A Wealthy Tale


A WEALTHY TALE

“WHAT IS WEALTH?”

 

 

For as long as I remember, I’ve been fascinated with the concept of wealth.  It is a subjective concept that we’ve objectified.  Almost 99% of the world’s objective wealth was earned in the last 200–300 years.  Yet there was tremendous wealth well before.  Clearly, it is subjective.  So why is the planet getting richer at a faster rate?  Will this exponential growth continue?  The point behind wealth is that it is much more of a theoretical concept than most people realize.  Why does a middle class person in America have a standard of living comparable to the wealthiest titans of 100 years ago?  Is it technological advancement?  Is it evolutionary?  Is it how we organize our society?  The answer is all of the above.  But this tale deals with wealth at an individual level and is far more practical and less esoteric.

As a young man with no money and armed only with human capital—or what others call “potential”—I studied the many ways people built wealth.  Along the way, I invested two years of my life in what today I describe as a financial brainwashing known to some as an MBA.  The investment theories they taught me made unrealistic assumptions, but were still worthwhile since the real benefit was the resultant disciplined thinking.  It taught me to assume that the only way to manage money was through the diversified portfolio and only the diversified portfolio.  What a mistake.  Unfortunately, my training left out a huge component.  It assumed people and investors act rationally.  This couldn’t be further from the truth and is why I see very little merit today in the theories I embraced as a student.  What I know today is that the biggest problem to overcome as an investor is your own behavior.  If you don’t factor behavior into the equation, your equation may be elegant, but it’s wrong.

Let’s switch topics for a second.  Why do academians believe so strongly in diversification?  The answer is because academic studies prove that most people, including professional investors, can’t outperform the stock market over extended periods once you adjust for risk.  It is why so many preach passive investing through the purchase of index funds.  The catch is in the word “risk.”  What clever academians do is say, “Yes, this approach or that approach makes more money than the market, but it is doing it in a riskier manner.”  They furthermore create a measure of risk that is inconsistent with how society defines risk.  Society defines risk as not losing money.  Academians define risk with an arcane statistic that assumes people are equally happy going from poverty to wealth as they are going from wealth to poverty.  Today, even the most hardheaded developers of these academic theories recognize that this assumption is unrealistic.  Unfortunately, the best minds have yet to develop an approach that explains the complexity of investing, so they stick with what they’ve got.  We are thus stuck with what I call Newtonian laws or mechanical laws in a quantum world.

This leaves us in a quandary.  When the default portfolio is a diversified portfolio and there is no consensus reason to deviate, the investor typically attempts to diversify.  So what types of people should diversify?  The answer is simple.  The types of people I think should diversify are wealthy people looking to preserve and grow their wealth and people looking to create wealth slowly.  The process of slow wealth creation follows a simple formula.  The formula is as follows: Income minus Spending equals Surplus, and Surplus over Time equals Wealth.  However, you won’t get rich quickly following the formula.  You will never read the following:  Johnny and Jill graduated, got jobs, saved their money, invested in a low-cost diversified portfolio of stocks, bonds and cash and were wealthy by the time they were 30.  They might be by the time they are 50 or 60, but not 30.

So how do you get rich?  If you interview enough rich people, you quickly discover they didn’t get rich by investing in the stock market.  This is not what advisors would have you believe, but the evidence is irrefutable.  Interview self-made millionaires and ask them how they got rich.  They will tell you it was through the application of their skill and some combination of natural resources, innovative ideas, financial capital, the market economy and luck.  You will seldom hear, “I got rich investing in the stock market.”  They preserve their wealth through a diversified portfolio, but unless they inherited wealth, it was seldom the source of their wealth.

Toward the end of my education, I remember asking my favorite finance professor the best way to build wealth.  So what did this wise professor tell me?  At the end of almost two years of study, he said I should put all my eggs in one basket, preferably one that I knew and understood and then watch it carefully.  He then told me that if I was lucky or skillful enough to build wealth, then, and only then, should I look to manage my wealth by owning a diversified portfolio.  He was clear to point out the stark difference between what he called the wealth building and wealth retention stages of life.  In the first stage, you should take risks no longer required once wealthy.  He went on to say that his advice wasn’t inconsistent with what he had preached for the last two years; his advice was “adjusted for risk.”  I wouldn’t have understood the nuance of what he meant two years earlier, but I did at that moment.  At that moment of clarity, I also understood that my understanding wasn’t going to make it any easier to build personal wealth.  In a “connoisseur of the obvious” fashion, my professor advised me to do the same thing that others had advised for centuries and that I advise to those looking to build wealth.  To build wealth, you must focus or concentrate your resources and you must be very good at doing it.  To retain wealth, you diversify.

