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NEWS - PLANNING
10 rules to make you rich
3/14/2005
There are remarkable similarities between a campaign to improve your personal wealth and a serious diet and exercise program. Both require lots of discipline and some fundamental rules that most of us ignore until we realise they can change our lives.
Just like most dieters who fall by the wayside, many who set out to become wiser about wealth will be overwhelmed by the challenges involved. But if you stick to a sensible program, the potential rewards are worth the trouble.
Helena Gibson, a senior technical adviser with financial planner Bridges, says you can plan to be wealthier. In other words, you can become rich if you put your mind to it. But you need to be aware from the outset that implementing your plan may take a major effort.
The 10 fundamental rules that accompany this report should set you off on the right track.
Financial adviser Rob Bradford of the Montaigne Group, a NSW country-based financial planner, says any serious program to improve your financial health should start with an analysis of your financial circumstances. By using something as fundamental as a family budget, you need to identify whether you are living within your means and where the scope is to create new wealth.
"The bottom line of any budget," says Gibson, "is to work out whether you have a surplus or a deficit and if it is a deficit your first task is to turn this around. You need to do this before you entertain any investment ideas."
If you have a surplus, it must be identified to be able to explore money-making opportunities, such as extra contributions to superannuation or an investment strategy.
Understanding your savings potential is vital as it allows you to set achievable goals. Like dieters who set themselves over-ambitious goals and give up when they don't achieve them, being unrealistic is a trap for the financially ambitious.
"We all want to save more than we actually can and see our savings earn the best possible returns but we need to be realistic," Gibson says.
"It's a matter of setting goals that are achievable and knowing that if we do, we're more likely to stick to them."
Financial planner Peter Crump, chief executive of Adelaide-based Portfolio Planning Solutions, says: "Many of us can be instantly better off if we learn to manage our debts in a smarter way."
Whether the debt is a home mortgage or a personal or credit card loan, there are various ways these obligations can be managed better.
Brad Holmes, manager of financial planning at Perpetual Private Clients, says that if you apply fundamental concepts such as automatically directing a percentage of income to strategies such as superannuation or borrowing money to invest - rather than spending it - you can't help but improve your financial circumstances.
A fundamental investment concept advocated by Tom Murphy, the head of investment research with Deutsche Bank's private wealth management division, is investment diversification.
As an example, Murphy says the strong Australian dollar carries a message for investors to diversify into overseas share assets.
Yet most Australians are overweight in Australian shares because they only understand the franked dividends that come with local shares.
Diversification operates on the principle that no matter how good an investment or investment concept may be, you should never be entirely reliant on it.
Investors have been fortunate that Australian shares have delivered excellent returns over the past couple of years - but the time will come when overseas diversification will pay off. It is also important to understand concepts such as tax if you want to become wealthy. Understanding how capital gains tax works and when to take profits or let your investment profits run are important issues.
"It's a good idea to have fundamental rules that help you in your investment decision-making," says tax adviser Gordon Cooper, of Sydney-based Cooper & Co.
It is better, for example, not to sell investments unless you have owned them for more than 12 months so that you qualify for a 50per cent capital gains tax discount.
And as it gets closer to June 30, it is a smart tax idea to consider offsetting any capital gains with capital losses.
"You could have bought an investment six weeks ago that's gone the wrong way. It will still have the same capital gains-offsetting clout as a loser that's been owned for years," Cooper says.
1. BE TAX SAVVY
Tax has a huge role to play in the wealth creation process. Every profitable investment includes a tax liability that you need to net out in order to keep an investment return in perspective.
And tax concessions are a vital part of superannuation.
Tax basics include holding investments in the name of a non-working spouse.
If your investments are in your name, it is possible to give them to the non-working spouse, says tax adviser Gordon Cooper, of Sydney-based Cooper & Co.
The attraction of this strategy is that income and capital gains earned by the investments should attract the lower rate of tax paid by a non-working spouse. And excess dividend imputation tax credits on shares can generate a cash tax refund.
Family trusts also can help distribute investment income to lower-taxed family members.
Tax is also important if you borrow money to buy assets such as shares and property.
You can negatively gear if the cost of interest payments are greater than any income from an investment. If you own shares that pay only a 2 per cent dividend return and have borrowed money at 8per cent, you can get a tax deduction for the other 6 per cent.
It is a different story if the shares have no prospect of ever paying a dividend.
