Acquiring Wealth - An Introduction

How does a person become wealthy? The goal of this blog is to help me and those around me achieve this goal, so this post will start a multi-part discussion to address acquiring wealth. First, what is wealth? For now I am only going to consider economic wealth, which is something which has monetary value. To be wealthy a person simply must accumulate things which have value and get rid of those things which take away value. Examples of things which have value, called an asset, would be stock, bonds, real estate, or business venture. Examples of things which take away value, called liabilities, would be debt, spending, and gambling. Once you recognize the difference between an asset and a liability you can begin to acquire assets and eliminate liabilities to create wealth.

In order to establish a common set of terms that are used to describe the process of acquiring wealth we must define some of the most common financial concepts. First, the outflow of money (spending) is called a debit and the inflow of money (income) is called a credit. Over a specified period of time (a month for example), the credits during that period minus the debits during that period is called the cash flow. When income is greater than spending it is called having positive cash flow and when the opposite is true it is called having negative cash flow. When positive cash flow is carried over to be spent in the future it is called saving. In the most basic sense, it is impossible to accumulate wealth over any period of time if there is no savings.

The model presented in the previous paragraph neglects additional concept that is essential. Appreciation is the increase in value of an asset, and depreciation is the decrease in value of an asset. Appreciation and depreciation can be clearly seen in the fluctuating value of a share of stock. Stock is bought and sold at a price which changes over time based on the perceived value of the stock. When the stock is purchased and the selling price for the stock goes up it has appreciated and wealth has been created. The same process can occur in reverse whereby the selling price for the stock goes down and wealth has been lost. Appreciation and depreciation of assets are the most important process for acquiring wealth because it allows an individual to create wealth many times greater than the positive cash flow that was used to buy the asset.

The final basic concept which must be defined is compound interest. It is the simple concept that the appreciation of an asset is subject to further appreciation. In other words, with compound interest if the value of an asset goes up 25% and then later goes up 25% again the effective appreciation is actually 56.25% rather than the 50% appreciation which would result from simple interest. Over long time periods during which regular savings are invested, the assets which accumulate due to compound interest can greatly outweigh those which result from savings.

An example of all of these terms should help clarify how the wealth acquiring process of assets functions. At age 25, Joe Worker starts saving some of his income each month. At the end of each month his income exceeds his spending by $200. He puts half of his savings into a tax free retirement account at his local bank which pays him interest at 4.75% compounded yearly. He puts the other half into a retirement savings plan which invests commission and tax free in the S&P 500 stock index (historical annualized return 11.9%). Joe continues making both of his contributions each month until he retires at age 65 and is surprised to find that his bank savings account has a balance of $143,011.35 and his S&P 500 account has a balance of $1,139,903.70. The in each account Joe saved $48,000 and compound interest accounts for the remainder of the balance.

This example includes a number of simplifications and assumptions which may not hold true in the real world. It is also important to note that past performance of investments in not a predictor of future success; however, Joe’s example does illustrate the power of building wealth by investing in appreciating assets. Investing only $100 per month can create over one million dollars of wealth if invested.

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