Building wealth for your future Author Date
: Dineshrie Pillay : 26 October 2010
South Africans do not have a savings culture. The latest government statistics for the first quarter of 2010 show that nearly 50% of South Africans between the ages of 16 and 24 and 28% of those aged between 25 and 34 are unemployed. Further research findings by Old Mutual show that less than one third of South African youth have any kind of retirement savings vehicle in place, this includes trainee accountants. Every time we work on our computers we are reminded to ‘save.’ As auditors and professional accountants, we are taught to implement back up procedures over our data and business processes in the event of loss, yet the importance of ‘saving,’ and having a ‘back-up plan,’ does not seem to have been transferred over to our personal finances. As qualified accountants we have been trained to look after a company’s finances, not necessarily our personal affairs. The lesson of how to manage our personal finances was usually learnt in the school of hard knocks, an experience that we call life. The South African Savings Institute cite that the fundamental reason for South Africans not saving is that there is, ‘no savings culture in the country,’ and that education is its core strategy at targeting the gap. I believe that as individuals we all do value wealth and savings, so there must be a culture that values saving. What I believe is missing is a methodology based on sound principles of how to go about saving. I have been searching for such, ‘principles,’ for the past five years and what I have found is that are certain laws to creating wealth that if applied diligently gives you a step by step process to achieving your wealth goals. This article is a summary of those most important principles. Know your values! When I was a newly qualified Chartered Accountant, a favourite phrase of mine was that, “Life is short and we must live for the now!” I had a value system that was focused on short-term gratification. As a result, I did not plan financially for the long term and my money was usually spent on entertainment, going out and clothing. That fact became a harsh reality when I relocated to Johannesburg just after completing my articles. I realized that although I earned my qualification, my only other asset at that time was my accumulation of clothing. In spite of working and earning money for four years prior to my relocation, I did not have any savings to my name. If you wish to build wealth for yourself, you first need to understand what is important to you, that is, what do you value? I have found that if building wealth is not within the top three of your personal value hierarchy, then you usually do not have sufficient reasons to save. This is the first principle. Know your values and make building wealth part of your top three values.
Limiting beliefs As a life coach, I have worked with individuals that believe that, ‘money is not important,’ or that, ‘money is evil – it attracts bad luck!” Beliefs are built over time and are usually a mix of cultural upbringing; environmental influences or personal experiences that have led to an individual having such a belief system. However, in the process of building personal wealth, such beliefs can be a hurdle to achieving personal financial fulfillment. So it is wise that you identify if you have any limiting beliefs about money and start creating more empowering beliefs about building wealth for yourself. The power of association “If you want to learn how to howl, go hang out with wolves. If you want to learn how to fly befriend eagles.” Anon Learning how to build wealth is similar to the above quotation. Make a list of people in your personal, social or work life with whom you perceive to be successful at managing their personal finances. By associating with other like-minded successful individuals, it is like sticking your hand into a jam jar – some of that jam eventually sticks onto you! A Shock to the system In his book, ‘How to make one hell of a profit and still get to heaven,’ Dr John F Demartini outlines a simple calculation and financial strategy that will get you thinking on the importance of saving. This calculation and strategy have been summarised below: Step 1: Work out your current monthly lifestyle expenses. For illustration purposes, let us assume that it is R20k. Step 2: Work out what your ideal monthly lifestyle expenses would be, if money were not a scarce resource. Again for illustration purposes, let us assume that figure to be R100k. Step 3: Add the two amounts together and divide by two. This in essences gives you a more realistic average lifestyle expense. In our example that amount would be R60k. Step 4:
Next take your current age and increment by 15 years until you get to about 100 years. Below these increments, take your average lifestyle expenses and double at each level. In our illustration this would be as follows, assuming a current age of 27 years: 27 60k
42 120k
57 240k
72 480k
87 960k
102 1.9m
This means that by the age of 102, your living expenses will be R1.9m. We double the value of the living expenses based on a financial principle called the Law of 72 that says if you divide 72 by the rate of inflation (average of 5% used in example above), your result will be the number of years it takes for the annual living costs to double. Step 5: Work out how much principle you need to have invested that will give you a safe interest income of R1.9m. At the current money market rate of between 6-8%, this means that you will have to invest between R31.6m - R23.7m to ensure that you earn sufficient income to cover your expected living expenses, as worked out above. Are you currently on track with your savings to earn such an amount? Pay yourself first! Having self-discipline and a high self worth are essential factors to building wealth. To illustrate, the usual spending path for an individual at month end is: 1. Pay debt first. 2. Pay credit cards and bills. 3. Pay lifestyle expenses. 4. Save (if any left over) To change to a ‘savings culture,’ an individuals spending path should be as follows: 1. 2. 3. 4.
