This article first appeared in Personal Wealth, The Edge Malaysia Weekly on June 12, 2017 - June 18, 2017
It is common to hear people expressing a desire to be rich or wealthy. But are the two words synonymous? Here is a clue to the answer: While get-rich-quick schemes abound, have you heard of get-wealthy-quick schemes?
Which of the following families is richer?
Adam began working at 25. Although his starting salary was fairly low after graduation, he has managed to live well below his means. He invested at least 20% of his income and diligently managed his monthly cash flow. Through hard work and excellent performance, he worked his way up to a management position and now earns RM120,000 a year.
Adam’s family lives in a simple three-bedroom house, the mortgage of which was paid off a few years ago. The children went to public schools and when they grew up and needed cars, they bought second-hand ones. They may not have a lavish lifestyle, but the family is living comfortably and are debt-free.
After 30 years of investing 20% of his income, Adam has built up an investment portfolio worth RM2 million. With an annual budget of RM84,000, his family can sustain their current lifestyle for more than 20 years without Adam or his wife having to work.
Meanwhile, Peter has a high income and his family lives extremely well. Unlike Adam, he attended a private university after taking a study loan of RM300,000. After completing medical school, he worked as a physician at a private hospital and earned more than RM360,000 a year.
Peter took out a housing loan of RM1.2 million for a home in a gated and guarded community. He and his wife drive the latest imported luxury vehicles while his children study at a prestigious international school.
Peter has increased his income, but the family’s expenses — housing loan instalments, car instalments, children’s school fees, study loan instalments, maids’ salaries and expensive vacations — and the total cost of indulgence all add up to almost equal his annual income. Since he is self-employed, he has yet to start saving for his retirement.
Peter lives from paycheque to paycheque despite his high income. He cannot afford to stop working.
Although Adam has never earned a high income, clearly, he and his family are better off financially than Peter and his family. Usually, those who earn a high income tend to spend more and buy luxury items to look rich. So, if you earn a lot but also spend all of that income, then you can never be wealthy.
Wealth has to be accumulated. Being wealthy is defined as having sufficient financial resources to support one’s lifestyle for the long term even if one does not physically work to generate an income.
From the above example, Adam’s annual living expenses total RM84,000. Assuming he has an investment portfolio of RM2 million, his wealth can last him about 23.8 years. Wealth, therefore, is measured by time (duration) and not by the income you earn. It takes into consideration your expenses.
Wealthy people are motivated by their dreams, purpose and passion in life. Wealthy people know how to make money to achieve their purpose in life. On the contrary, rich people only have money. But the moment they stop working, they also stop making money.
I am not saying that rich people cannot spend money on their lifestyle. You can, provided you have done one thing first: invest at least some of your income — well, unless you are earning so much that your accounts continue to grow even with the impulsive spending.
As I have told Ben many times, it is not how much you make, it is how much you keep and invest. His annual income has been on the rise recently due to market demand for his services. He is an IT professional who came back to Malaysia to work in 2014. He did not have much savings back then.
Ben, 44, runs his own business. As it grows rapidly, so does his annual income. He now earns about RM1 million a year, compared with RM90,000 in 2014. He has saved RM1.3 million in a bank account and his investment portfolio is valued at RM539,000. His current lifestyle expenses are about RM25,000 a month — a drastic increase from RM7,000 a month previously.
Ben lives with his parents and wants to buy a property either for his own use or as an investment. He believes that the current sluggish property market is the best time to buy. He wants a bungalow with a lot of land in a gated and guarded community that costs about RM4 million. He strongly believes that he can afford it, so I did a cost breakdown for him (see table).
Besides the monthly loan payments, there are other expenses such as property maintenance fee, utilities and facility fees for the maintenance and upkeep of the property. Ben can afford to buy the property of his dreams, provided that he is willing to extend his retirement age to 65 and live on RM153,000 a year during his retirement. Alternatively, he can delay the purchase of the property for two years, by which time he would have saved up the money to fund this property. He was perplexed after realising his actual financial situation.
So, does high income equal wealth in the real case above? Ben appears to be rich with his high income. However, he cannot stop working as his high income does not mean a high conversion of wealth. He needs to accumulate more assets to become wealthy. He also needs to build sustainable wealth that can last for many years through asset investments that generate multiple passive streams of income.
Owning a property is everyone’s goal nowadays. There are so many success stories of those who made their first million primarily through property investments. As with any investment, Ben must be clear about his objectives and assess the suitability of the instrument, that is, whether property investment is the right tool for him. For instance, taking into account the holding period, affordability and market and liquidity risks, are there alternative instruments that could achieve the same investment objectives but at a lower risk?
Market timing may not be a concern if the property is for Ben’s own use. He can always wait until he has saved up sufficient funds to buy his dream home.
Real estate remains an important instrument for most investors and it should form a part of your investment portfolio. Based on Ben’s investment objectives, financial situation and risk tolerance, it is recommended that he diversify his investments (see pie charts).
Ben keeps too much cash in his bank accounts. If he is willing to delay the purchase of the property and start accumulating wealth, he can adopt a portfolio or asset allocation strategy that has been proven to be successful.
Portfolio allocation is the process of spreading your investments into different asset classes, such as cash, equities and real estate, using different combinations that result in optimum returns at acceptable risk. Portfolio allocation can help diversify your investments that are likely to perform differently in the same market environment.
Since one investment may be up while another is down, a broad diversification in asset classes may help reduce your risk and improve performance over time. Because short-term market trends cannot be predicted with any degree of accuracy and to avoid buying high and selling low, we should allocate some of our investments to each asset class seen in the chart.
Ben should hold his investments for five to seven years. He should review and rebalance his portfolio at least once a year to ensure that he is on track to meeting his investment objectives.
Since wealth is not achieved overnight, Ben must learn to distinguish an asset from a liability. If buying a house is a big liability to him, then it is a no-no decision now. He can buy it at a later time with much less opportunity cost incurred. Focusing on creating and buying income-producing assets to generate passive or portfolio income will help him build up long-lasting wealth.
Catherine Khoo is a licensed financial planner with CWA. For queries, email us at [email protected].
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