The Formula for Riches / The Difference Between Rich and Poor - by Dr. Hannes Dreyer / Chapter 9.

Application?of?The?Formula?For?Riches.

In order to become a Wealth Creator, you need to know how to create wealth, transfer wealth and how to enjoy wealth.?

Once you have mastered these skills as an investor and/or an entrepreneur, you are a Wealth Creator.

There are two ways to create wealth.

The?First?is?the?Investment?Method.

The investor learns how to take the surplus and create more money. There are different strategies one can use, but very few investments conform to The Formula For Riches. Unless you can apply the formula to the investment strategy which you choose, the investment will not help you to become a Wealth Creator.

The?Second?is?the?Creation?Method.

You begin with nothing and learn how to create a surplus. The only way to do it is to learn how to become an entrepreneur, but again there are two ways; the conventional way and the Wealth Creator’s way.?

The difference between the two is in the application of The Formula For Riches.

Once you know how to distinguish between the different asset and business classes and how to evaluate and apply The Formula For Riches, you will need to learn how to preserve and enjoy your wealth.

This book is about learning how to invest money in order to get phenomenal growth on your investment. In other words, while Wealth Creators know how to create, preserve and enjoy their wealth, in this book, I am focusing entirely on the creation aspect.

I am not going to pay attention to the preservation or the enjoyment of your wealth at this stage, other than to recommend that you find out how to do it the Wealth Creator’s way。

In order to understand how you can apply The Formula For Riches, I am going to tell you why The Formula For Riches?will?not?work?for?most?conventional?investments?and?businesses.

Quick?Investment?Overview。

This is the general overview as seen from within the financial and investment industry. At the end of the discussion, I will do an analysis to see whether or not the specific asset class adheres to the principles of The Formula For Riches.

Investment?as?taught?the?conventional?way?–?read?with?care!

This?is?what?the?financial?industry?teaches?us.?We?have?already?discussed?the?financial?institutions’?conflict?of?interest?between?giving?the?growth?on?your?money?to?you,?or?to?their?shareholders.?Because?of?this?conflict?of?interest,?there?are?serious?flaws?in?what?they?are?teaching.?And?because?99%?of?people?take?their?word?as?the?truth,?99%?of?people?never?become?wealthy.

For?the?record,?here?is?their?version,?which?I?will?comment?on?at?the?end!

Paper assets are those assets where you have a piece of paper confirming that you have invested money in that particular asset. Typical examples are pension funds, endowment policies, annuities, mutual funds, shares or stocks, fixed deposits, etc.

All financial institutions issue paper assets.?

The exception is public companies where you can buy shares in the company.?

Normally, if you own shares in a company, you can classify it as a business but because you have a minority share and they issue a share certificate, you will see this asset as a paper asset and not as a business asset.

You will also find that most financial institutions invest heavily in returns on their capital or investment. Mutual funds rely on the same principle. Any investment which is conducted on the Stock Exchange or in an unlisted public company will be seen as a paper asset.

My comment: you have no control over the management of your investment. All you have to show for the investment is a piece of paper confirming your ownership. Should the investment go bankrupt, you cannot say that this part of a building or that piece of gold is yours, because you do not know where your investment actually is.

Factors?Affecting?Conventional?Investment?Classes。

In order to make informed investment decisions, it is important that the factors affecting those decisions are properly understood.

The factors affecting investment decisions must be viewed in the light of the investor’s requirements and circumstances. Ignoring this reality and considering the factors are in a vacuum will have disastrous consequences for the investor.

Risk。

Of all the factors that have an effect on investment decisions, the risk is probably the most misunderstood. In its simplest form, the risk to an investor is the chance of losing some or all of the money he invested.

The general consensus is, that the more risk an investor is prepared to assume, the greater the potential return.

The amount of risk an investor is prepared to take will vary from one person to another. Typically, investors will be more risk-averse with regards to their retirement capital, as opposed to discretionary investments.

Similarly, an investor’s risk profile will change as his life circumstances change. An older investor approaching retirement will be less willing to assume risk, than a young investor who has time on his side.

The risk an investor is prepared to assume is very often dictated by the investment return that that investor actively needs to achieve.?

An investor, who wishes to accumulate capital to pay for his child’s education, may be forced into a situation where he has to achieve a certain rate of return within the time remaining; otherwise, his fund will not be sufficient to meet its objective.?

The higher the return required, the higher the risk indicated for that investment.

It is obvious that risk and return go hand in hand. For this reason, an investment return offered by a particular investment that is in excess of the market return for that particular type of investment will be a good indicator that the risk involved is higher.

