May 15th 2018
In our last newsletter we looked at the concept of net worth, and saw that it was the difference in value between what we own and what we owe. Hopefully you’ve had a chance since that time to calculate your current net worth. The other thing we learned last issue is that while net worth is important, the real key to wealth accumulation is change in net worth. In other words, not just what you’re currently worth, but whether your net worth is growing, and if so, how? and how fast?
Essentially, there are three ways your net worth can grow. The first is by saving. This is extremely important. Without savings you can’t hope to accumulate wealth. Just like the grains of rice on that checkerboard we talked about in our first issue, savings is the starting point. It’s that first grain of rice. But savings in and of itself will never suffice to provide for your retirement, or generate abundant wealth. Let me explain.
Suppose you were extremely frugal and disciplined when it comes to money. In fact, you are about the world’s best saver. So good, in fact, that you are able to save ½ of every dollar you ever earn. Of course, this degree of saving is very unrealistic. Our top tax bracket sits at about 50%. In addition you have to live, eat, wear clothes, etc., etc., etc.
But let’s throw caution to the wind and for the point of illustration assume you could save half. In all likelihood your entire working life, from the time you leave school until the time you retire, won’t exceed 40 years. Maybe less, if we handle things right. But let’s assume 40 years.
So by saving ½ of your earnings for 40 years, you’ve managed to save 20 years salary. Of course it won’t actually be 20 years worth because your early years will be lower in earnings generally than your later years. But suppose by impossibly severe, sacrificial savings, you’ve managed to salt away 20 years earnings. If you retire at 60, you’re covered to 80, at which point you run out of money. And the fact is, you can’t hope to save at a 50% rate. 20% is probably all you could hope for. That’s a total of 8 years accumulated salary. So while Mom was right when she told you to save for a rainy day, savings in themselves are not enough. It’s what you do with those savings that is critical, and that brings us to our second way of growing net worth.
When you take savings and buy something, what you are doing is converting cash into a tangible asset. Now assets can do one of three things. They can decline in value. We call this a depreciating asset. Most things we buy fit into this category. They have value, but that value diminishes over time. Cars and furniture for the most part fit into this category although there are exceptions like vintage cars and antique furniture which actually may go up in value. Boats, appliances, clothing are all depreciating assets as of course are consumables like food.
Assets can sometimes be static. I mean by this they generally hold their value over time. They don’t seem to go up in value, but they don’t really lose their value either. Suppose, for example, you purchased a used upright piano for your home. It cost you $800. Over several years your children learned to play on that piano. But they’re grown now and no one uses the piano anymore. You put it up for sale, and to your surprise you can still get about $800. for it. It was well worth buying because you got great use out of it over the years, but as an investment it was pretty static.
But assets can also appreciate over time. The longer you own them the more valuable they become. Generally speaking when people invest, they try to invest in appreciating assets. Mutual funds or stocks in general are intended to be appreciating assets. We buy them with the hope that they will go up over time. The same is true for gold, art, diamonds and a host of other assets people choose to invest their money in.
Probably the greatest appreciating asset, and the one most people have as their single most valuable investment is a home. Or as accountants like to call it, your principal residence. If you own a home, stop and think about it in monetary terms for a moment. What did you pay for it? What’s it worth today? The chances are if you’ve owned it for any length of time, those two numbers are considerably different. Homes generally speaking are very significant appreciating assets. In fact, for most people, doing their Net Worth Statement, the principal residence stands out as the most valuable asset and generally accounts for most of their net worth.
But while appreciating assets are hugely important in the composition and development of net worth, there is a problem. To obtain the cash you need to live, you must sell the asset. You save. You invest. You retire. Now you must step-by-step begin selling off the assets, the gold, the art, the mutual funds or the house in order to survive. And the longer you live, the greater the challenge gets. Generally, in this process, as time goes along people recognize the trend; the danger of running out. As a result of the fear of outliving their resources, they develop a frugal lifestyle. Absolutely not the result we want to experience in retirement. Hardly the abundant wealthy lifestyle we scrimped, sacrificed and saved for all those years. Certainly better than not having the asset to fall back on. But there is a better way.
It’s the third way your net worth can grow. That is by investing in revenue producing assets. I mean by this, assets that generate wealth automatically. Assets that produce an income stream without our having to sell them to get at it. Kind of like a goose that keeps laying golden eggs. Revenue producing assets. We’ll talk about these in our next issue.