calculate the risk on property investment before the course.
Even more fascinating is the fact that in my eighteen years as a professional financial planner I have never met anyone (including actuaries) who could determine and calculate the risk of any paper asset.
Paper asset investors enter into a contract or give a mandate to the financial institution stipulating that the financial institution does not take any risk. Many investors are so well trained by the system that they believe there is no risk involved in the investment.
If they do their jobs badly and lose your money, well, they don’t suffer because they still get all those fees and charges and commissions you agreed to pay them in the small print.
If they do their jobs well and make money with your money, the investor has no guarantee as to how much of that profit you will get and chances are very good you will get the minimum.
All the admin charges will still be deducted. They can do this because they have trained you to think that any growth which is higher than the inflation rate is a good investment. So during a boom time on the stock market, they could reach growth rates such as 40%, 100%, or more, but they will still give you the smallest profit margin they can get away with.
They can do all of this because we accept unconditionally what others tell us to think and do with our money. All because we think we are not equipped to look after our own money and we do not want to take responsibility for our own financial well-being and we tend to believe that the financial institution takes the risk.
What is even more interesting is the investor carries all the risk of the investment but has no control and cannot manage the risk, because the financial institution is in control on behalf of the investor.
The investor has almost no say in where and what and how they are going to invest, except perhaps for a mandate as to a specific kind of portfolio to invest in. The most important factor in financial planning is to determine and manage the risk. Yet, as I have shown, we totally neglect this! How is it possible that we as investors can be so blind and leave this single most important factor out of our day-to-day planning?
I believe it is because most investors were raised in an era where they were trained to believe that they do not have a say. The financial institutions led the investors to believe that there is a module on which the investor can determine their risk profile.
This module was accepted unconditionally. The investor completes a questionnaire and based on the outcome of the questionnaire the investor is instructed as to what kind of portfolio will suit him the best.
I have studied these so-called risk profiles. It is my opinion that there is no substance to these and that their purpose is purely to confuse and impress investors so that they believe that they have a say in managing their risk. The risk profiles are based on emotion at their best.
You know, back in the days when women were supposed to be airheads who were richly fulfilled by domestic work, a pre-prepared cake mix was introduced that needed no work, effort, or extra ingredients. It could simply be mixed and put in the oven and it would come out perfectly. But it didn’t sell well.
Then the marketers realized that the housewife wanted to feel that she was doing something, so they told her to add an egg. Once they did this, the cake mix started selling very well!
The people who marketed this product had the lowest opinion of her intelligence and judgment. “Let the little woman feel useful” was their patronizing approach. The classic risk profile where you as an investor are led to feel that you are in control of your investment reminds me of this.
And yet it is quite meaningless. I have often seen investors classified as conservative investors, whose money has been invested in so-called conservative portfolios, lose more money than people classified as aggressive or risk-tolerant investors.
Up till a few years ago, the general public thought that if you invested your money with the banks in a fixed deposit it was "safe" - in other words, a risk-free investment. Nowadays people are beginning to realize that what they perceived to be a "safe" investment was in fact as risky as any investment because there is always a chance that you can lose your capital. Did you know that the bank does not guarantee your fixed deposit?
When a bank or other financial institution goes bankrupt, and the state or other financial institutions do not intervene, the investor's "safe" investments are gone. There are no guarantees.
Here’s another way of looking at it: when they succeed, the bank’s owners and shareholders keep the profits. When they fail, the taxpayer bails them out (most of the time). Nice business to be in!
This paradox is so important it bears repeating: if we have a surplus, to whom do we give it to grow our money on our behalf? We give it to the financial institutions or the "expert" advises us to invest with the financial institutions in order to give us the best growth.
The institutions are not asset managers. They make their money by deducting administration, management, and other costs from the investment in return for managing and administration, but they never guarantee the allocation amount.
Some financial institutions give a "guaranteed" minimum, but that guarantee is based on the assumption that they will still be in business when your investment matures.
Please note that I am not saying that what the financial institutions are doing is wrong. I think that they have an important role to play to help the masses because if the masses do not want to take responsibility to save and invest to provide for their old age, there will be even more poor people.
The truth is the products these institutions offer you are better than nothing. If doing nothing is the alternative, then they’re a better choice. I don’t think this is your scenario, however. I don’t think you’d be reading this book if it was.
