Cash flow ≠ wealth

There is more to being wealthy than having a high income.

Cash flow can come and go. Ben Carlson recently had a post citing research from Thomas Hirschl at Cornell. The research shows:

  • 50% of Americans will be in the 10% of income-earners for at least one year during their working lives.
  • 11%+ of Americans will be in the top 1% of income-earners for at least one year.
  • 94% of Americans who make it to the top 1% income status will maintain that position for only one year.
  • 99% of Americans who make it to the top 1% will lose their top 1% spot within a decade.

Johnny Depp might be the most current and extreme example of this; he has reportedly squandered $650M of earnings on a lavish lifestyle with nothing left to show for it.

Cash flow

Cash flow is not wealth. High spending during years of strong cash flow may afford the appearance of wealth, but when the cash flow is gone the lifestyle goes with it. Saving a portion of that cash flow can lead to a base of assets.

Assets

Growing a base of assets is by no means easy. It takes some combination of planning, discipline, and luck. The fortunate side effect is that anyone who has applied planning and discipline to build up their assets is likely to maintain their planning and discipline into the future.

Wealth

Without discipline, a large asset base can be easily spent. Based on this someone with substantial assets relative to their neighbour may not be wealthy. Wealth is assets relative to current and future expenses. This is where the intersection of assets and expenses becomes interesting.

Take a financially independent 45-year-old with an $8,000 per month lifestyle. They would need about $3.8M to be financially independent, and each additional dollar of desired lifestyle spending would require about $40 of additional assets. That magnifying effect works in both directions; the required assets to fund financial independence for a 45-year-old drops to $1.5M if they can manage to live on $3,000 per month.

Expenses

Expenses are the link between cash flow, assets, and wealth. If wealth is defined as independence and freedom, then low expenses can be one of the strongest drivers. Lower expenses lead to a higher savings rate while also reducing the amount of assets required for financial independence. It is easy to spend more by becoming accustomed to luxuries while effectively robbing your future self.

Spending wisely is an idea that has been popularized by Mr. Money Moustache, among other frugality bloggers:

When you wriggle yourself into the narrow nook of luxury, your perspective on the world, and your ability to survive and thrive in it, also constricts dramatically. Like any drug, it can be fun to indulge in occasionally. But to seek to constantly maximize luxury in all areas of your life to the limits of what you can afford? Pure insanity.

There is, of course, a balance between frugality and comfort. The takeaway is the true cost of expenses. If you have cash flow, high expenses reduce your ability to build assets. If you have assets, high expenses reduce the value of those assets relative to your lifestyle, making financial independence less attainable.

Wealth is relative. Not relative to other people, but relative to your own expenses.

Original post at pwlcapital.com