Before money becomes wealth, it’s just money. For money to become wealth, it must be managed. Absent a clearly defined money management plan and the discipline to manage it based on proven principles, money is merely an instrument used in the “pursuit of more,” with no real destination and no opportunity for self-fulfillment. For people of wealth, having and spending more money doesn’t necessarily improve their happiness. Their fulfillment comes from having an income they can’t outlive while fulfilling their life ambitions and providing a meaningful legacy to those they love.
Money management incorporates the key financial disciplines for developing wealth accumulation, protection, and preservation strategies specific to your needs, objectives, values, priorities and risk tolerance. Equally important, money management focuses on the behavioral influences on your decision-making that can adversely impact the outcomes of long-term strategies. In fact, in our individual pursuits of wealth, each of us is waging a battle against powerful elements (i.e. taxes, inflation, market volatility, risks, debt) that have the potential to take away that which we’ve worked hard to attain. And, any indecision or inaction will virtually ensure our defeat.
The core elements of money management include:
Establishing Clear Goals
Under a comprehensive money management approach to building wealth, you can have more clarity and conviction in your decisions knowing which are the ones will get you closer to your destination. It starts by establishing clearly defined goals. Having a clear vision of what you want to achieve and a time horizon for achieving it is essential.
Having clear goals helps you to track where you are. Very often, when people can’t see how they are progressing towards their goals, they give up. When you break your goals down into shorter-term milestones, it’s easier to see your progress and gain encouragement.
Finally, having clear and quantifiable goals can give you more clarity and conviction in your decision-making. If a certain choice won’t get you to your destination, don’t take it. Suddenly, your choices are clear and your decisions are driven by purpose.
Controlling Your Cash Flow
It’s impossible to accumulate wealth if you spend more money than you earn. Even if you don’t, you really can’t know if you will be financially successful if you don’t track where your money is going. Having a spending plan and the discipline to follow it, may seem elementary, but it has been central to the success of some of the wealthiest people in the world. If you were a business, your objective would be to find ways to increase your profits every month, which could then be invested for growth. With a sound money management plan, you would know how to prioritize your spending and make decisions based on whether they will get you closer to your goals.
Having a Long-Term Investment Strategy
Studies have shown that investors who adhere to a sound long-term investment strategy can achieve positive long-term returns. In part, that’s because when investors have confidence in their strategy, they avoid falling into behavioral traps, such as following the herd in trying to time the markets or chasing performance. In addition, having a sound long-term investment strategy as a part of a comprehensive money management plan helps investors keep their focus on their personal benchmarks rather than meaningless market benchmarks or indexes, enabling them to ignore short-term market events.
Managing Portfolio Risk
Most investing mistakes are due to mismanaging risk. Investors who misunderstand, underestimate, overestimate, or miscalculate risk are prone to underperformance. Achieving positive long-term returns requires proactive risk management along with a clear understanding of the risk-return relationship. It is actually the deliberate assumption of risk when applied to a properly allocated portfolio that drives return performance. To a great extent, it is through the management of risk, not the management of investments, that optimum portfolio construction takes place and superior long-term returns are achieved.
Disciplined investors accept the fact that there is risk in the markets and the chance of experiencing negative returns in their portfolio at one time or another is a very real likelihood. They know that the longer they hold their portfolio, the more likely they are to experience extended periods of negative returns. But they also know that the longer they hold their portfolio, and it is properly diversified with all risk factors considered, the greater the likelihood that their compounded annual return will be positive.
Being Tax Efficient
While it is our responsibility to pay taxes, we are under no obligation to pay more than is absolutely necessary. Yet, most people are unaware of how much in taxes they pay or the impact of unnecessary taxes on their ability to accumulate wealth. Money management shifts the focus away from what you make to what you keep after taxes. That’s where it becomes important to consider the tax characteristics of the investment you own and where they reside in your overall portfolio.
First, you consider “account location” – how to allocate your money among different types of accounts based on their respective tax treatment. Then you consider “asset location” – how to allocate different types of investments among the different types of accounts based on the tax treatment of the investments and the tax treatment of the different accounts. For example, you might consider allocating your least tax-efficient assets (i.e. taxable bonds) to a tax-deferred account, such as an IRA or 401(k). More tax-efficient investments (i.e. low-turnover funds, stocks held long-term) could be held in a taxable account.
Not only will this enable you to accumulate wealth faster, but it also gives you more options for distributing income more tax-efficiently in retirement.
Managing Your Risks
As you accumulate wealth you also increase your risk exposures in several areas of your life, and all you need is one to jeopardize all or a part of what you’ve worked so hard to create for you and your family. As much as we would like to think that wealth can make life easier, the difficult and oft-ignored reality is that it can actually make life more complicated – houses get bigger, cars more expensive, toys more plentiful, identities more visible, and lifestyles more lavish. The bottom line is with wealth there is a commensurate amount of financial exposure with the potential to take it all away.
Your money management plan should include a risk management assessment of your financial exposures along with protection strategies to prepare for the unexpected, including
- The loss of income due to an extended illness or accident resulting in a long-term disability
- The loss of a breadwinner to premature death
- Catastrophic losses resulting from major property damage or medical costs
- The exposure of assets to liability claims
- The financial exposure of employing domestic staff
- The financial perils of identity theft and fraud
- The potential interruption or loss of a business due to any of the above
Money management provides you with a 360-degree view of your financial picture while applying key financial disciplines to help you overcome the obstacles to wealth. With a clear purpose for your money and sound money management principles behind it, you are in much more control of your financial destiny.