Tax rules say that if your only expectation is capital gain, you cannot claim a tax deduction for interest. But you can add it, along with other expenses, to the cost of the shares and reduce any future taxable gain.
A classic example is a block of land bought as an investment. It is important to keep a record of expenses for future tax offsets.
Negative gearing can also reduce your Medicare levy and superannuation surcharge, says technical adviser Helena Gibson.
2. BE MORTGAGE SMART
You should reduce your mortgage as quickly as possible by making extra payments. The most basic reason is that interest payments are based on an outstanding loan balance. If you reduce the balance, you pay less interest.
And remember that interest on your home is not tax deductible - it is a very undesirable form of debt. Once you have cleared your mortgage, you can get on with making investments that will increase your wealth.
But financial planner Rob Bradford reckons there is a point at which simply increasing your mortgage repayments may not be the best strategy for any surplus cash flow.
He illustrates this with the example of a standard 25-year $200,000 mortgage with an interest rate of 7.5 per cent.
If you pay the normal monthly amount of $1478, the total amount repaid over the full term will be $443,400. About 55 per cent of that amount will be interest.
But Bradford uses a rule which says that the optimal monthly mortgage repayment is $12 per $1000 of mortgage (or $2400 for a $200,000 mortgage). This would reduce his hypothetical loan to 9.84 years and the interest to $83,400 or 29per cent of total repayments.
Increasing the monthly payments to $2900 (another $500) will reduce the loan period to 7.54 years and the interest bill to $62,500, or 23 per cent of the total repayments.
This is not a dramatic improvement and Bradford says the extra $500 could instead be put towards a tax-effective loan to buy shares. This would diversify your assets away from property.
One timely strategy for a property-owner with large mortgage repayments, says technical analyst Helena Gibson, is to rent out your home for six years. You can do this without paying capital gains tax on the property when you sell.
You could live somewhere cheaper and claim deductions for the proportion of the interest repayments that exceed your rental income. She says this is not an easy decision - but could improve your financial health if interest rates continue to rise.
3. PUT YOUR CASH TO WORK
It takes time to become wealthy but you can speed things up if you put your money to work properly. Work means investing in assets that have the best potential to grow.
Rather than hanging on to your cash, you need to invest in assets that will generate a real rate of return, says Tom Murphy, the head of investment research with Deutsche Bank's private wealth management division.
A real return is any amount you earn over inflation. The current inflation rate is about 3per cent, so an investment that gains 6 per cent has a real return of 3 per cent.
An investor in shares and property ideally should look for a real return of between 4 per cent and 5 per cent, Murphy says. But these investments take patience, emotional fortitude and a humble nature.
Assets that depend on capital gains experience periods of unpopularity but over the long term should deliver a better return than cash.
Some people may consider themselves smart enough to time their involvement to coincide with periods of growth - but a golden rule is to invest regardless of the mood of the moment.
"If we could all pick the best time to buy and sell, becoming rich through investing would be simple," says financial adviser Rob Bradford of the Montaigne Group.
But he says that trying to time financial markets is a strategy that rarely works and is difficult even for investment professionals.
Dollar-cost averaging or systematic investing is an alternative approach. This involves investing regular amounts in a market regardless of short-term price fluctuations.
You might, for example, buy shares every three months rather than all at once.
It works for a very simple reason - your regular investment might buy less when the market is up but it is going to buy more when the market is down.
4. UNDERSTAND DEBT
One of the major wealth hazards is debt - especially high interest credit card debt.
Credit cards offer easy money that can become a major millstone, especially if you repay only the minimum amount each month, says financial planner Peter Crump.
Many credits cards with interest rates of 13 per cent to 15per cent per annum will often ask for a minimum payment of less than 2 per cent of the outstanding balance. You may be asked to pay as little as $60 on a $5000 debt - or only 1.2 per cent of the loan.
"If you are incurring interest at an annual rate of 15 per cent, it is a monthly expense of 1.25 per cent. Your credit card debt becomes a virtual interest-only loan and you'll never pay it off at this rate. You are just servicing the interest," Crump says.
An $8000 debt will attract monthly interest of $100, so it is smart to pay off a credit card debt as quickly as possible.
If you are caught in a credit card trap, you could consider consolidating it into your mortgage. This could reduce the annual interest charge to about 7 per cent. But you should still seek to clear the debt and be careful about running up another large credit car debt.
