Wealth Creation is a process and not an event, so you must be willing and ready to go through the processes of increasing your personal awareness, improving your personal education (on and about wealth/value creation), building your capacity and positioning for impact generation. Importantly, there is no better place to start than where you are right now. The common mistake that people make, especially because they are either too much in a hurry or they want to circumvent the process and cut corners is to attempt to start at the front of the line or from the top. Unfortunately, it does not work out that way. However, if you bide your time and do the follow the process, you will get ahead.
Goal setting is the first and most fundamental step in the wealth creation process – when you have a specific goal, the rest of the financial planning process falls into place.
Start Saving Now
It's never too early to start. If you start saving money right now, you will have a better shot of reaching your goals as time plays a huge factor in how your savings will grow.
Compound interest is a fundamental component of wealth creation and by understanding just this one principle, you can make a significant difference to your financial independence over the long term. Compound interest means that you receive interest, not only on your initial investment, but also on the prior interest added to your investment.
As you can see from the example below, if you combine the benefits of compound interest with the benefits of saving early, you'll be off to a great start.
Let's say you begin with two separate $100,000 investments that each earn 6% a year (keep in mind this is a hypothetical example, and actual returns would likely be different and a lot less predictable). In one $100,000 investment, you withdraw your investment earnings in cash each year, and the value of your account stays steady, as you see with the flat line in the chart below. In the other investment, you don't cash out your earnings – they get reinvested. The curved line below shows the power of compounding and time. If you keep reinvesting the earnings (and again, we're assuming a steady hypothetical return of 6% each year) after 10 years your investment will have grown by more than $79,084. And if you've got an even longer time frame – for example, 20 years, your investment will have grown by more than $220,713.
After 10 Years;
After 20 Years;
If you start early and you're patient and disciplined, your money can work for you and make a real difference in your account balance over time.
Understand and control investment risk
All investment decisions involve a balancing act between the return you need from your investments and the risk you're prepared to accept. The general relationship between risk and return is that the higher the amount of return you seek, the higher the level of risk you must take. There are several strategies that can be employed to reduce risk while still generating returns but beware of anyone offering 'risk free' high return investments. The most common investment strategy mistakes result from investors not understanding the risk involved and selecting strategies and investments that don't match their risk profile.
Diversify your investments
Diversification in the financial equivalent of the saying "Don't put all your eggs in one basket'. One of the most common mistakes made by investors is to have too much money invested in one single asset or one asset class (eg, Australian shares). The risk is that if that one asset (or asset class) fails to perform, a substantial portion of your portfolio is affected.
Assets move in different economic cycles – this year's best performing investment becomes next year's worst. It's very difficult to know what the best performer will be.
The best way to reduce the risk market fluctuations present is to invest in a number of different asset classes. This will help reduce risk, smooth and increase your returns.
Don't try to time the market
Many people worry, "Is now a good time to invest" They worry that if they invest at the 'wrong time', they might not get the best result. There are always apparent reasons not to invest – the market is nearing its peak, the market is falling and so on. The fact is, despite all the doom and gloom, throughout history the market has maintained a significant upward trend over the long term. The ultimate success of your investment portfolio largely depends on the length of time you spend in the market, not your ability to predict short-term market highs and lows.
Stay on track
Changes in your personal situation, legislation or the economic environment can have a significant impact on the long-term success of your wealth creation plan. Even the best-laid plans need to be regularly adjusted and fine-tuned. Regularly reviewing your investment portfolio and strategy can help you avoid unnecessary taxation, poor investment performance and missed opportunities.
The earlier you start investing and the longer you stay invested, the more wealth you can build up over the long-term. But investors must also let go of their short term focus.
Ever wonder why so many people these days are focused on short-term trading as opposed to long-term investing Or why it's so hard to get younger individuals to effectively plan and save for retirement Hyperbolic discounting can help us understand these phenomena.
The following quote is from John Maynard Keynes: "Human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate."
The fact of the matter is that we place greater emphasis on rewards today than we do on rewards in the future. And this effect magnifies as the distance into the future increases. Welcome to hyperbolic discounting. The term is coined based on the "discount" we apply to the value of rewards as they are delayed further and further into the future.
Here is a common example: If you were offered $100 today or $200 tomorrow, which would you choose Most of us would naturally wait for the $200 tomorrow. Now what if you were offered $100 today or $200 a year from now I don't know your individual responses, but studies have shown that the majority would take the $100 today. Here's where the hyperbolic nature comes in. Stretch out the time horizon -- offer people $100 in 5 years or $200 in 6 years, and most will take the $200. Notice that the time delay between rewards is identical (1 year) but the increased time horizon of both rewards causes a change in behavior. This shows how we discount time periods differently depending on how far into the future they occur -- an example of our loveable yet irrational selves. It seems we are hard-wired to prefer immediate gratification.
An interesting observation about holding periods can be seen in the chart below. We see that holding periods for stocks have greatly declined over the last six decades. There are a number of drivers behind this behavior, but hyperbolic discounting plays a role. The temptation for quick profits is just too strong.
Understanding this bias is paramount for those of us who watch the markets daily. It's easy to become fascinated with the daily ups and downs of the stock market, which tease us with returns that some would be happy to see over the course of a year. Watching the markets daily can lead to trading the markets daily -- taking us off our game plan of identifying and sticking with the Primary Trend.
Financial institutions leverage hyperbolic discounting against us. By offering easy ways to obtain credit (whether loans, credit cards, or margin debt), they entice us to use future resources for immediate enjoyment. Paying $500 a year from now doesn't seem nearly as bad as paying $500 today, right And the pleasure of that new iPad seems much more enjoyable today than it would be in a year, agreed
This bias is also frequently used to explain addiction. In the same way we discount the positive value of future rewards, we also discount the future negative impacts of behaviors such as drinking or smoking.
Therefore investors need to stay focused on their long term goals and not pay attention to short term 'noise'.