If you do not want to take any responsibility and you are prepared to take the risk, then financial institutions are the perfect place to save your money.
Just be aware, if you choose this option, that it is not as "secure" as you may think. If, however, you want to take the responsibility to create wealth, then you should know that the key is to understand that you cannot separate the risk and growth on your surplus.
The question remains why do so many people put money into investments or businesses which are highly questionable? They hope for the best, thinking it’s about luck and faith? They don’t even consider the option to calculate the risk.
The risk always stays with the investor. If the investment does not perform, it is the investor who loses money.
As a result of this system, we stay poor.
Income or capital?
Because in most investment portfolios the capital determines the income, the general consensus will be that capital is the more important one.
If this is the case (as with any class of paper asset) then capital is more important than income and therefore the risk is more severe if you lose capital. Let me give you a typical example:
If you have a fixed deposit of $120,000 and you invest it at 12% per year it will give you an income of $1,200 per month. If you need that $1,200 to cover your living expenses and your income and your expenses are the same then you have no risk.
But what will happen if you lose 50% of the value of the capital?
Your income will decrease to $600.
If you base your financial wealth on any module where your income is dependent on the capital value of your investment, then your biggest risk is losing capital.
In other words, risk has different meanings for different people. To become financially independent, your passive monthly income must cover your monthly expenses.
Let’s take the following example. (Please note that I am explaining an investment principle – the returns on the property will differ from country to country and even from state to state.)
Say you still need $1,200 to cover your living expenses, as in the previous example. But in this case, instead of a fixed deposit, you have a property you bought 5 years ago for $100,000 and it is worth $200,000 today.
Your rental income at this stage is $1,200 per month after costs. You are covering your living expenses and you are financially independent at this stage.
What happens if the property market tumbles and you lose 50% of the capital value on your property? So, the market value of the property drops to $100,000 ... how does this affect you month to month? The answer is, not at all, because you still receive a monthly income of $1,200. So the risk of losing capital is not as serious.
What would happen if your property did not lose value and was still worth $200,000, but your income from the property dropped to $600?
The moment this happens you have a shortfall of $600 per month and you must now start using capital to maintain your standard of living.
If, however, your capital growth per year is more than your income loss per year it is arguable that you can subsidize the loss of income with the capital gain and therefore make the assumption that if your capital gain is more than your income loss it is better to offset income in order to improve capital.
Because of this argument, a new financial term came into use, called negative income gearing.
Negative gearing (Also called hedging or leverage)
”Negative gearing refers to the situation where you borrow money to buy an investment, but the investment does not have enough income to cover your expenses (i.e. the interest on the money you borrow and the expenses involved in keeping your investment).”
The moment the income is less than the expenses, there is a loss in the cash flow of the real estate.
There is a risk now that the investor cannot repay the bond or mortgage. If you do not have the cash flow, you cannot repay the bond and the financial institution repossesses the property.
The financial institution is an operating business; it is not interested in risky investments. So before it lends you money, it will need confirmation that you can repay your debt. As a general rule, you will only be allowed to repay thirty percent of your gross income (including your spouse’s income) on a property. Alternatively, they may take your assets as an additional security measure.
The interest rate, as well as the term of the bond (or overdraft repayment), will have a direct effect on the amount of money that they will lend you.
If you apply for a bond of $400,000 at 14% over a 20 year period your bond repayments will be $4,974.08 according to the amortization method. That implies that you must earn a minimum income of $16,580.
If the interest rate goes down to 9% your repayments will be $3,599 and your income must be $11,996. As a result of a lower interest rate, you can now buy a more expensive property to the value of $552,843 for a monthly repayment of $4,974.08.
The term and interest rate, therefore, play an important part in determining the risk. If either one of these changes, it will have an effect on both the risk and the growth of the investment.
We all know that interest rates do not stay the same for 20 years. A property that was affordable initially can become unaffordable overnight if you did not take the possibility of rising interest rates into account when you did your initial calculations.
Risk will also depend on your personal financial position. What may be a risk to one investor may not be a risk to another.
Let’s look at another factor that will determine the risk for an investor. If you need the income to maintain your standard of living then the consequences of losing income constitute a higher risk than losing your capital.
If the investor is rich and does not depend on the capital to generate income then the chance of losing capital constitutes the highest risk.
If, however, you are not dependent on the income from the new investment and you have enough income to pay for your monthly expenses, without taking the proceeds of the "new" investment into consideration, your risk profile again will look very different.