Crump says this is an important behavioural management issue and will take discipline, especially if you are a debt junkie. It is one of the first steps in any wealth-creation program. Another important step is to pay down debt with any savings you may have squirrelled away. It is not uncommon for people to have both high-interest loans and savings that earn a low rate. The logic is a desire to have some ready cash but it is not a smart financial strategy, says Crump.
If you earn 4 per cent in interest on your savings and pay 7 per cent on a mortgage, or 15 per cent on a credit card, you are either 3 per cent or 11 per cent in the red.
5. GET EDUCATED ON FINANCE
While it will not guarantee your success as an investor, being financially literate will not do you any harm. It is useful to understand the basic concepts of investing, investments and structures such as superannuation.
Concepts worth exploring include the power of compounding, the future value of your hard-earned dollars, asset allocation and portfolio rebalancing.
When money is invested, it produces earnings that can then be reinvested. The idea is that you receive earnings on your earnings. This added boost is called compounding and the longer the money is invested, the more powerful are the effects.
It provides evidence for the argument that you should invest for as long as possible. Over long periods of time - 20 or 30 years - the impact of compounding can be substantial. For instance, if you invested $10,000 today and it earned an average annual rate of 8 per cent, you would have $100,626 at the end of 30 years.
If the earnings rate was 9per cent, you would have $132,676. This is a $32,000 difference with only a 1 per cent difference in annual return.
But over time, inflation erodes the worth of money, so a given amount buys less in the future than it can today. When planning for the future, you need to consider the future value of your savings rather than today's value.
And don't forget to get your head around basic investment concepts such as asset allocation.
This is a strategy that involves spreading your money over different assets such as shares, bonds and property. The amount you devote to each type of asset depends on how much capital you are prepared to risk, at least over the short term.
You need to check your asset allocation occasionally to make sure it matches your objectives. This is a process known as rebalancing. It is difficult to be a successful investor without coming to grips with concepts such as these.
6. MAXIMISE YOUR SUPER
Superannuation is a major opportunity to create wealth, even though many people regard it as a bore.
Super, in essence, is a government-approved tax shelter that encourages you to defer income until your retirement. It offers genuine tax benefits - so all possible strategies must be taken seriously.
Start by calculating how much you can actually contribute this year. There are many ways to invest more than the 9 per cent of your salary contributed by your employer every year. The self-employed, for example, get extra incentive to put money into super. Others can salary sacrifice a significant amount into their retirement fund every year.
The federal government also offers extra entitlement such as spouse contributions and the new superannuation co-contribution.
The co-contribution scheme sees the government match a $1000 personal contribution with a maximum co-payment of $1500. The payment decreases by 5¢ for each dollar of income above $28,000. Tax adviser Gordon Cooper describes it as a handout from the government.
Salary-sacrificed amounts are taken from your gross salary, rather than deducted from wages after you have paid income tax. The advantage is that money salary-sacrificed into super is taxed at a lower rate than if you received it as part of your regular income.
Of course, you are unlikely to get the money back until you retire and you should factor this into your investment strategy.
You should strike an agreement with your employer, preferably in writing, to include salary sacrificing in your remuneration package.
One common question is whether you can salary sacrifice your entire salary. The answer is that there is no law that prevents a 100 per cent salary contribution to super - but there is a limit to the tax concessions you can claim. Your limit is based on your age.
Another possible hitch is that an industrial agreement might place restrictions on a salary-sacrifice strategy - check with your employer to see if it applies to you.
7. AVOID GET-RICH-QUICK PLANS
Get-rich-quick schemes are the financial world's equivalent to the latest fad diet. But just like diets that promise a quick fix, they rarely work.
The common theme of get-rich-quick schemes is a promise of high returns accompanied by the lure of tax breaks. It might be a property seminar that claims you can buy several apartments because of tax breaks and capital gains, or a share seminar that claims to teach a trading system that is guaranteed to produce profits.
The simple truth is that the promoters of these schemes would not run seminars if their advice worked - they would get rich by using the strategies themselves and not sell their secrets to anyone else.
There is no magic formula for creating wealth - compound interest and patience are two of an investor's best friends. But there are simple steps you can take to avoid getting caught by get-rich-quick schemes.
