A WEALTHY TALE: WHAT DOES IT MEAN TO BE WEALTHY?
Carlos M. Sera, MBA
August 14, 2015
For as long as I remember I’ve been fascinated with the concept of wealth. I would consider individual wealth and collective wealth. I would wonder about wealth across borders and this lead me to think about wealth reallocation or redistribution within borders and across borders. Wealth creation also occupied my thoughts since I recognized that close to 99% of the world’s wealth had been created in the last 200-300 years. I would ask myself, why is wealth creation an exponential function, meaning that as a planet we are getting richer at a faster rate. I would ask the question, 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 advance? Is it evolutionary? Is it how we organize our society? The answers to these questions will be ongoing throughout my life. But this tale deals with wealth at an individual level and is far more practical.
WHAT ACADEMICIANS BELIEVE
As a young man with no money and only armed with human capital or what others call potential, I studied the many ways that others built wealth. Along the way I invested 2 years of my life in what today I describe as a financial brainwashing that others call an MBA. The MBA is where the student gets their brain reprogrammed to think in a disciplined manner and accept academic financial and business theories as real world truths. The theories are based on unrealistic assumptions but worth studying as a mind expanding exercise since the real benefit is the resultant disciplined thinking. It had been pounded into my head that the only way to manage money was through the diversified portfolio and only the diversified portfolio.
Why do academicians believe so strongly in diversification? The answer is because academic studies prove that a person can’t outperform the stock market over extended periods of time once the portfolio is adjusted for risk. The catch is in the word risk and how academicians define it. What clever academicians do is say, yes that approach makes more money than the market but it is doing it in a riskier manner. They create a measure of risk which is inconsistent with how society defines risk. Society defines risk as not losing money. Academicians define risk by assuming people are equally happy going from poverty to wealth as they are going from wealth to poverty. Today, even the most hard-headed developers of these arcane academic theories recognize that this assumption is unrealistic. Unfortunately, the best minds have yet to develop an approach that explains the complexity of investing. We are thus stuck with what I call Newtonian Laws or Mechanical Laws in a Quantum world. This leaves the investor in a quandary. When the default portfolio is the diversified portfolio and there is no agreed upon reason to deviate, the investor chooses the default portfolio. For those that don’t know better or don’t want to know better or can’t figure out how to hire someone that knows better, I suggest you should have a diversified portfolio. However, you won’t get rich that way. I make this point very clear in A Tale of Diversification.
Towards 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 is the best way to build wealth? At the end of almost 2 years of study he said I should put all my eggs in one basket, preferably one that I knew and understood, and then to 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 management 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 2 years, his advice was adjusted for risk. I wouldn’t have understood the nuance of what he meant 2 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 had advised me to do the same thing that others had advised for centuries and I also 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.
SO WHAT IS WEALTH?
So what have I learned about the word wealth now that I am older. What is wealth? Some people define wealth as simply a person’s net worth. Some definitions are spiritual, others emotional and still others are anthropological, but since 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 as a financial professional I can’t work with that definition. I need something concrete as do those that manage their own money. I need a formalized definition of wealth that I can apply when advising clients as does everyone else. I’ve come up with the following,
“You are wealthy if, at a 4% annual rate of return you could stop working and live indefinitely from the income your investments generate and guaranteed inflows from other sources while maintaining your standard of living.”
What can we gather from this definition? We can gather that wealth is not age, race, gender or nationality 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, assets, spending habits, background, geography, and investment performance. Lastly, we can gather that wealth can be attained in many ways and that if not properly understood and respected can be lost since it fluctuates daily.
The most complicated aspect of the word wealth and why I say wealth is a state of mind is that you can instantly go from being wealthy to not or vice versa simply on how you choose to live the rest of your life. If one day you for no reason other than “I want to” 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 that regardless of how much we may want to avoid it has a metaphysical side to it. How you look at wealth determines if you are wealthy or not. 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.
Many fellow practitioners argue that my static definition of wealth puts too much emphasis on a person’s spending habits, consumption pattern or lifestyle. They argue that you can’t call a person with a net worth of $500,000 dollars wealthy while calling someone that has amassed a $10 million dollar net worth as not just because the one with more money spends too much. They argue correctly that the person with a $500,000 net worth can’t increase their spending habits, consumption pattern or lifestyle and is thus restricted and not wealthy. They don’t have the financial freedom or choice. Similarly they argue that the person with the $10 million dollar net worth can cut down on their expenses and easily meet our definition. I understand the classic argument that $10 million is more than $500,000 and that means they have more money. I recognize that my definition is limiting but for planning purposes one can’t just look at a person’s assets. Lifestyle is a crucial component and must be factored into the equation. Everyone’s heard of the athlete, businessman or entertainer that made a fortune to only lose it all due to a lavish lifestyle, poor investments, fraud or some combination of the 3. In an attempt to tie these two concepts 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 by 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 that is called the “burn rate.” What is the burn rate? It’s an old concept and one that most people will 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 they take in by $10,000 per month and they have $100,000 in their checking account they have a burn rate of 10. This means they will be out of cash in 10 months. The same term can be used when analyzing a person’s finances. Many a time I have scribbled on a piece of paper a number such as 72 or 80 or 82 and hand it to a client. They look at it and ask 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 it’s 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 but it is beyond this tale and you can read about it in An Inflationary Tale. This means that under our wealth definition once someone is wealthy you can’t determine if that someone is wealthier than another wealthy person since neither will run out of money. I suppose one could come up with a formula to show just how much wealthier a person is relative to another wealthy person but I don’t see the purpose.
This tale should be read after A Cyclical Tale. The reason I say this is because after reading this tale and A Cyclical Tale, you should be able to take a quiz which I call The Wealth Challenge. I present The Wealth Challenge in A Challenging Tale where I describe a few case studies of individuals and couples. The idea is to educate the reader on practical guidelines to what wealth means in practice. If they can correctly differentiate between, wealth or not, wealth challenged or not, they are far along towards their wealth quest.