How many of us consider income and wealth as one and the same thing? My best guess is, majority.
But income and wealth are not the same.
They are not the synonyms of each other.
Though it is true that income and wealth share common boundaries, hence their functionality can be confused.
To understand the difference, lets take an analogy of a water tap.
Income is the flow of water through the tap.
Wealth will be like a bucket kept below the tap for storage.
Income is flowing water, and wealth is more like a reservoir.
So what does this explain?
If we do not keep a bucket, the water continues to flow from a tap.
This way some water is used but majority gets wasted and ultimately goes down the drain.
Needless spending is like water going down the drain.
Focusing only on income will trigger needless spending.
Focusing on income plus wealth building is more useful. How?
Majority think like this; a continuous flow of water (income) from a tap (job/business) means, no worry.
Why to bother about the storage (wealth creation) when income keeps flowing in?
Income is not forever…
It is not wrong to think like this, till, the big fallacy attached to this thought-process is realised.
The fallacy lies in the assumption that ones income from job/business is assured.
In moments of truth, people realize that one cannot rely hundred precent on income from job.
It is always better to build a safety net for self. This safety net is what we call “Wealth”.
The bigger is the wealth, lesser will be ones reliability on job/business.
Financially independent people are one who can support their standard of living even when income from job completely stops.
How this is possible?
This becomes possible only if one has accumulated sufficient wealth.
Let me ask a question.
Who is richer, a person who has larger income or a person who has larger wealth?
Suppose there are two friends, Tom & Jack.
Tom earns $100,000 as annual income from job. Tom has wealth of say $15,000.
Jack earns $85,000 as annual income from job, but Jack has wealth of say $120,000.
If one looks only at the income, Tom is earning far higher income than Jack.
So does is mean that tom is richer? No.
The accumulated wealth of Tom is $15,000. This is only 15% of his net take home salary.
The accumulated wealth of Jack is $120,000. This is 141% of his net take home salary.
If one has to quantify a person as rich or poor, the reference datum should be ‘wealth’ and not ‘income’.
Take a look at Forbes list of world’s richest people.
This list ranks people on basis of their accumulated wealth (net worth) and not income.
There may be some CEO’s on this list who draw salary (income) like $1 per month.
But how come they appear in this list?
People appear in this list based on their wealth, and not income.
So what it explains about the income and wealth?
It is ‘not’ sufficient to earn a big fat paycheck.
It is equally important to accumulate wealth gradually over time.
To become wealthy it is not essential to earn large income.
So focus should not be on income.
Focus should be on the amount of money one diverts towards wealth accumulation.
A person X who earns $50,000 each year diverts $5,000 towards wealth building.
In next 20 years @15% per annum, X will have wealth worth $585,000.
A person Y who earns $100,000 each year diverts only $1,000 towards wealth building.
In next 20 years @15% per annum, Y will have wealth worth $115,000.
Who is richer after 20 years?
Y whose income was $100,000, or X whose income was only $50,000?
After 20 years, X has accumulated more wealth, hence X is richer.
The difference is clear, no matter how high is ones income (Y earns twice than X), but if sufficient fund is not diverted towards wealth building, one will remain poor (financially dependent).
How to accumulate wealth?
Now we know that wealth accumulation is not about level of income.
It is more about how much one can divert (from income) to buy assets.
A portfolio of good assets is called wealth.
Assets are something which cannot be found in market free of cost.
One has to pay money to buy them.
But assets has potential to grow in value or generate income for its owner.
So the first few steps to accumulate wealth are:
- Save more,
- Identify good assets &
- Buy assets at undervalued price.
People who save less, no matter how high is their income, can never accumulate high wealth.
It is absolutely essential to save sufficiently.
People who maintains a frugal lifestyle, compared to their income levels will save more.
Hence can build higher wealth.
‘High income plus frugal lifestyle’ is a combination which can work like amazing for wealth building.
No matter how high is ones income, if he/she is not frugal, he will never accumulate necessary wealth.
Person earns high income. But spends it all. Not useful
Lets see how an average man spends money.
Suppose ones income is $100.
Generally people spend close to 45% ($45) to pay EMI’s.
Ideally one must not pay more than 20% on EMI.
People also spend exorbitant money on child’s education.
Generally people spend close to 10% ($10) to pay fees on education.
Ideally one must not pay more than 5% on education.
You can see, an average person spends close to 55% of his income on just two items alone.
But if one can decide to live a frugal life, this expenditure will not be more than 25%.
These extra savings one can divert to buy more assets and accumulate higher wealth.
One must do their best to get out of the loop of living a paycheck-to-paycheck life.
Wealthy people abhors this lifestyle.
The trick is to start becoming sensitive to ones dependency on monthly paycheck.
If one cannot pay next months bills if paycheck is not received, it’s a sign of danger.
Think over it.
How dependent you are on your paycheck (income from job/business).
But what is the problem if one has very high income and a stable job?
Should this person still count wealth?
Yes, having a stable job is always good.
But a stable job with high salary (income) comes at a price.
The amount of time one stays in office.
The number of holidays one can take in an year.
The kind of bosses/clients one has to face etc.
Earning high income does not have only a happy side.
The sad part is the sacrifices that one has to make to maintain those high income levels.
What is the way out?
Start early, save money and keep buying good assets from day one.
Small-small drips to buy assets goes a long way in building substantial wealth over time.
I have been following your articles for few months, its more helpful and easily understandable. I really started saving emergency funds after reading your articles. You are changing someone’s spending habit to saving for their better future, good job.