So, what have I learned about wealth now that I am older?  What is wealth?  Some people define wealth as simply a person’s net worth.  Some define wealth as spiritual, others emotional and still others as anthropological.  Because these definitions are outside my expertise, I will focus on a financial definition of wealth.  After years of dealing with people’s finances, I am convinced that wealth is a state of mind, but investors and financial professionals can’t work with that definition.  You/We need something concrete, a formalized definition of wealth.  I’ve come up with the following working model:

You are wealthy if you can stop working and indefinitely maintain your standard of living from other sources of income.  To be specific, if any combination of pension, Social Security or a 4% annual return on your capital is enough to maintain your income, you are wealthy.

What can we gather from this model?  We can gather that wealth is not age, race or gender driven.  You can be wealthy at any age or anywhere.  What else can we gather from this definition?  We can gather that wealth is relative based on the person’s lifestyle and assets.  Therefore, the model serves as a standard so that you can gauge your spending.

The most intriguing aspect of the model and why I say wealth is a state of mind is you can instantly go from being wealthy one moment to not or vice versa simply based on how you choose to live the rest of your life.  If one day you choose to increase consumption or “up” your lifestyle and you no longer fall under my static definition of wealth, then presto—you are no longer wealthy.  The reverse holds true as well.  Wealth is thus an “in the present” phenomena.  We may want to treat wealth logically but regardless of how much we may want to make it seem scientific, it has a metaphysical side to it and a reflexive side as well.  Perceptions of how you look at wealth determine if you are wealthy or not, because our “needs” are always changing.

One of my friends, when asked about wealth, likes to say that the wealthiest person is not the one who has the most, but the one who needs the least.

I recognize my definition of wealth puts too much emphasis on a person’s lifestyle.  However, if you are planning your future, you need a working model, and some version of this is what most advisors use.  Lifestyle matters, and advisors need an objective definition of wealth and so do you.

Let’s take an extreme case.  Can you call a person with $500,000 dollars “wealthy” while calling someone with $10 million “not wealthy?”  My model says you can and is why wealth is a state of mind.  If the richer person maintains an impossible lifestyle relative to their assets, they are eternally lacking, and therefore they are “not wealthy,” while the poorer one feels abundance and is “wealthy.”  This means that you can’t just look at a person’s assets, because people come in different varieties, and yet we need a model to suit all.  Lifestyle is a crucial component and must factor into the equation.

Everyone’s familiar with the athlete or entertainer who made a fortune and then lost it all due to a lavish lifestyle, poor investments, fraud or some combination of the three.  In an attempt to tie wealth and lifestyle together, I believe that how much a person has, though a great indicator of whether they are wealthy or not, by my definition, is not in itself sufficient to determine if they are wealthy.

To tie these two concepts together and thus add clarity to my definition of wealth, I would like to introduce a term called the “burn rate.”  What is the burn rate?  It’s an old concept and one that most people recognize.  Most investors are familiar with the term “burn rate” as it applies to companies, but it also applies to individuals.  If a company is outspending what it takes in by $10,000 per month, and it has $100,000 in its checking account, it has a burn rate of 10.  This means it will be out of cash in 10 months.  I use the same term when analyzing a person’s finances.  On many occasions, I have scribbled a number such as 72 or 80 or 82 on a piece of paper and handed it to a client.  The client looks at it and asks what it means.  I tell them, “That’s how old you will be when you run out of money.”  They get what I mean by “burn rate” very quickly when illustrated so vividly.

My definition of wealth implies an infinite burn rate.  This means that a person is wealthy if, and only if, at the current and projected spend rate they cannot exhaust their funds.  Please note that investors must factor inflation into the spending equation.  It is crucial, and you will learn about it in other tales.  Unfortunately, under our wealth definition, we can’t distinguish degrees of wealth.  Once someone is wealthy and can’t run out of money, you can’t determine if that someone is wealthier than someone else that can’t run out of money either.  I suppose I could come up with a formula to show just how much wealthier a person is relative to another wealthy person, but who cares.

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