Many commonly accepted “facts” about wealth building are, in fact, fallacies.
Here are 6 fallacies examples:
1. Risk and reward are inversely correlated.
2. Wealthy people are stingy for a reason.
3. The most important factor in building wealth is ROI – the rate of return you get on your investments.
4. A well-balanced investment portfolio is composed primarily of stocks and bonds, with the rest in cash or cash equivalents.
5. The surest way to acquire enough money to retire on is to buy the most expensive house you can afford and gradually pay off the mortgage.
6. Asset allocation is the single most important factor in building wealth.
Those are the fallacies.
Here are the real facts:
1. Safety grows wealth, not risk.
The intelligent wealth builder takes advantage of safe bets and avoids risky ones. He understands that smart financial decisions are cautious decisions. When he must take a risk, he does so with some sort of loss limit in place. He never loses more than he is comfortable losing.
2. Being cheap doesn’t make you richer.
Spending money prudently is an economic virtue, but being stingy is not. The rich man who undertips does so not because he has learned the value of money but because he is a cheap bastard. It’s as simple as that.
3. The most important factor in wealth building is not ROI.
The accumulation of net investable assets, the amount of money you’re able to devote to investing after you’ve paid for all your regular expenses is. Plus, individual investors chasing yield typically get ROIs that are less than half those of market averages. This is why the astute wealth builder devotes the lion’s share of his wealth-building time to increasing his income and setting realistic goals for his stock and bond portfolios.
4. Diversification is key.
The typical portfolio of stocks, bonds and cash, however allocated, is an inadequate approach to building and safeguarding wealth. The savvy wealth builder will also include other assets, such as income-producing real estate, tangible assets, alternative fixed income investments and direct investments in cash-generating private businesses.
5. Buying bigger isn’t better.
Buying a more expensive home every time you get a big raise is a great way to ensure that you will never get rich. What you want to do is find the least expensive house you really want and keep it. The longer you keep it, the more net investable income you will have to invest in income-producing assets that will eventually make you rich.
6. There’s a proper way to manage risk.
Asset allocation is indeed very important, but it is only one-third of a larger strategy that truly is most important. Risk management is the key. Risk management has three parts: asset allocation, position sizing and loss limitation. The intelligent investor pays equal attention to all three.
Bonus Round
Here are 4 more facts:
1. The biggest mistake retirees make is giving up their active income.
To keep your wealth for a lifetime, you need multiple streams of passive income. Your goal should be to build each stream of income to a level where you can live on that and that alone.
2. Compound interest also applies to knowledge.
The power of compound interest applies not just to money but also to skill and to knowledge. If you want to get rich and stay rich, you need to invest as much of your spare time as possible in acquiring financially valuable skills and learning about your business.
3. Don’t expect more. Or less.
Every type of financial asset has its own unique characteristics in terms of growth potential, income potential and risk. Expecting more growth or less risk than normal from any investment is a bad idea. That is why 90% of ordinary investors have results that are far worse than market averages.
4. There are two ways investments can build wealth.
One is by the generation of income. The other is through appreciation of the value of the underlying asset. Asset classes are inherently structured to increase value, preserve value or do both. Investments that provide both income and appreciation are generally superior to investments that provide only one or the other. But in developing an overall strategy of wealth building, the prudent investor will incorporate all three types of investments.
Sven Franssen