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So your risk will vary according to where you are in terms of building wealth.
If you are not financially independent and you rely on your income, your biggest risk is to lose your income or your job.
If you are financially independent, in other words, your passive income covers all your monthly living expenses, then income is more important than capital (unless you have invested in paper assets when the risk of losing capital constitutes a bigger risk than income because the capital provides the income).
So from these arguments, we can see that risk will have different meanings to different people. But here is the catch! Unless you can determine your risk and can manage that risk you are always in danger of losing money.
So it is becoming clear that risk is central to success or failure. Yet we are not properly informed about risk. This is because the institutions do not want educated investors and many investors don’t want to take the responsibility to educate themselves.
It is possible to overcome this habit of investing in emotion. Find a system that works and stick to it. Then evaluate the risk. It is that simple.
Let’s look at different types of risk and what the financial institutions want you to know about it.
Investment Risk.
If you buy shares in a public company and the company goes bankrupt, you will lose all you money.
If you invest in your own business and the business does not make it, you stand a chance of losing everything you have invested in the business.
You can even take it one step further. If you stand security, you can lose a lot more than the amount you actually invested.
Market Risk.
The stock market is based on emotion and sentiment. You may buy shares in a company that is doing extremely well, but if the stock market crashes, the value of your shares may drop. This has nothing to do with the performance of the company in which you invested.
Lost Opportunity Risk.
Most “experts" will never tell you about the risk of lost opportunity, allow me to give you an example of how this works.
Let’s say you buy shares and the shares drop by 30% over the next month. Usually, the expert will advise you to keep the share and "ride" out of the cycle. If you are lucky and in two years’ time the market returns to the original level, some "experts" will tell you that you have not lost anything because you get all your money back. This, for most people, is acceptable.
Think about this. Is this really the whole truth? What would happen if a really good investment opportunity presented itself in the interim, but because you held onto the first investment you lost the opportunity to invest in the second because your money was tied up in the first investment?
If you know how to calculate the risk you would be able to make an informed decision as to decide which opportunity would be best to invest in.
Hidden Growth Risk.
No financial institution will tell you about this risk. Why not? Because, once they understand this, no serious investor would ever invest in their products.
The hidden growth risk exists because all future maturity values are projected values. In other words, there are no guarantees that this growth will actually materialize.
So the investor cannot identify or manage the growth on his investment. The financial institution has full control over the investment. They however take no risk when “managing” your investment and have no responsibility to give you a return on your investment. All you get is a promise.
As a business, not a public-interest group, the financial institution is geared towards making a profit. Their number one priority is to make the biggest profit they can.
If this means you get little growth while they make record profits, read the small print, you were given no guarantees. That is the way their products are structured and that is what the investor agreed to when he signed the contract.
What about the global stock exchanges? The same principle applies here as well. The brokers cannot lose. They receive their transaction fee, no matter what.
In other words not only does the investor carry the "risk" of losing his capital investment but he also takes the "risk" of no real growth on his investment. The scary part is that most of the time he will be quite happy thinking he is "making" money.
Again let me give you an example: If you earn 5% on your investment and the inflation rate is 6%, you are losing 1% per year on your investment in real terms even if your investment is growing.
Risk in terms of growth is that you as an investor have no say as to how to manage the growth on your investment.
What is the REAL risk?
The real risk is the unknown. It is the way we deal with the uncertain aspects of investments. There is always risk involved if you cannot identify what can go wrong. Some unknown, unforeseen event can come out of nowhere and you can lose it all. It again starts with education.
If you are ignorant and don’t know about the risk involved, you cannot measure it, look out for it, or decide how it is going to affect you.
The moment that you can identify the risk it is not a risk anymore because you can manage it. If you cannot identify the risk then the risk will manage you.
Sometimes the real risk is to be found behind official, expert-sounding terminology like market risk, financial risk, and lost opportunity risk. All of these terminologies sound as if you should know what they are, but you cannot do anything to prevent these risks.
What I am saying is that while people talk knowledgeably about them, this disguises the fact that there is sometimes no way of managing them. In other words, experts can give you a false sense of security.
If an investor understands this principle when he hands over his investment money to the financial institutions, then he accepts responsibility for the outcome of the investment. Actually, he accepts responsibility even if he hasn’t a clue – that’s what the contract he signs says.