The term investment also has a significant effect on risk. For an investor who wishes to invest for one year only, choosing unit trusts as the investment medium could be regarded as high risk. A fall in the market during that period could result in the investor losing his money.

A deposit with a reputable financial institution would seem to be more suitable and have a lower risk. If however, the investor wished to invest for a term of ten years, the mutual fund or unit trust would not be a high-risk investment.

On the contrary, the deposit could be regarded as high risk, simply because the combined effects of inflation and taxation could result in the investor losing money in real terms.

The concept of risk is a very personal one that has different connotations for different individuals. For this reason, it is valuable to have a flexible understanding of what risk may be to the specific investor.

The most important consideration involving a decision about risk is that the investment is suited to the risk profile of the investor.

The?Different?Factors?which?can?affect?your?Risk?Tolerance?Profile?are?as?follows:

1.?Personality

Each person has a different personality and this should be considered when determining a risk tolerance profile. If you are a very volatile and insecure person, it would be foolish to look at a high-risk investment portfolio.

An important point to remember is that none of these factors can be assessed in isolation. You must take all the above factors into account, and make a rational decision that will satisfy your needs and expectations.

Different risk profiles consist of different asset types. Below is a categorization of the different approaches to investment risk exposure and the asset class combinations they represent.

Note: These are only an approximation / a rough indication and may vary from person to person. There are also different levels other than those discussed here.

2.?Conservative。

This investor has very little appetite for risk and is looking for long-term capital preservation. There is little possibility of growth in this portfolio and the asset types comprise mostly of cash and bonds.

3.?Moderate。

A moderate investor is someone who seeks both income and growth. The equity portion slightly outweighs the cash and bond portions. He wants to smooth out the volatility of the portfolio and is seeking long-term growth together with short-term income.

4.?Aggressive。

The aggressive investor has a high tolerance for risk and seeks high growth opportunities. This portfolio can however be very volatile and should be considered within a long-term strategy. If, however, the investor is doing lifestyle planning, this option might be necessary to meet stated goals and objectives.

5.?Age。

Does the older person necessarily have a lower risk tolerance profile?

A person who is older and has saved enough for retirement might not necessarily fall into the lower risk tolerance category. He may be able to afford to take risks because he has built up a comfortable nest egg.

The same theory applies to the younger person who needs to provide for his child’s education, pay off a bond and maintain a specific lifestyle. Should this person be conservative or should he take risks when investing?

The answer to this question cannot be answered by looking only at the age of the person but should take other factors into account such as future needs. If this person needs to build up a substantial shortfall he cannot afford to be totally conservative and should expose himself to a certain amount of risk.

Age is an important factor but not the determining factor.

6.?Time。

When it comes to paper assets deciding, when to invest, is probably the most difficult of all investment decisions. It is not surprising then to realize that it is the one decision that investors get wrong more often than not. The timing decision is made less critical as the term of the investment increases.

The longer he has to invest, the more risk he should be able to tolerate as markets have indicated cycles.?

Should the investor, for example, need to realize money within one year's time he will have very little tolerance for risk since there is no opportunity for the investor to wait out the poor market conditions.

In contrast, an investor who has a long-term strategy will be able to ride the ups and downs.

According to the conventional approach, you should not change your investment strategy purely because of under-performance. You should rather stick to the risk tolerance profile and maintain exposure to the higher-risk investment vehicles.

Research has shown that equities outperform bonds, cash, and inflation, over a ten-year period.

7.?Term。

When it comes to conventional financial planning and paper assets, the term of investment has a dramatic effect on the investment decision.?

An investor wishing to invest only for a few months should not enter the equity market unless he is prepared to accept very high risk.

According to general belief, the risk associated with the equity market decreases as the term of the proposed investment increases.

8.?Inflation。

Just as the bottom line for most investors is the after-tax return of an investment, so is the real return over time. By real return is meant, the return after the effects of inflation have been taken into account.

My comment: if an investor is not earning a positive real return, he is in fact becoming poorer by investing. In this context, it is often useful to regard risk as to the converse of real return. In other words, if we accept that fundamentally risk is about the probability of an investor losing money, this should be qualified by adding the words "in real terms”.

Viewed in this light, low-risk investments, such as fixed deposits, suddenly become high-risk investments after taking tax and inflation into account. In fact, any investment which cannot help you to achieve your investment objective can be considered high risk as you will see in later discussions.

The risk of inflation depleting an investment portfolio is a real threat. This steady erosion of one’s investment reduces the buying power over the long term. The following example illustrates the effect inflation has on investment.

9.?The?Law?of?72。

In nine years' time, an investment of $100,000 will have half its buying power. How was this conclusion reached?

The rule of 72 can be used to explain this. 72/8 = 9.

