Tuesday, October 7, 2008

What is wealth?

Adapted from Adam Khoo's email newsletter, with some of my own additional views and points.

Is a person's wealth is defined by how much he earns, by the clothes he wears, by the car he drives, by the amount he spends, by the house he lives in and by the way he lives? Obviously not!

Wealth is determined by a few factors.
1) Monthly expenditure
2) Monthly income
3) Liquid assets

Number 1 is pretty standard; it is how much you spend each month.

Number 3 is also pretty standard. Liquid assets is the amount of cash or cash equivalents you have. This can include stocks, bonds, money market fund & fixed deposits.

Number 2 is a bit larger. To me, monthly income consists of 2 portions
(a) Active income
(b) Passive income

(a) Active income is how much you earn by putting your effort into it. This includes your full-time job.

(b) Passive income is the income that you will continue to receive even after you stop working. This could include any advertising revenue from websites, interest, dividends, royalties and profits from a business.

So after all these definitions, what is wealth?

A person's wealth is actually defined by how long a period of time he/she can sustain their lifestyle if they stop working. The longer you can go on living your life without working another day, the wealthier you actually are.

An example. George holds a big post in a multi-national company and earns a $30,000 monthly salary. He lives a lavish
lifestyle that results in personal and household expenses a month of $27,000.

He hasn't really saved much over the years as he has spent any surplus on house improvements and other liabilities. Besides his full time job, he has no other sources of income. His liquid assets are just under $27,000.

On the other hand, Lily, another employee in the same multi-national company, earns a monthly salary of $5,000 a month. For 20 years, Lily saved 20% of her income and invested it in the right stocks and mutual funds that have given her average returns of 15% per year. Her liquid assets slowly build up to $1.3 million as time goes by. In addition, she spent her free time building up a home-based business that sells collectible items over the Internet, earning about $800 a month. She does not drive a fancy car nor spend lots on home improvements.

Let us now compare between Lily and George. Who is wealthier?

For George, if he stops working today, his liquid assets of $27000 can only pay for his current lifestyle for only a month. His wealth is thus one month.

For Lily, if she stops working today, with her $1.3 million in savings, and a monthly expenditure of $4k (80% of $5k), she would be able to survive 325 months (or 27 years)! This excludes her monthly passive income of $800.

Let's say, Lily puts her money into a fixed deposit of a pathetic 1.2% (given a bad recession), along with her monthly passive income of $800, she would be receving an average of $2100 a month. If the economy is good and fixed deposits give an interest of 4%, she would have about $5133 a month! So you can see, Lily can go on living quite comfortably for a very long time without working much again in her lifetime.

Can you see that wealth is not determined by how much you earn, but by how much you saved, how wisely you invested, and how much you spend? It is a factor of time, and not a factor of the absolute amount in dollars and cents.

Conclusion: Even with a middle class income, one can still be a millionaire if one has sufficient financial intelligence, discipline and patience to achieve it.

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