Let’s look at some more reasons why investors are confused most of the time. The financial institutions educate the investor as to what risk is (their version of it) and how to manage it (their way). To do this, they rely on some powerful myths.
For example, “the higher the risk, the greater the reward” or what about “you need money to make money”. Why do investors believe this? Because then you will give them more money every month.
Also, a few years down the line you may see that the growth is not going to make you rich, and when you complain they can simply say you must invest more money.
What is risk tolerance and how does it affect the investor?
So the investor is conditioned to think that risk and reward go hand in hand, the higher the risk the bigger the return, and of course also the bigger the chance that the investor can lose everything.
This is supported by the articles which we read in the media, such as interviews with daredevil entrepreneurs who risk everything and win. (You seldom read about the ones who lose, of course). The result is to condition you to think that you must take risks in order to be successful.
The institutions then tell you that the ideal investment is one that falls within your particular tolerance for risk and has a potential rate of return that exceeds the normal growth for the amount of risk that you as an investor are prepared to take.
By now you know that you should try and be bold, and take a risk, and here comes the promise of staying within your own risk tolerance!
Now, this may seem like good advice – logical – rational – and surely in this way you increase your chances to succeed (i.e. you lower your risk). But be careful in your thinking! I will show you why shortly.
According to the financial institutions, there are two different but proven strategies for investing in shares (and unit trusts or mutual funds) to minimize your risk. The first one virtually everyone has heard of, but very few investors actually understand how it works.
Dollar-Cost Averaging.
If you invest $100 every month into a mutual or unit trust fund, in the months when the share price is down your $100 will purchase more units than when the share price is up.
In essence, it means that over a long period of time you will own more units purchased at a lower price than you will own purchased at a higher price.
Thus the average price you paid per share is lowered. If you paid $10 per unit share in your first month and ten years later you sell all your units trust for $10 per share, there is a distinct probability that you will still make a profit.
Although the share price changes throughout your ten years of investing, the $100 per month, the average that you will have paid, will be significantly less than $10 per share.
However, if you had taken the money and invested it all at once, and ten years later the share price is exactly the same, then you haven't made a cent profit. In fact, you have lost money due to inflation. You get all your money back, but it isn't worth as much as when you originally invested it.
According to financial institutions, the next tried and proven method of investing is more sophisticated and until recently wasn't even available to the average person.
Modern Portfolio Theory.
With the use of this strategy in your investment module you could make the same rate of return, but with significantly less risk. Another way to say it is that you can make a higher rate of return for the same risk.
The modern portfolio theory basically acknowledges that different investments perform differently at different times. So, if you divide your investments between various different investments when one is down another is likely to be up.
One of the major benefits of this approach is that, in theory, with the law of averages, you should have one portion of your portfolio doing well at any given time. Later in life, when you want to start spending your money, you don't need to sell the investment that happens to be at a low point at that stage.
You allow the investments to continue through their cycles of recovery and you sell those investments that have done very well.
An aspect of good money management that works well with the modern portfolio theory is to regularly evaluate your investment sub-accounts to ensure that you always stay invested consistently with your tolerance for risk.
How to calculate your risk profile?
The standard procedure at most financial institutions is to complete a risk profile before investing.
You answer questions like:
"How would you react if your account dropped more than 10% in one month?"
"How many years before you will need this money?"
These questionnaires help the financial planner (salesperson) to set up your account at the beginning.
For example, a very conservative investor will probably have a fairly small percentage of his total investment placed into "small-cap" stocks. These are small companies with very little working capital and are riskier than bigger companies with blue-chip shares.
When we hit a part of the economic cycle that makes small-cap stocks really take off, your portfolio gets out of line with your risk profile because now small-cap shares represent a much higher percentage of your total investment.
Modern portfolio management would re-balance your account on a regular basis, like quarterly or semi-annually, by selling off some small-cap stocks and buying more of the other investments in your portfolio.
You may have as many as ten or twelve different investment categories: long-term bonds, short-term bonds, growth, blue-chip, small-cap, mid-cap, global shares (of foreign corporations), real estate investment shares, commodities, and different sector shares such as energy, environmental or medical shares, etc.
Common Investment Mistakes.
The single biggest mistake investors in shares make, is that they almost always buy and sell based on their emotions.