It is therefore imperative for the long-term investor to make sure his portfolio is properly structured in order to accommodate this phenomenon.

10.?Interest?Rates。

How does the interest rate affect an investment?

Investments such as government bonds and money market instruments are very closely linked to interest rate movements. In a lower interest rate environment, these instruments are affected by the lower rate in that returns will be limited.

If the investor were to speculate as to whether interest rates would go up or down, he could make a fatal error and invest in a long-term investment that is pegged at a lower interest rate.

11.?Goals。

When looking at financial planning, it is important to take your goals into account. A distinction can be drawn between short, medium, and long-term goals. Each of these goals is affected by factors such as your personal needs, circumstances, and stage of the lifecycle.?

Goals should play an important role in any investor’s investment decisions.

12.?Circumstances。

Events such as the 11 September 2001 terrorist attack on America will have a significant impact on investment returns over a specific period of time. It is important to note that these events cannot be seen in isolation and must not affect your risk tolerance profile.

In the event of such a disaster, markets usually fluctuate dramatically. Your risk tolerance profile should not change unless your circumstances change due to such an event.

13.?Return。

The return offered by investment can take the form of a flow of income or the growth in the capital invested or both. A deposit with a bank is an example of an investment offering a return in the form of a flow of income, in this case, interest.?

A mutual fund and fixed property are examples of investments that offer both. The nature of the return desired by the investor will be a strong indicator in the investment decision.

14.?Liquidity。

The liquidity of an investment is all about how quickly an investor can convert his investment into cash, should the need arise. A mutual fund is very liquid because the Management Company guarantees to repurchase units from an investor.

My comment: yes, but at what price?

Listed shares would be less liquid because the investor would only be able to sell if there was a buyer prepared to buy at that price.

The shares in a private company are not at all liquid, because the seller will usually only be able to sell to one of the other shareholders. Only if they are not prepared to buy his shares, is he allowed to find an external buyer.?

However, there is no mechanism for the introduction of buyers and sellers as is provided by a stock exchange. This means it is harder to find a buyer.

Using the investment as collateral for a loan can provide liquidity. This means that even though it may not be possible to realize the investment at short notice, it is possible to cede or pledge the investment to secure a loan.

A consideration allied to liquidity is the cost of termination. What is the cost structure of the investment? What will be the costs associated with terminating the investment within a certain period? Liquidity is one thing. Liquidity at a price is another altogether.

15.?Taxation。

The tax consequences of investment are fundamental to any investment decision. The return desired by an investor is usually the return after tax.

The effect of taxation on the investment return will be affected by the taxpayer's tax position, a marginal rate of tax, etc. It could be that the investor is a tax-exempt body.

It will also be affected by the identity of the investor. In other words, is the investor a natural person, a trust, or a legal person such as a company? In addition, the nature, of the return will also have a significant influence.

To a young investor wishing to maximize capital growth, an interest-bearing investment may not be suitable, because the interest will be taxed in his hands, thereby reducing the after-tax return considerably.

The taxation of the proceeds of an investment will often be determined by the intention of the investor. If an investor invests with the intention of making a profit, the gain realized by the investor could be regarded as income and be taxed accordingly.

Consequently, two investments of identical nature could be taxed differently in the hands of two investors simply because the one had a different state of mind regarding that investment.

Very often an investor’s intention changes during the course of an investment. Such a change of intention could be fatal in subjecting the realized gain to income tax.

Why?don’t?Wealth?Creators?use?Paper?Assets?when?Creating?Wealth?

What you have just read is investment according to an industry that has a conflict of interest that endangers your returns to the extent that the vast majority of people never become rich.

And this is simply because if you use paper assets as a way to invest you are breaking The Formula For Riches.

Let’s look at how.

With paper assets you must have a surplus – and the bigger your surplus the more money you will make. (At least, this is what it looks like!)

Let’s look at two scenarios:

Scenario 1: If you invest $1,000,000 and you get 10% growth on your investment you will make $100,000 at the end of the year.

Scenario 2: If you invest $100,000 and you get 30% growth on your investment you will make $30,000 at the end of the year.

At first glance, the first scenario looks good because $100,000 is a lot more money than the $30,000 you will make if you invest only $100,000 in Scenario 2.

But if we compare the growth on the surplus - 30% versus 10% - this can make a huge difference over time.

If you apply The Formula For Riches and take the investment over a thirty-year period compounding the growth, you will find in Scenario 1 the future value will be $17,449,402.?

In Scenario 2, over the same term, the future value will be $ 261,999,564.

The difference between Scenario 1 and 2 is $244,550,162.

So it is the size of the growth not the size of the surplus which makes the most difference.?