Pay yourself first (Save) Then pay taxes Then your lifestyle expenses And finally pay bills according to priority
This principle was also illustrated in George S. Clason’s book, The Richest Man in Babylon. When you pay yourself first, it can be likened to harvesting the best of the crop when first in season versus waiting for the dregs and remainders after everyone else has been paid. Also, psychologically it is more inspiring to see your savings grow than your debt erode.
A strategy to building your wealth Step 1: Open a bank account Determine your monthly income and commit to saving either 10% of your income or an amount, whichever is the greater. Open a separate bank account wherein you will deposit this amount each month, knowing that you will in essence be, “paying yourself first.” There are some rules to this account: 1. Once the money has been deposited into this account, it cannot be used for any other purpose but to earn you a greater level of return, than it is already. 2. Your savings is not to be used for any type of emergencies or holiday expenses. If you wish to travel, save for this separately, after you have paid yourself first. 3. Let the interest that you earn on the total value accumulate within the same account, giving you the benefits of compound interest growth. 4. Ultimately you need to consider the money in this account as your, ‘employees,’ who are working for you to earn you more income! In his book, Rich Dad, Poor Dad, Robert Kiyosaki described the principle of money working for you via the illustration of a personal set of financial statements. As long as your money is being spent on ‘Income Statement,’ line items, you are losing money. However, by investing in assets or personal investments that earn you a healthy return, your personal balance sheet is strengthened. Every quarter run a projection of how much income you will have by a certain age with continued increased saving contribution. This exercise further inspires you to stick to your plan. Step 2: Increase the amount that you save Every three months, increase the amount that you are saving by 10%. To illustrate, if you started saving say R100 your savings will look like this: Month: 1
2
3
4
5
6
7
8
9
10
etc
R100 R100 R100 R110 R110 R110 R121 R121 R121 R133
On average it takes about three months before doing something new becomes a habit. To apply this principle in the context of saving, if you continue saving a fixed amount indefinitely the value of the amount saved no longer inspires you and you become bored. It is usually at this boredom stage that you find other purposes for your money and are sidelined from your ultimate goal.
You can also liken the above with the economic principle of supply and demand. When you place a demand on yourself to save a higher amount, you are supplied with more to look after. What is important in this early stage of saving is not the amount that you save but rather it is about building the habit and discipline to save. Step 3: Budget Draw up a budget for yourself, with an, ‘actual,’ column that summarises your last 12 months worth of expenses. Review your expenses taking note in which of the seven areas of life you are currently spending your money, namely, work; spiritual; social; family; wisdom; health or financial. As noted above, this will give you some insight into your current hierarchy of values. You spend your money in accordance with your values! As you would do for a company, each month review your monthly expenses against your budget noting the variances with reasons. Use this feedback to change your spending habit rather than to justify an increase in your budget so that by the next month the actual expenses are more in line with your budget expectations. Small amendments like changing the grocery store that you shop in; buying in bulk versus purchasing in smaller quantities or waiting to take advantage of the month end discounts, all contribute to reducing your overall cost base. In the areas of your spending where your actual expenses were lower than your budgeted amount, transfer the differential, ‘saving,’ into your separate bank account. Note, that this amount will be over an above what you have already contributed each month. The simple reason for doing this relates to a principle that says, if you do not decide first what to do with your money, then someone else will! Step 4: Build up reserves Without a doubt we all experience months when unexpected bills occur. The usual response is to fund these unexpected expenses from your hard earned savings. Remember that the universe is constantly testing you as to how serious you are about saving. Unexpected bills is just one of such, ‘tests.” The best way to pass this test is to have a, back-up plan, by building up an amount that is at least equal to two months of your income. This provides you with a cushion to fund emergency and unbudgeted amounts without having to tap into your savings.
