The Wealth Creation Pyramid
Building personal wealth is all about using your money, assets and knowledge to take advantage of opportunities that will enable you to earn more money, acquire more assets and grow your knowledge.
Financial goals will vary from person to person. Some people consider themselves wealthy because they live in a big house and drive an expensive car. Others believe they are wealthy because they no longer have a mortgage and can comfortably pay their bills on time.
No matter what your financial goals are, the core principles of building wealth are always the same. I call it the Wealth Creation Pyramid:
Laying the Foundations for Wealth Creation
At the base of the pyramid lie the foundations for your wealth creation strategy. Before you begin to develop your strategy you need to get a clear picture of your current wealth situation and understand the gap between where you currently are and where you would like to be in the future.
The first step is to work out your net worth. This is calculated by a simple formula:
Assets – Liabilities = Net Worth
Your assets are possessions that you own that are likely to increase in value or provide a return, typical examples are:
- Your house
- A savings account
- Stocks & shares
Other possessions that we own (such as cars and consumer goods) are also assets, but they tend to decrease in value and won’t contribute to growing your wealth.
Your liabilities are any debts that you might owe, such as:
- Credit card debts
- Bank loans
- Student loans
- Unpaid bills
The difference between what you own (assets) and what you owe (liabilities) is your net worth – this is your wealth and forms the starting point for your Wealth Creation Strategy.
Setting Financial Goals
You may already have had some thoughts around your financial future and for many; these are likely to be ambitions that include large houses and expensive cars, but successful wealth creation requires us to solidify these ambitions into short, medium and long-term financial goals:
- Short & medium-term goals should span the next 3 to 5 years and may cover such things as paying off your credit card or saving a deposit for a house. These goals tend to be very specific to particular activities.
- Longer-term goals tend to cover the bigger picture and will determine your Wealth Creation Strategy. If your long-term goal is to retire at the age of 50, you will need to have paid off your mortgage and built up a big enough pension pot in order to do this.
Remember the more specific, measurable and realistic your goals are, the more likely you will succeed in achieving them. Setting yourself a goal to become a millionaire within the next 3 years may not be impossible, but will be an incredibly difficult goal to achieve.
By all means be ambitious, but set yourself a realistic time period and specific milestones to ensure you stay on track.
How To Get There
Now that you know where you are and where you want to be, you can start working out how you are going to get there.
Just like a traveller setting off on a journey, there will be a number of options for how you get to your destination:
- Some will be quicker, some will be slower
- Some will be less comfortable, some will be more comfortable
In order to arrive at your destination, you will need to decide on the most appropriate options for your situation and the next stages in the Wealth Creation Pyramid can help guide you through those options.
Clear Your Debts
Before you can begin building your wealth, you need to clear your debts. This is because debt is expensive and the interest that you have to pay on debts is generally much higher than the money you can earn from savings and investments.
Essentially debt is a bad thing to have and people should always try to save up for new purchases, rather than rely on credit cards and hire purchase agreements.
The one exception to this debt rule is when you borrow money to buy a house, start a business or fund yourself through higher education. In these situations you are borrowing money to increase the value of your assets or future earning power. But even with these debts it is best to borrow as little as possible and to repay the money as soon as you can.
The key step in taking control of your finances, reducing your costs, clearing your debts and growing your wealth, is to create a budget.
Save & Invest
This is the bread & butter of your Wealth Creation Strategy. Every penny that you save and invest has the potential to increase in value and grow your wealth. The more money you are able to save and invest, the greater your potential for growing your wealth.
Ideally you will want to have a spread of higher and lower risk savings & investments. This is known as diversification and means that your money will be working harder for you to achieve higher rates of return, but you won’t be completely exposed to major problems in the market.
The first savings step is to create an emergency fund. The experts normally recommend you keep the equivalent of three months salary in an instant access bank account, which can be used to cover emergencies, such as leaking pipes, broken down cars or in the worse case, redundancy. Having an emergency account reduces your dependency on credit cards and expensive insurance policies, helping you to keep your costs down.
Sounds dull, but actually compound interest is the secret formula that helps you build wealth faster.
Imagine you have £2,000 and put half into a high interest bank account (at 5%) and the other half into a shoebox and hide it underneath your bed.
Assuming you do not touch the money, after five years the £1,000 that you put into the bank would have grown to £1,276, whilst the money that you hid under the bed would still only be £1,000.
Now assume that you decide to save £3,000 a year, every year for the next 30 years:
- Simply saving that money without any additional interest payments will result in a total figure of £90,000.00
- Assuming you are able to earn an average of 5% over the 30 year period, you will have a total figure of £209,282.00
- And had you invested you money in the stock market and managed to achieve an annual return of 12% growth, the total figure would be £810,878.00 !!!
To ensure you maximise the power of compound interest it is vital to:
- Ensure you automatically reinvest all interest and returns from your savings and investments
- Begin saving and investing as early as possible – compound interest works best over time – even if you can only afford to put a few quid away each month, make sure you do and get that money working hard for you
- Look for ways to maximise the rate of interest or return – investing is higher risk but generally provides a greater return on investment, so try to diversify between saving and investing
Finally – remember that compound interest has a flip-side. Any money that you borrow will incur compound interest charges, which can just as quickly drag you back into debt.