Yet we are always hearing “the greater the risk the greater the reward” which is another way of saying “give us more of your money” – and this message comes to you courtesy of the financial institutions.

With paper assets you must have a surplus, to begin with. (Wealth Creators know how to create a surplus as you will learn later on in this book.)

Once you have the surplus you must be able to identify the risk and growth of the investment in order to manage the investment. The management function is to use different strategies in order to lower the risk and to increase the growth of your investment.

With paper assets, this is not possible because you give the responsibility to a financial institution. With relief, usually, because you think it’s the right thing to do but I think you may be starting to see how wrong this is!

You have no say whatsoever in the management of your money except for the fact that you can give instructions on the different asset allocation of the money according to your risk profile.

As the investor, the real risk of losing money is yours – simply because you have no control over the growth.

It will prove to be very difficult to hold the financial institution responsible, should your investment not perform as expected or promised. The mandate or contract signed between the investor and the financial institution invariably safeguards them against liability for any losses on the investor’s behalf.

The financial institution has no real risk they always receive their administration fee upfront.

In other words, it is impossible to determine the growth potential of the investment if you invest in any paper asset.

You cannot put in more effort in order to lower your risk or to increase your growth or decrease the time horizon of the investment because all those rights were taken from you when you signed the mandate or contract to invest in a paper asset.

You sign away the responsibility to increase the value of the investment and that’s why the growth is so poor and the much-vaunted security and peace of mind is an illusion.

You will receive a "fair" growth over a period of time according to most financial institutions but their “fair” is linked to the inflation rate. They benchmark themselves against inflation. If they can beat the inflation they will lead you to believe that it was a good investment.

Let’s look at reality to determine whether or not an investment is a good or a bad investment.

In this example, the investor has a surplus of $1,000 per month.

He will have this surplus available for the next seven years – no more and no less - and he must accumulate an additional $5,000,000 over the next seven years, in order to achieve his financial goal. If he doesn’t, there is no more money to inject into his investment.

At a 12% projected future value, he can expect only $130,672. This is a far cry from the needed $5,000,000. The investor will not be able to do anything to increase the monetary value of his investment even if he needs a lot more maturity value.

The total investment over the 7 year period will be $84,000.

In addition, many people do not take income tax into consideration. Although the maturity value is normally "tax-free" in the hands of the investor the payments that the investor made were not.

So the investor must actually earn $1,666.67 per month in order to invest $1000 per month if he is in a 40% marginal tax rate. If he earns an additional $1,666.67 and he pays 40% tax his tax bill will be $666.67 per month. That leaves him with $1,000 to invest.

Taking this into consideration the total payment over the seven-year period is $140,000. In other words, the projected maturity value is less than the payments!

The reason why this happens is not difficult to understand. Up till now, financial institutions have taken the opportunity to train people on how to become investors – their way.

?And they have had no competition, which is why there has been no correction of their distortions. But the financial institutions’ business is not to care for their investors it is to make money for themselves.

The only way they can make money is by making use of the investor’s money and guiding them on what to think and what to do. In this way, they get lots of money in, and they train people to be satisfied with very little growth. And the cream they skim off the top – the real growth – goes to their profits.

It's astonishing how long this has been going on without much awareness from the investors, but then, how would they find out? Who’s been telling them the truth? On the other hand, investors are just as responsible, never questioning and just accepting what is dished up to them.

The first step is to take the responsibility to learn how to apply The Formula For Riches.

In order to achieve the above-mentioned goal, you must find an investment that will give you growth of at least 87,31% not taking tax into consideration.

The only way to do that is to know how to compare different asset types with one another. The next step would be to understand the tax implications, identify the risk and growth and learn how to manage both.

On top of that, you need to accept the responsibility and apply yourself to manage the investment in an effective way with the objective of reaching your goal.

Summary。

There is no paper asset class that a Wealth Creator can use in order to create real wealth. This is because you cannot take responsibility and this allows others to use your money to serve their interests, not yours.

The reason why a Wealth Creator may use paper assets is to offset risk or to have assets (cash) available at any given moment to utilize opportunities when they present themselves.?

There are however better ways to make provision for this as I will demonstrate later in this book.

I also do think that until you know how to do better, you shouldn’t cancel any policies. Don’t worry - it is easy to do better –– but first, you need to educate yourself and understand the formula.

Financial?Entities。

One of the entrepreneur’s most overlooked risks is which financial entity the person is going to use in order to safeguard himself and his assets in the event of death, disability divorce, and sequestration.

Each country has its own laws regarding financial entities and I strongly advise you to make sure you understand and incorporate the best possible financial entity into your overall financial strategy, which will give you the necessary protection.

For more information on the Formula for Riches book;