Many commonly accepted “facts” about wealth building are, in fact, fallacies.
Take these six as examples:
- “Risk and reward are inversely correlated. If you want to acquire great wealth, you have to be willing to take great risk.”
- “Wealthy people are stingy for a reason. Pinching pennies is a necessary part of building wealth.”
- “The most important factor in building wealth is ROI — the rate of return you get on your investments. When investing in stocks and bonds, therefore, look for high ROIs.”
- “A well-balanced investment portfolio is comprised primarily (80% to 90%) of stocks and bonds, with the rest (10% to 20%) in cash or cash equivalents.”
- “The surest way to acquire enough money to retire is to buy the most expensive house you can afford and gradually pay off the mortgage.”
- “Asset allocation is the single most important factor in building wealth.”
Those are the fallacies. Here are the facts:
Fact No. 1:
The intelligent wealth builder takes advantage of safe bets and avoids risky ones. He does this as an employee, a business owner, and an investor. 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.
Fact No. 2:
Spending money prudently is an economic virtue, but being stingy — i.e., paying less than market value for goods or services simply because you can — is a flaw. The rich man who undertips does so not because he has learned the value of money, but because he is simply a cheapskate. It’s as simple as that.
Fact No. 3:
The most important factor in wealth building is not ROI but the accumulation of net investible assets, the amount of money you’re able to devote to investing after you’ve paid for all your regular expenses — your car, home, debts, and loans. Plus, individual investors, chasing yield, typically get ROIs that are less than half those of market averages. This is why the intelligent 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. By “reasonable,” I mean market averages plus or minus 10%.
Fact No. 4:
The typical portfolio of stocks, bonds, and cash — however allocated — is an inadequate approach to building and safeguarding wealth. The intelligent 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.
Fact No. 5:
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 can “love long time” and keep it. The longer you keep it, the more net investible income you will have to invest in income-producing assets that will eventually make you rich.
Fact No. 6:
Asset allocation is indeed very important, but it is only one-third of a larger strategy that truly is most important. I’m talking about risk management. Risk management has three parts: asset allocation, position sizing, and loss limitation. The intelligent investor pays equal attention to all three.
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Four More Facts
Okay, those are six facts that dispel the common fallacies. Got a few minutes more? Here are four more facts, some of which are very basic but often ignored.
Bonus Fact No. 1:
The biggest mistake retirees make is giving up their active income.
Yes, I know that’s exactly what you hope to do. But 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.
Bonus Fact No. 2:
The “miracle 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.
As a general rule, buying makes you poorer, whereas selling makes you richer. If you want to develop a wealth builder’s mindset, develop the habit of asking yourself every time you buy or sell anything: Is this making me richer or poorer?
Bonus Fact No. 3:
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. And that is why 90% of ordinary investors have results that are far poorer than market averages.
Bonus Fact No. 4:
There are two ways investments can build wealth. One is by generating income. The other is through appreciation — an increase in 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 income or only appreciation. But in developing an overall strategy of wealth building, the prudent investor will incorporate all three types of investments.
You may find some of these facts instantly sensible. Others you may disagree with, be confused by, or see as unimportant. But don’t just read them and dismiss them, please. Give yourself a bit of time to think about them. For me, they are useful and important because they worked for me and for people I mentored — and they worked over and over again. Which means, of course, that they might work for you.$
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