As financial advisors we are responsible for helping our clients build wealth in the most effective way possible. After all, that’s what they pay us for. Also, if we are going to help them build wealth, then we should be successful at building wealth in our own personal portfolios. Looking in the mirror, does that description fit you?
After many years in this profession, I believe that there are just a few fundamental steps to building wealth. The first step is fairly obvious but often ignored: In order to build wealth you must spend less than you earn. I have seen individuals that earn $40,000 a year but save $5,000 of that for the future. Albeit at a slow pace, they are on the path to building long-term wealth. In contrast I have seen others that earn $200,000 a year and spend $220,000. Because the more they earn the more they spend, they will never build wealth. I have even seen individuals worth over $50 million spend more than they earn and systematically destroy their fortune. While it may sound simplistic, Rule Number One is to spend less than you earn.
Step number two is to commit to and follow a sound, long-term investment strategy. Again, it sounds simple, right? Yet most investors and many advisors can’t describe their strategy because they don’t have one. Far too many people invest a little here and a little there based on what they’ve read or who they’ve talked to recently. They often bail out of the stock market after it has tanked. Or they buy real estate after it’s had a great run. Or they invest in the latest get-rich-quick strategy being promoted on late night television.
For example, there’s the recent “follow the newsletter” trend. Every year, Hulbert Financial Digest ranks the performance of investment newsletters. According to Hulbert, many investors have started basing their investments on the advice found in last year’s top-ranked newsletter. On the surface, it seems like a good idea. You’re following the advice of a proven winner, right? And after all, it feels good to follow a winner.
The only problem is that like most “feel good” decisions in the investment world, it doesn’t work. At all. According to Hulbert, if you had taken $1 million in 1985 and followed this brilliant strategy every year for the next 21 years, you would have a whopping grand total of $365 today. That’s an average loss of 31.4% per year. While it might be emotionally and intellectually appealing, this is an example of a strategy that simply does not work. Unfortunately, no matter how disciplined you are, if you follow a bad strategy you will never build wealth.
So what are the keys to a sound strategy for building wealth? In my opinion, any successful investment strategy must:
- Work over different time frames
- Provide effective diversification–not just diversification for diversification’s sake
- Work in both bull and bear markets
- Be disciplined yet flexible and evolving
- Reduce risk and provide downside protection
- Have a good long-term track record
After you find or develop a strategy that meets these criteria, it’s all about patience, self control, patience, and more patience. In summary the steps–which we should practice as well as preach to our clients–are: