To a certain extent, investors like myself desire to see a steadily rising net worth. Up and only up please! Unfortunately, life and the stock market don’t always comply with what I want them to do.
There will be years where the market is down, and weeks when more cash flows out than flows in. So how do I know I’m actually building wealth?
On a day to day basis, wealth grow is pretty much invisible — and I don’t mean invisible in the sense of “stealth wealth” where you don’t tell your friends and neighbors about your growing wealth pile.
I mean you can’t actually see it! This is because most well-known financial measurements don’t actually measure wealth growth. Instead, they (mostly) measure financial noise.
Think about it — If you track your monthly spending there’s going to be big swings to the positive when that monthly paycheck comes in, and likewise a big drop in the negative direction when you pay the mortgage and credit card bills. Those swings day to day are going to be pretty large.
If you track net worth, your number will also swing to the positive or the negative if the stock market has a good day or a bad day. Or a good month or a bad month. A good year or a bad year.
All those fluctuations don’t necessarily mean you aren’t building wealth. It just means you’re measuring HUGE amounts of noise. Statistical noise is not the same as wealth building.
Think of these financial fluctuations as waves crashing onto the beach — perpetually moving in and out.
Wealth building itself is actually closer to the relentless rise of ocean levels. It’s a well known fact that ocean levels have been rising around the globe for decades now, but if you take a trip to the nearest beach can you see it rising?
No, you can’t see it! The process is very slow and it’s drowned out by all the ‘noise’ from the waves and tide! Waves are certainly connected to the sea level of the ocean, but watching the waves closely isn’t going let you see the ocean’s rise. There’s just too much noise in the system!
Certainly online financial tools can help you track day-to-day cash flow levels in your bank accounts, or catch up on current market prices for your assets… but that’s really just wave-watching.
Wealth building is more like the rising ocean — powerful, slow, and almost invisible to our everyday eyes. It can really only be measured and seen in the past tense. Trying to see it in the “here and now” is practically impossible.
So how do we deal with this problem of ‘invisibility’ and keep building wealth in the face of market ‘noise’ and the tidal forces of economic cycles?
Relentlessly Building Wealth
In essence, there are two forces that contribute to a growing net worth — thrift (spending less than you make) and compounding (investing money to earn more money). Combined, these two superpowers (if maintained) will eventually build wealth for anyone who can achieve them consistently over time.
Sounds simple, right? Then, why isn’t everyone a multi-millionaire?
The key word here is consistency. In reality, consistency is a lot tougher for humans than we like to let on. We get bored. We change jobs. Tragic accidents happen. Priorities change. Life just gets in the way sometimes, and we fail to keep saving and compounding. Being consistent is hard.
While the ideas behind wealth building might sound simple, the real trick is putting in-place systems to keep both forces happening over a lifetime.
Weak Thrift And Strong Thrift
Imagine for a moment that you have a friend who claims to understand the value of thrift. During certain months this individual saves a reasonable percentage of their income (say 20%), and they think they’re doing pretty well. The problem is, the following month this individual eats-out a little too often, buys some new consumer junk, pays for car repairs, and before they know it they’ve spent 20% more than they earned.
The savings disappears!
These swings could even be greater than simple month to month swings, they could happen over years — one year your friend might managed to save 20%, but the following year he/she spends it all on a nice new car. This effectively wipes out any savings from previous thrifty periods.
This is what I call weak thrift. That individual isn’t actually saving anything. They’re just deferring spending for a few months, (or even a year or two) until a major spending event happens.
Strong thrift requires a more serious commitment and dedication to saving. Individuals that practice strong thrift frequently save 50% or more of their income and they relentlessly hold onto it.
The practicers of strong thrift don’t fall prey to the newest iPhone, or “fashion” trends popularized by social media. They’re perfectly willing to look “unfashionable” and drive ugly rusted cars for the sake of building wealth.
Standing apart from the crowd like this takes serious strength — hence the term “strong thrift”. You have to be strong. It isn’t easy to maintain this level of thrift in the face of social pressure, but some people do manage it.
How? Start by not caring what other people think about you. Become a big weirdo. After that, it’s all just practice.
Are You Compounding?
The second force to consider when thinking about how to build wealth is Compounding. Compounding consistently is something very hard to do because investors are typically very far divorced from the mathematical forces of compounding.
The nature of compounding is something that I’ve written about before, but maintaining it is tricky. Why? Most compounding is in the form of what I call “internal compounding”. This is the internal reinvestment of cash earned from the investment back into itself. In theory it sounds great, but the problem is investors have little control over how (and if) that compounding actually happens.
For all we know, the CEOs controlling these investments could be wasting our dollars on private jets, Caribbean “retreats”, and gold plated washrooms instead of reinvesting our earnings properly into the business. This happens more often than you think!
What we need to ensure compounding over long periods of time is control — The most likely form of control we can get when trying to compound is something I call “external compounding” — That is, the reinvestment of dollars earned from our investments into even more assets. This is done external to the investment, by our own hands, so *we know* compounding is really happening.
(Note: While external compounding is typically not quite as tax efficient as internal compounding, the lack of control and oversight around internal compounding makes these two sub-forces of wealth building roughly equal in my mind.)
External compounding is one of the reasons I’m a big believer in Dividend Growth Investing. I constantly have fresh cash coming in from dividends that needs to be reinvested, thus ensuring the continuous compounding of my wealth.
Large Eroders of Wealth
Beside growing wealth, investors also need to be aware of wealth erosion.
Just like the ocean slowly eroding away at the beach, wealth has forces of erosion that will “eat away” at your wealth over time. We need to be aware of these wealth eroders and minimize them (as much as humanly possible).
The most important wealth eroder to remember, has to be Inflation. Inflation, is the gradual rise in prices over time. Typically this happens because of a growing money supply.
Like it or not, inflation is probably here to stay long-term. Some years the rate of inflation is going to be greater than others, but current monetary policy supports the idea that a certain amount of inflation is actually good thing. I see no reason why this would change anytime in the near future.
That’s right, the Federal Reserve is actively working to increase the money supply and they want to keep eroding away at your wealth. Primarily this keeps consumers spending (instead of hoarding and waiting for lower prices), and it keeps savers investing in assets with actual risk.
The only real way to beat inflation is to: Earn a salary that grows faster than inflation, OR invest in assets that earn a greater return than the rate of inflation (after taxes).
The second big wealth eroder everyone needs to be on the lookout for, is something called Lifestyle Creep. Lifestyle Creep is the gradual increase in lifestyle expenses as someone becomes accustomed to greater and greater levels of comfort and luxury during their lifetime.
At first, we all start out as a poor college student with minimal expenses. Over time, it gets harder and harder to “live like a poor college student” as we hedonically adapt to a comfortable lifestyle filled with nice things. Basically, we slowly become spoiled babies.
This wealth erosion is really hard to beat, but the best advice I can give is to Sip Lightly From The Bottle Of Comfort and slow the trend of continuous higher spending as much as you possibly can.
Wealth building isn’t terribly easy to track. It’s like an invisible financial force of nature. You can record the rise of your net worth, but if you do so too frequently you’ll just end-up measuring all the noisy movements of financial markets.
This is exactly why I don’t publish my net worth more frequently than once a year — too much financial noise drowns out what’s really important to building wealth: Thrift and Compounding.
Whether you build wealth by working at a job or by just investing money, I firmly believe that everyone needs to understand what it takes to build wealth. We owe it to ourselves — the world has seriously changed. Financial Independence is no longer just a luxury to be achieved only by elite earners. We all need be building wealth to ensure a comfortable life in retirement… even if it isn’t easy to see or track by conventional means.