1. Spend Less Than Your Earn
Spending less than you earn is crucial if you want to accrue wealth during your lifetime. However, it does not mean your average monthly earnings must exceed your average monthly expenditure at every point in time during your life. The concept of spending less than you earn must be applied over the long term, to take into consideration changes in expenditure patterns that occur throughout your life. Most people experience a steady growth in their annual earnings throughout their working life, reflecting their increasing value based on experience, skills and knowledge. However, expenditure follows a different pattern, and depends on your stage of life – for many this entails:
- lower expenditure in the early stages of life, reflecting limited financial commitments;
- significant increases in expenditure when children are born, homes are purchased or businesses established;
- diminishing expenditure toward the end of life as children leave home, mortgages are reduced or paid-off, businesses are making higher profits and investments have grown and are performing well.
Due to high expenditure during some phases of life, such as the period after you purchase a new home, many people are unable to avoid spending more than they earn. But you will save money if the overall amount you spend throughout your life is less than the amount you earn. The graph below simplifies the expenditure and earning patterns that most people will experience during their lives. The areas in red represent periods where expenditure outpaces earnings. The areas in blue represent periods where earnings outpace expenditure.
2. Protect Your Capacity To Earn
With opportunities come risks. As we have tried to demonstrate, the key is to make the most of your opportunities, while avoiding or at least reducing, the risks that may prevent you from achieving your goals.
Of course, some risks cannot be avoided entirely and these risks may be transferred. Few people can afford to insure themselves against all the risks they face in life. However, most of us can insure ourselves against the risks that are more likely to affect us.
A good rule of thumb is, ‘protect yourself against the risks you could not afford, if they occurred’.
Putting safety nets in place ensures your capacity to earn is protected throughout your life, and this helps to make your life goals more achievable.
3. Pay Off Non-Deductible Debt First
Non-deductible debt is debt that you pay off with after-tax dollars. This means you bear the entire cost of borrowing, including the interest. Tax-deductible debt, on the other hand, means that interest repayments and other expenses associated with the debt are deductible for tax purposes. This type of debt is considered active because although it costs you money, it also makes you money.
4. Make Your Money Work For You
Three common ways to make your money work for you.
- Invest in shares. Shares work for you by paying you dividends.
- Invest in property. Property works for you by paying you rent.
- Invest in a business.
A business works for you by generating income. When you invest your money, consider at least two important investing concepts: diversification and your tolerance to risk. Diversification Diversification spreads your risk across numerous financial investments, reducing the impact that poor returns from any one investment is likely to have on your overall portfolio.
Diversification follows a simple logic:
- The prices of shares, bonds, listed property and other investments often do not rise and fall in tandem. When one type of investment is on the rise, another may be declining.
- By investing in two or more types of securities, you increase the possibility that when something you own is doing poorly, something else you own will be doing well. Your winner’s good performance can offset your loser’s disappointing returns.
- The end result: Your portfolio’s overall performance is likely to be less volatile – that is, undergo less price fluctuation – than a portfolio invested in just one security, or one type of security. Accordingly, a well-diversified portfolio typically achieves smoother returns than an investment in a single asset class. You can spread your risk by investing in:
- All main asset classes: cash investments, bonds, property (listed or direct, or both), and shares.
- Various types of investments within the main asset classes, for example both short-term and long-term bonds, and both Australian and international shares.
- Managed funds, rather than individual securities. Managed funds pool your money with that of many other investors to buy an array of securities within a single asset class, or even across more than one asset class. Keep in mind that diversification does not and cannot eliminate market risk – the possibility that a particular market will decline over short, or even extended, periods.
Your risk tolerance is your ability or willingness to endure declines in the value of your investments while you wait for them to return a profit. Some investors find it easy to ignore market fluctuations and to focus on their long-term investing goals. Others become anxious when their portfolio declines in value by even a small percentage. Your emotions play a significant role in how you allocate your investment assets. Consider how you would react to a ‘bear market’, where the value of a share investment declined by 20 per cent or 25 per cent over an extended period of time.
Keep in mind:
over the past four decades, ‘bear markets’ have occurred, on average, about once every five years; and
during October 1987, the Australian share market dropped by 42.1% and in the first half of 1994, the Australian bond market dropped by 6.4%.
If the possibility of such a loss would keep you awake at night, you might choose a relatively conservative asset mix. However, in doing so, you run the risk that inflation will erode a greater percentage of your returns. Keep in mind, too, that all investments – even ‘safe’ choices like bank accounts or cash funds – are subject to some type of risk.
This website contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information.