Step 5: Build your financial pyramid Building wealth involves a step-by-step rational and disciplined approach. By this stage you would have built up two months worth of income in your personal bank account that earns on average between 3-5%. You would have also disciplined yourself into making a monthly deposit into your separate savings account that will yield between 6-8% (typically a money market account.) You are now ready to accept a higher level of, ‘interest risk.” For the next stage, find a suitable investment (that could include unit trusts; government bond; property and equity investments) that will yield interest or dividend income between 5-7% return. Ultimately the investment at this level should be slightly higher than the interest income being earned in your personal bank account. Keep making deposits into this investment until it equals two months worth of your income at which point you can move on to the next level of investment that will earn you a higher rate of return. Over time you will hold investments in that will yield higher rates of return, with each successive level holding the equivalent of two months worth of your income. As a result, your financial pyramid will look something like the following: Reserves Investments Investments Investments Investments
: : : : :
3-5% 5-7% 7-9% 9-11% 11-13%
Your personal financial adviser will be able to give you insights into which investments or stocks to purchase that will yield returns as indicated above. Every year, review your finances and ‘top up,’ each level by reallocating your money to equate to two months worth of your income. Some people might ask why not first invest in instruments that yield a return in excess of 20%, since it is available. This strategy is similar to the concept of, ‘climbing the corporate ladder.’ You first need to show that you are able to deal with lower and mid-tiered risk before you can be, ‘promoted,’ to a more senior, riskier position. I have seen people invest in high return stock, they get all excited about their, ‘big returns,’ to only then lose their money a few months later and feel depressed. This is because they have not built their risk tolerance from a lower level up. They were looking for a quick return. Building income for the long term needs a long-term view.
Protect your assets! Insurance is another key principle to building your wealth. If there is something that you value, insure it. This includes your vehicle; household; furniture and your life. If you do not place a value on your assets via insurance, someone else will value it by taking it away from you! Personal insurance includes life policies; medical aid; disability and critical illness policies. Get your financial affairs in order! Before you start with the strategy indicated above, you first need to set up files and a recording system to monitor your assets. Have a separate file for all your assets with respective invoices that places a value on them. For investments, have these regularly valued and file its respective valuation certificate away. In order for your assets to appreciate, you first need to appreciate it by looking after it! Compile a list of your assets and liabilities and know your net worth. If you do not place a financial value on yourself, the rest of the world will continue to devalue you until you learn how to value yourself first! By following a strategy of saving, both your self worth and net worth increases over time. Draw up a personal will and update this annually in accordance with the changes in your personal finances. Promotions – earning more income When you receive an increase at work, save the differential between your new and old income and transfer this amount to your separate savings account each month. The principle is that you should live simply and save more. This can be likened to a bank teller who looks after cash. If the bank teller is initially given a float of R1k to look after and they do it well, accounting for every cent over or under, they are soon promoted to look after say, R10k. Again, if they show that they can look after R10k, they are subsequently given more cash to look after and so the cycle goes on. Likewise, every time you are given an increased pay, it can be likened to a bank teller role. You are being given the opportunity to look after a greater amount of money and are being tested in a way. If you can show that you are able to look after the increased amount and you place a value on it and you appreciate it and you grow it, in time you will be given more money to look after.
Conclusion Building wealth for the long term takes time and a strategy that is aimed at building your emotional maturity to handle progressively larger sums of money. As with most things in life, in order to become a master at a skill, you first need to observe others who are good at it, then learn the skill yourself and finally to become disciplined at applying the technique. The skill of building personal wealth is no different. First you need to study the skill and then, you seek it!