First, check to make sure that the promoter is a licensed financial adviser by asking for its Australian financial services licence number. And make sure that any schemes offering a tax carrot have a tax ruling from the Australian Taxation Office, says tax adviser Gordon Cooper.
A tax ruling lists the circumstances under which deductions are allowed - you may get no deduction if there is no ruling.
One final tip is to look for research reports from independent analysts that investigate the commercial potential of a scheme, including its scope to generate income and earn capital gains. This applies to investments such as agricultural projects.
It is important not to be seduced by the tax advantages to a point where you lose sight of the commercial realities. Otherwise tax-motivated investments are a wealth hazard.
8. DON'T OVER-COMMIT
In these days of easy money, it is easy to over-commit yourself financially. It is easy to get two or three credit cards, personal loans and overdrafts. Modern mortgages let you dip into home equity to fund your daily expenses or luxuries.
You are over-committed if you are living on short-term debt. One way of dealing with this is to have a budget - a written plan that outlines how you will use your available financial resources to achieve your financial goals.
A budget can be used in conjunction with a cash flow management system - or a system to manage your income and expenses. Cash flow management is used widely in business but can also be applied to personal finances.
A budget shows your income and expenses - but a cash flow system outlines how you will meet your obligations. Many people find themselves using short-term debt offered by credit cards because they have not organised their cash flow.
And an integral part of every budget is an allocation to savings.
A useful habit to develop is saving 10 per cent of your income every time you are paid.
9. BE CAUTIOUS
Good financial habits include caution. If you inherit money or come into a windfall, it is wise to do nothing for at least six months.
This will allow you to get used to your new wealth rather than making snap decisions such as paying off all your debt or buying a bigger house.
Caution extends to being prudent in your financial strategies and buying only investments that you understand, as well as avoiding investments that may keep you awake at night because they are too risky for your nature.
Strategies such as margin lending - where you can borrow money to buy shares - can be very attractive but also increase the chance you will suffer a significant capital loss. Caution is imperative.
Margin lending is a long-term strategy only suitable for people who understand the risks of gearing - you have to be prepared to stick to it for seven to 10 years, says the manager of financial planning at Perpetual Private Clients, Brad Holmes.
Caution can also make you diversify your investments instead of relying on only one to set you up for life. Many people, for example, fall into the trap of concentrating on super at the expense of other assets.
Super has obvious tax attractions but there is always the risk the laws that govern it will change before you retire and reduce its benefits.
10. USE ADVISERS PROPERLY
There is a growing army of financial advisers offering their services to personal investors - including planners, brokers and private bankers. It is important to learn how to use their services and what to expect from them.
One simple measure is whether you get superior investment returns as a result of their recommendations. Ask yourself if you have achieved higher gains than if you had made all your own financial decisions.
But financial planner Peter Crump says he would be concerned if this was the only criteria on which he was assessed. He says the service he offers can deliver a better outcome once issues such as tax are taken into account.
In other words, a good adviser has technical knowledge that a lay person probably lacks. Many people, for example, hold investments outside superannuation that are taxed at their personal rates.
The same investment could be held in a super fund, particularly a do-it-yourself fund, and taxed at concessional rates. The gross returns from the investment will be the same - but the after-tax gain in a super fund should be higher.
Structures that most people do not understand, such as testamentary trusts, can also help people get the most desirable outcomes from their investments.
"Better financial planning advice should consider an individual's whole circumstances and not just specific investment issues at hand," says Crump. It is the outcome that needs to be superior and not just the return.
It is also important to understand that different advisers suit different investors. Some financial planners, for example, offer very simple advice, suggesting managed funds that might best suit a client. If you want advice on more sophisticated strategies or a planner who can act as a sounding board, you may need more expert advice.
WHERE TO LEARN MORE
There are plenty of places where you can learn more. The Australian Stock Exchange (http://www.asx.com.au) runs courses that explain the basics of the sharemarket and listed companies. Adult education institutions such as the WEA and the Victorian Adult Community & Further Education Board (http://www.acfe.vic.gov.au") run courses on finance.
Major universities that offer continuing education to the general public are another option. Fund managers such as Vanguard Investments ( http://www.vanguard.com.au) have education pages on their websites that can be an excellent source of basic investment information.
For the more dedicated student, US website http://www.investopedia.com provides hours of entertainment. It has lively explanations of most financial markets and investment concepts.
Reproduced from the Australian Financial Review - 12 Mar 2005
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