In other words, they buy out of "greed" and they sell out of "fear". Greed because they hope to make money; fear because they are scared their investment is going to lose money. On a large scale, these emotions lead to the ups and downs of the market.
If the stock market heats up and investors start getting wind of this, it is the desire for the quick buck which motivates them to buy. When the market makes a major, or sometimes a minor negative correction, then everybody panics and sells.
In other words, most investors buy high and sell low and lose money in the process. The herd instinct takes over, the gossip, the corridor talk, the articles in the paper and the items on the news, the comments of the experts ... all this adds up to fueling mass emotion and based upon the fact that people buy higher than they should and sell lower.
This is why only a small percentage of investors on the stock exchange make money consistently. They’re the ones who have the iron will, the experience, wisdom, knowledge and sometimes there is a little bit of luck involved to do what the herd isn’t doing. They make their money out of the “uneducated” investor, the one who operates on emotion!
Every time someone buys high, someone else sells high, and every time someone sells low someone buys low. Guess who wins?
How can you avoid risk?
It is wise to invest when you can calculate the risk potential in the investment. If you do not know how to identify the risk you will not be able to calculate it. If you cannot calculate the risk, don’t invest.
It is really that simple, but I know that most people are so conditioned in their belief systems that they will simply not believe a word I am saying. They are swayed by the latest craze which “everyone knows” is a winner.
Here is the truth about paper assets and specifically shares: you cannot calculate the risk, no matter what anyone says. It is impossible to calculate it because you keep all the risk and you cannot manage it.
Why would you invest your hard-earned money in anything if you keep all the risk and you cannot manage the risk? Do you think those are the actions of a wise investor?
The best way to manage risks is to identify them. If you don’t know how to identify them, educate yourself. Risk is in ignorance.
Ignorance may be bliss until you want to retire and then find out you cannot. Invest in yourself first, learn how to identify the risk, calculate the risk and then make your decision. It is really that simple.
Don’t get confused by terminology like "dollar cost averaging" or the "modern portfolio theory" or “how to calculate your risk profile”.
These are all strategies used to confuse you and distract you from where the real risk lies.
The risk of handing over your hard-earned money and having no say in the management of the investment – is your real risk.
Re = Responsibility to manage the growth and risk.
As we have seen it is impossible to manage the risk and growth potential in any investment or business unless you can identify it. Once you have identified the risk and growth potential it becomes your responsibility to manage the risk and growth of your investment. That responsibility is yours whether you like it or not, the moment that you give the responsibility away you lose control.
Your responsibility then is to learn to manage the risk and keep it as small as possible and the growth to be as large as possible in order to optimize your investment.
How do you manage your risk down and your growing up?
In order to become rich, your risk must decrease or at the very least you must be able to calculate the risk and then apply strategies and techniques to minimize it. At the same time, you must increase the growth potential of the investment. Unless you can identify both the risk and growth you cannot manage them.
How do you manage growth and risk on an investment?
1. The first step is to identify the risk.
2. Secondly you need to identify the growth potential of the investment. In order to determine what growth you need on your investment, you must first determine what surplus you have available for your investment. As you know there are two kinds of surpluses and they are either of an income or capital nature.
3. Once you have determined the risk and growth potential of your investment you must benchmark it. In other words, set the level from which you wish to grow.
4. Next you will determine when you want the capital, in other words over what period of time.
5. Lastly you will have to determine what growth you need in order to achieve your objective. Let’s say that you need 50% growth on your surplus compounded per year for the next five years in order to achieve your objective. This 50% will then become your benchmark.
6. Now it becomes easier to make a decision. If an investment cannot give you 50% growth on your surplus you will not even consider it. An investment only becomes a considered option when it has the potential to give you growth of 50% or more.
7. The next step is to determine how much risk you are prepared to take on the investment. The quick way is to determine how much money you are prepared to "lose" if things do not turn out as you have hoped for.
If you can afford to "lose" $1,000 per month you use this as your risk benchmark and you will not invest more than $1,000 per month. The risk will be determined by the surplus.
Please take into consideration if you used negative financial gearing (hedging or leverage) that you must make provision for the worst-case scenario.
8. Next you must identify the asset class or classes which will fit with your benchmark.
9. It is important to have a system in order to identify the risk and growth potential of an investment. I have developed two systems, the Property Pro Program™ and the Wealth Pro Program™ for this purpose. Both of these systems also incorporate The Formula For Riches®.
