The basic principle of how to build wealth couldn’t actually be more straightforward. You simply accumulate high quality assets over the long term. The earlier you start saving and investing, the longer the power of compounding investment returns will have to work their magic.
The table below illustrates the potential rewards of building wealth from regular annual contributions and high investment returns.
|Year (£)||Opening Valuation||Investment||Total||Growth at 15%||Closing Valuation|
That table shows what could be possible if you had £10,000 to invest each year and if you managed to achieve a consistent annual return of 15%. That is no mean feat. £10,000 invested each year for 20 years would turn into a cool £1,000,000. Of course, not everyone would achieve a 15% return for 20 years! The historical return from the London stock market is approximately 9% a year.
Look at the table below which shows how long it takes to reach a million pounds by investing £2,500, £5,000 and £7,500 a year using 5%, 10% and 15% annual investment returns respectively.
|–||5% Growth||10% Growth||15% Growth|
|£2,500||62 years||38 years||29 years|
|£5,000||49 years||31 years||24 years|
|£7,500||41 years||28 years||21 years|
To Build Wealth, Spend Less Than You Earn
I believe anyone can build up a reasonable sum of wealth if they are willing to spend less than they earn and invest the difference. Unfortunately, a lot of people put off saving and investing. That’s because there is always something else that needs to be paid for or they believe they can’t afford to. Yet somehow, these people seem to find a way to buy a new car or go on lavish holidays.
If you’re really serious about building wealth, then you may well need to keep a close tab on your spending. I personally keep track of regular monthly outgoings in a spreadsheet which I update approximately twice a year. This enables me to see roughly what we have spare at the end of each month. I don’t keep tabs of small items as I personally am very good at keeping track of our finances in my head. You may find it easier, especially to start with, to track all expenditure for a month. You may surprise yourself with where you are actually spending your money.
Work out what you can afford to put aside for saving and investing each month. Allow for unexpected bills and emergencies. Most financial advisers would recommend keeping 3 months salary on deposit as an emergency fund.
Once you have worked out how much you can afford to invest, it makes sense to put your monthly investment contributions on autopilot. It’s best to invest by direct debit in order to avoid any temptation to blow any surplus cash at the end of each month. I recommend setting your direct debit payment for just after pay day.
Get Out Of Debt First
I would like to think that getting out of debt was everyone’s priority but that’s not the case. The Bank of England is concerned about the ever rising number of people with growing debt. They are piling more debt onto credit cards and loans. Headlines such as this whereby drivers earning as little as £8,200 can get a new ford fiesta worth £12,500 highlights the issue.
If you’re struggling to make ends meet or are having difficulties getting out of debt, then I would think you are probably reading the wrong article right now. There are plenty of resources on the internet that cover this subject, including National Debtline. Make getting out of debt your no. 1 priority.
Invest In High Quality Companies
Most people will be invested in the stock market via an Investment fund or trust within their pension or an ISA. Investment funds are useful for establishing a highly diversified portfolio of shares where someone else makes the investment decisions for you. Unfortunately, most active fund managers under-perform the general stock market over long periods of time. Investing in tracker funds should ensure that you match the market in most cases.
However, it’s possible to beat the stock market by seeking out, and investing in high quality companies. Even when markets are stagnant or falling, it’s possible to invest in great companies that rise when others are falling.
As a private investor, you are able to pick any small selection of stocks you wish. You’ll have no strict investment criteria to stick to. No geographical region or particular size of company to stick to. You are free to choose any company from around the world that is listed on a stock exchange to invest in.
You don’t have to spread your money across dozens of different companies, you can just have a few. Your first pick will always be better than your second choice which will be better than your third choice. If you had to choose 30 companies to invest in, then your last choice will be considerably less attractive than the first.
One last point to note when investing in great companies is that you will be investing in companies that pay dividends. It’s imperative to reinvest those dividends!
Elephants Don’t Gallop!
A lot of investment funds and especially trackers, tend to invest in medium to large companies. Even the investment funds that invest in smaller companies may have some restrictions as to how small a company they can or will invest in. There needs to be enough free float and liquidity in the stock in order to buy shares. Also, when it comes to the fund manager wanting to sell their stake in the company, there may not be a matching buyer.
As a private investor, the chances are that you will not be able to, or want to invest hundreds of thousands of pounds or even millions of pounds into buying shares in a single company. So that means that you can invest your money into much smaller companies than investment funds can.
One of the main attractions to investing in smaller companies is that they grow much faster than big companies. It’s harder for a company worth £1 billion to grow to £2 billion than it is for a small company to grow from £10 million to £20 million. All companies start small, but eventually the steam runs out. That’s why most high growth stocks are smaller companies.
Because a lot of large institutional investors and fund managers don’t invest in smaller companies, they tend to be under researched. Also for that reason, analysts tend not to cover them as much as their bigger rivals. You can use this to your advantage to find undervalued companies.
Small companies with a small capitalization do come with risk. Because of the lack of coverage with these stocks, you need to be extra vigilant in your research. You will need to do a certain amount of number crunching yourself and learn how to invest successfully.
Use A SIPP or ISAs To Build Wealth Tax Efficiently
Any capital gains tax liability resulting from high returns on your investments could seriously affect your investment performance. No one likes paying tax but there are ways to minimise and even shelter your money from tax altogether. The two most popular tax ways to do this is either via a pension or an Individual Savings Account (ISA).
Self Invested Personal Pension (SIPP) – There are several different types of pensions. However, in order to be able to invest in individual companies via a pension, you’ll need to use a special type of pension account called a Self Invested Personal Pension.
Pensions are especially tax efficient for higher rate taxpayers who can get tax relief on money going into a pension, but may only pay basic income tax on the money coming out. You can’t get to your money until age 55 at least with a pension though. Also, costs, which are coming down all the time, tend to be slightly higher on SIPP accounts.
There is an annual allowance limit of £40,000 (2017-2018). There is a tapered reduction for anyone with a ‘threshold income’ of more than £110,000. You can find more info on the tapered annual allowance here.
Individual Savings Accounts (ISAs) – You can invest up to £20,000 each year into an ISA. As opposed to pensions, money going into an ISA account is paid in with money that has already been taxed. All the profits and money coming out of an ISA, no matter how much, is completely tax free. The great thing with ISAs as well is that you can access your money at anytime you wish without penalty.
ISAs are often used in addition to pensions for shorter term savings and investments. They can also be used for pension savings and investments where someone is concerned that they may breach the £1 million Lifetime Allowance on their pension.
Hopefully you should have a good idea of what’s involved in building wealth now. Building wealth takes a great deal of time, effort and sacrifice. You have to commit to a proper investing philosophy and take full advantage of ISAs and pensions.
Often, you’ll have to invest away from the crowd, in sectors that have been forgotten or in shares too small for institutional investors and investment funds to pick up on.
Consistently reinvesting your dividends and keeping trading costs to a minimum are other great ways of maximising your wealth. None of this is easy of course, but none of it is impossible.