Create a System for Saving & Investing and Automate It
To most people saving & investing is not that exciting, but the good news is that it is possible to automate the process.
Using your budget you should be able to see how much money you can allocate to your savings and investments.
You then set up standing orders to transfer the money into the various saving & investing vehicles that you have decided to use, such as high interest saving accounts, cash or share ISAs, mutual funds, share dealing accounts or pension funds.
Make sure that the money is taken out of your account at the start of the month, so that you don’t spend it on other things.
Once your automated saving & investing system is set up, you can leave it to run in the background, but it is a good idea to review your system every six months to ensure you are getting the best rates of interest on your savings.
Invest for the Long-Term
Changing economic conditions will cause your investments to rise and fall, so it is important that you don’t let short-term losses scare you into selling all your investments. Provided you have diversified your investments, you will soon recuperate your losses when the markets bounce back. Remember to hold your nerve and don’t follow the flock!
Take Advantage of Tax Benefits
Losing 40% of the money you have earned from your savings and investments to the tax man is no laughing matter, but there are a few tax breaks to help you reduce your tax liability.
Pension funds are probably the most tax efficient way to invest your money, however the rules about how and when you can access your money are quite rigid.
Cash or Stocks & Shares ISAs provide you a more flexible approach to tax-free saving & investing and from April 2010 the limit that you are able to invest in an ISA will be raised to £10,200.
A good Wealth Creation Strategy should maximise the use of both of these tax havens and it is worth consulting with a financial advisor for their advice.
Grow Your Knowledge
One of the key non-financially direct aspects of building your wealth is to grow your knowledge about both financial and non-financial matters.
Growing your financial knowledge will make you more aware and better equipped to make decisions about how you manage your money. A greater understanding of the financial world will enable you to ask the right questions and assess the best opportunities for making money.
At the same time, broadening your horizons and learning new skills will help to recession-proof your career and increase your opportunities for promotion, allowing you to maintain and increase your monthly wealth creation contributions.
So use every opportunity to learn from books, newspapers and reputable websites, look out for courses to attend and learn new skills, put yourself forward for projects and activities at work that will bolster your experience and help you to move up the career ladder, and get out and about to start networking with people who can mentor and advise you.
Often in our lives opportunities will arise where we can make a significant improvement. This could be an interview for a new job or a promotion, it could be a business opportunity to start and grow your own company or it could be an investment opportunity in a fledgling company with massive potential for growth.
Great opportunities tend to go hand in hand with growing your knowledge and occur more to those who go out there and make them happen.
Looking round at the great business people and entrepreneurs of today, it is nigh on impossible to find anyone amongst them who got rich by simply sitting back and letting the money find them.
Whilst it is unlikely that the majority of us will experience the vast sums of wealth enjoyed by the panel on Dragons Den, we can take inspiration from their experiences and work hard to create and leverage our own wealth building opportunities.
So if you have a job interview coming up, do your best to get the position or if you are thinking of going out on own, make that leap. Taking risks is important and provided you have evaluated and are comfortable with the risk, you should do your best to leverage the opportunity.
Protect Your Wealth
As you work hard to build up your wealth, you need to ensure it is protected. Most people take out insurance policies to cover themselves against risks and there is a very broad choice of insurance products available, but it is important that you take out the right sort of insurance policy to meet your needs.
The key insurance policies that you should be thinking about are those that cover your property, life and health. Other common insurance policies will cover your car, travel, home contents and possibly redundancy protection.
The cost of insurance premiums will soon mount up, so it is important to ensure you only take out the key policies that match your needs and avoid unnecessary policies such as extended warranties on electrical goods. Do your research and speak to an independent financial advisor to ensure you get the most suitable policies.
You can also keep the cost of your insurance policies down by reducing the level of risk that you present to the insurers. Keeping a clean driving licence, a healthy lifestyle and good credit history, will all help to reduce the costs of your premiums.
Keeping your costs low on all other expenses will also help you to maximise the cash you have available to save and invest. For example trading in a big 4×4 car for something smaller can significantly reduce your running costs on parts, maintenance, insurance and petrol. Running a low-cost lifestyle does not mean you should force yourself to live below the breadline, but helps to ensure you don’t waste your money on things that you do not need.
Finally maintaining a good credit history is vital for building and protecting your wealth. People with poor credit histories find it much harder to get accepted for mortgages and loans, and end up paying higher rates of interest. Protecting your credit history is simple – don’t take out any unnecessary loans and ensure you repay any loans that you do take out on time.
Start Using The Wealth Creation Pyramid
So now is the time to start building your wealth. Keep in mind the following:
- Understand your current net worth
- Set financial goals
- Clear your debts
- Start saving an emergency fund
- Remember the importance of compound interest
- Create a system for saving & investing and automate it
- Invest for the long-term and take advantage of tax-benefits
- Grow both your financial and non-financial knowledge
- Do your very best to leverage every opportunity that life presents you with
- Protect your wealth