Unless you have a proven system that can identify the risk and the growth potential in an investment you cannot benchmark the investment in order to manage it.
10. The next step is to apply different financial and life strategies in order to lower the risk and improve the growth of your investment. The best strategies are those whereby by applying a strategy, you will decrease the risk and at the same time increase the growth of your investment.
By managing the different strategies you must find the optimum balance between the lowest possible risk and the highest possible growth for your investment in that specific class of asset or investment.
The main objective then is to apply different strategies so that your risk becomes smaller and your growth is optimized.
11. One cannot manage these strategies which you use to improve the growth and lower the risk unless you can measure the results. This is why measurement is also incorporated into the financial systems which I have developed.
Once you are applying different strategies you have to manage them because of possible changes to legislation and changes in economic, social, and political environments.
nm = Time and Personal Effort.
The last determining factor when it comes to The Formula For Riches is the effectiveness factor (nm).
The effectiveness factor is the relationship between time and effort. If you are close to retirement age or have for some reason not much time left to reach your goal, the only way you will achieve it, is to put more effort into your Wealth Creation. In other words, you will have to work more effectively.
There is a big difference between working hard and being effective. Let me explain. Say I want to build a swimming pool. I can work all day and dig a hole in the ground. It is going to take a lot of effort.
If I can increase my effectiveness I will be able to save on the time and energy I am going to spend on the project.
How can I increase my effectiveness? The first thing would be to plan exactly what I want. How deep the hole must be, what tools and equipment I will need etc. I will also consider other factors such as the location, is the area suitable or will I need reinforcement.
I have seen too many people digging energetically without planning what they want to build, where, and how. They spend a lot of time and energy only to find out that they have dug a hole in the wrong place!
It sounds like a joke, but it’s not funny when you think most people make serious investment decisions this way. They invest without thinking when it comes to creating wealth. They have a vague idea that they want a profit at the end, not knowing and sometimes not even wanting to know what they are letting themselves in for. Not only do they waste valuable time, but also energy and money.
So the first step of wealth creation is to plan. You need to plan which road you are going to travel and decide on the vehicle you are going to use. The financial structure you decide on may not seem too important to begin with, but what is the point of building an empire only to give it (or a great portion of it) away to strangers when you die?
Yet that is almost sure to happen if you do not plan correctly. Many people fall into this trap because they do not plan at all and never consider the implications of their deeds.
Once you know where you want the swimming pool you must also do a feasibility study. How much is it going to cost you in terms of labor, time, and finances?
If you do not have the available resources it will not help to start something only to realize halfway through that you do not have the finances to complete the project.
What if you have borrowed the money and you cannot repay your debt and now the creditors not only take the unfinished swimming pool but also the land and all your other possessions because you did not consider whether you would be able to repay the debt?
Things to consider are the time and effort which you personally want to spend. Do you want to do the project yourself without any help? If this is the case you must take factors such as your health and your capability to do the job into consideration.
There are always different options available. A pick and shovel may do the same job as a machine but you will have to take into consideration the time and effort as well as the effectiveness of the different options.
Sometimes you will need to spend time and effort in order to learn how to operate the equipment so as to maximize what you have. In the beginning, it may feel as if nothing is happening on the site because you are planning and learning how to build the swimming pool and how to operate the equipment.
Once you know how to use an excavator you will increase your productiveness because you will be able to achieve a lot more in a day with a lot less effort than if you were to try and dig with a pick and shovel.
Concentrate on ways to increase your effectiveness. Focus. If you want to specialize in building swimming pools you should first learn the trade. Then you will learn the tricks of the trade. Once you know the tricks of the trade you do the job and you can train others as well.
You can use other people’s time. Let them do the work. If you follow this strategy and you have the market share you can build 20 pools per day instead of doing everything yourself and only completing one every 20 weeks.
You can use other people’s money. If you do not have the equipment you can borrow the money to buy it or you can lease it, depending on your financial situation.
Let’s say you can build one pool a week if you have the right equipment and leasing the equipment will cost you $1,000 but you will make a $2,000 profit. In this case, you can use other people’s money (it is their capital investment) by leasing the equipment to help you complete the job.
Effectiveness is the last part of the formula. It is the process of optimizing the relationship between time and effort.
