What is wealth? Let’s start with what it is not, a big bank account. If it were, lottery winners would never go bankrupt. Here is another way to think about it. What do you care about more?
1) Lots of bread today.
2) A supply of bread for your entire life.
Easy, a supply of bread for your entire life is naturally the answer. This is analogous to a big bank account today. Bread-for-life is wealth. Notice how time worked its way into the conversation. Bread-for-life means a steady supply over time. So wealth than is dynamic in the sense it plays a recurring role over time – securing your supply of bread.
The key now is to understand the elements of wealth in their fullest sense. So let’s break down each element individually.
Total Earnings Potential
Your total earnings potential is how much money will you earn over the time you work. In other words, you are your most important asset. Early in life you are by far the largest contributor to your wealth. But, again it is a function of time. As you gain experience, the amount you earn will increase. However, time is also passing. This means you have less time to work and at some point your total earnings potential will begin to decline, eventually going to zero, as you retire.
Assets can also generate cash and refill your bank account. Time plays an interesting role here. The more time you have, the less productive your assets need to be, because you have longer to work. But as you get older and your total earnings potential moves closer to zero, your assets have to be more productive to replace that loss.
Consumption is the supply of stuff you need over your entire life-time. Your shopping list changes over time. Often times, believe it or not, as you get older things get more expensive. So again, time is working against you. Not only is your work time shrinking, the price tag of daily life is increasing.
Liabilities are arguably the easiest to understand, as this is the debt you incur over your lifetime.
In conclusion, we are left with this relationship;
Wealth=(Total earnings potential + Assets) X Growth rate G(g) – (Consumption(t) + Liabilities) X Growth rate B(g)
The key to wealth should now be getting clearer. Grow part 1 faster than part 2, i.e. make G(g) > B(g). In other words, at a minimum the positives must grow at B(g), just to stay even. Creating value is increasing G(g), or shrinking B(g). This is the right way to value your time, in work, in consumption, how you save and when you should borrow money.
Let’s look at an example.
Let’s say you make $100,000/year after taxes. Using a 40-hour workweek and 50 weeks to work over the course of the year, means you are making $50/hour. So, if the goal is to growth G(g) faster than B(g), you have a number of dials you can turn to make that happen. First you can control your consumption, shrinking B(g). In addition, begin to pay off your debts, this will shrink B(g) more quickly.
Going to G(g), since you really can’t increase your work time, you can make sure you are maximizing it. So for instance, if you can work an extra hour and pay somebody to cut your grass for $30, work the extra hour. You are $20 ahead. The other way is to increase wealth. For most people this means investing in something earning a return equal to, or higher than B(g). But this isn’t the only way, starting a side-business can be another option. Fortunately, we live in a time where that has never been easier thanks to the internet. However, keep in mind, this also means you are working more than 40hrs, thus expanding your total earnings potential and wealth. That said, the overall effect of either effort is to increase G(g). If all this sounds familiar, it should, these are choices families struggle with every day.
What typically is lacking, is an understanding of what makes any decision a “smart one”? In other words; What is the minimum rate of return required? Easy, anything that earns a rate of return equal to B(g) will do the trick. We call this the “Necessary Rate of Return,” or NRR. However, it doesn’t stop there, ideally you are not simply earning something larger than B(g), but G(g) as well. That way the spread between G(g)/B(g) is increasing, expanding your wealth at an increasing rate.
So, what is the best use of your time, financially speaking, increasing the difference between G(g)/B(g). Do this consistently and wealth becomes a virtual certainty.