My experience has taught me that most people don’t want to hear that there is no such thing as a quick-fix solution to wealth creation. It is going to take time, and the more effectively you utilize your time and resources (effort) the more dramatic the results will be.
Most people do not want to wait that long and they don’t want to put in the effort. In the process, they hop, skip and jump from one investment to another to find a quick fix solution. In the process, it costs them money and they lose time.
Warren Buffet, the world’s greatest investor, has been working diligently for more than 50 years to build his empire. It is important to notice that it takes time and effort (work) - therefore he says he has been working willingly. It does not mean that he has done the physical work himself but it means that he has put in the effort and time to build his empire.
If you have a surplus and you can identify the risk and growth potential in the investment and you have strategies in place to manage the growth and risk of the investment but you do not have enough time, you will not become wealthy.
It is however sometimes possible to buy time. If you can be more effective you can increase the results.
There are four asset types:
The most dramatic results in improving effectiveness appear when you combine your personal assets (time, effort, effectiveness, talents, skills, drive) with any one or a combination of the other asset types.
Personally, I have three questions I ask myself before I invest money or time in any venture in order to see if I will be able to effectively manage the investment or business.
The questions that I ask are:
• Is it possible and legal?
• Can I make it happen?
• Do I have control over it?
If the answer to any of these questions is negative, I will break The Formula For Riches.
I believe that by asking and answering these three questions the entrepreneur or investor will be able to control and manage the effectiveness factor of the investment or business.
This is not to say that you must be able to do the work yourself. Most people associate work with effectiveness. This is part of our middle-class conditioning. We are taught to be good little worker bees but not to think of the bigger picture which is someone else’s business.
We think that if we work hard, we are being effective. We sometimes look at our bosses who obviously are not working hard (or not by our standards, anyhow) and we wonder how they get away with it.
This is a mistake that we make because we confuse hard work and effectiveness. The same mistake leads people to think that if they have been working in a business for 20 years they are qualified to run a similar business. Then they wonder why they lose their money.
So do not confuse work with effectiveness. You do not have to do the actual work, and if you do the actual work you are not necessarily being effective. By taking and managing the responsibility and by creating systems, you can manage a company without doing any physical work yourself.
There is a saying that he who controls the money makes the rules. With Wealth Creation this is true. Once you have systems in place to control the cash flow and the people, you are managing your investment or business.
The outcome must be positive.
Let me summarize The Formula For Riches for the entrepreneur and investor as follows: if the outcome is not positive you will find it very difficult if not impossible to become a Wealth Creator.
If you cannot apply The Formula For Riches without breaking it, then you know that the asset type or class will not help you to create wealth and in the process become rich.
The biggest difference between an entrepreneur and an investor is the application of the surplus in The Formula For Riches.
An entrepreneur must learn how to create a surplus. Unless the business gives the entrepreneur the ability to generate a surplus, it will never become feasible in order to sustain the entrepreneur.
An investor must have a surplus as defined in the formula otherwise he cannot become a Wealth Creator. It is interesting to note that you do not need to be an entrepreneur in order to become extremely wealthy - you can create wealth by following the investment strategy.
You can be an employee and still become wealthy on the condition that you have a surplus and apply The Formula For Riches to the surplus.
It is also possible to be an entrepreneur and remain poor. The reason for that is not hard to find. Unless you learn how to apply The Formula For Riches and learn how to get your money (surplus) to work for you, you will remain an entrepreneur and you will have to work for your money.
There are two ways to become an entrepreneur.
The conventional way; is where you buy a business but you have to keep working for your money. If you are not physically there to do the work the business stops.
The Wealth Creators way; you build a passive income without the need to actually work in the business.
The main difference between the conventional entrepreneur and the Wealth Creation entrepreneur is that the conventional entrepreneur works in the business and the Wealth Creation entrepreneur works on growing the business. Unfortunately, many businesses fall into the conventional category where businesspeople become the slaves of their business.
A true entrepreneur must learn how to get the business and his money to work for him instead of the other way around.
True Wealth Creators invest only in three asset classes.
The last point to remember: Wealth Creators do not take risks! Do not confuse entrepreneurs with Wealth Creators. Wealth Creators always apply and use a system that incorporates The Formula For Riches. The moment they cannot apply The Formula For Riches they will not invest.
Shortly we will look at why Wealth Creators will invest in business, real estate, and themselves, and will stay away from paper assets.
For more information on the Formula for Riches;