According to Robert Kiyosaki in Rich Dad Poor Dad,
Wealth is a person’s ability to survive so many number of days forward - or, if I stopped working today, how long could I survive?
Building personal wealth is all about building independence. In the Taxation discussion of wealth, we discussed how all incoming wealth must ultimately be either saved or spent. Here, we consider the implications of that on a personal level.
Wealth (in years) = (Savings + Passive Income) / Expenses (per year)
In contrast to most methods, Kiyosaki proposes measuring personal wealth, then, as a length of time. If I spend $20,000 per year, then savings of $20,000 gives me a wealth of one year ($20,000 savings / $20,000 per year = 1 year) while $10,000 gives me wealth of 6 months; it is how long I could survive before I must return to work. Savings of $100,000 is a wealth of 5 years, because that is the duration of time for which I can survive before I must return to work. ($100,000 savings / $20,000 per year = 5 years) On the other hand, if I spend $50,000 per year, then savings of $100,000 are a wealth of 2 years. ($100,000 / $50,000 per year = 2 years)
If I invest my savings in assets that appreciate and earn a passive income, then I can extend my wealth in an efficient manner. Consider the discussion in Buy, Borrow, Die about how the interest and appreciation provides financial support. If I still spend $20,000 per year and earn $10,000 per year in interest from my assets, then I can live for 6 months off of my assets before I have lost any wealth of my own; at that point, I must either sell assets or go back to work. If I can earn $20,000 per year in interest from my assets, however, I never have to go back to work because my assets will provide what I need for me every year, indefinitely.
The two sides of wealth on a personal level are a variation on the two sides from a taxation standpoint. If wealth is the length for which a person can survive after they are done working, then the first side is the amount she have saved and what she earn from those savings; obviously, the more someone has saved, the longer she will be able to survive, since everyone needs to spend at least some money to survive. This is like the sources of wealth discussed in taxation; it is where the wealth comes from. The flip-side of personal wealth is the amount a person must spend to maintain their standard of living. This is how far a person is stretching the wealth that she has; while everyone needs to spend some money to survive, the more she spends above that point, the shorter her savings will last.
Productivity of Savings
The first side mentioned above is the size of the savings a person has. These savings can be (and often are) in a bank account. For those who can afford it, this is a very inefficient way to save money, because the money is not working for you. It is just sitting there. If a person is able to save for the long term more confidently, then she will usually do so through stocks or bonds; these will also provide an income through interest and her money will be working for her, as people say. The more money a person has saved, the longer they will be able to live without working. If their money is saved in efficient ways, then it will be providing a passive income and can substitute working this way.
Efficiency of Spending
The second side determines how long the savings will last. Everybody needs to spend some money to survive; groceries and gas aren’t free. The less money a person spends, the longer the same savings will last. A person with $100,000 in savings who spends $50,000 a year on personal expenses will have wealth of 2 years, while a person with $100,000 in savings who spends $20,000 per year will have wealth of 5 years.
The biggest Mistake: Getting a Raise
The biggest and most common mistake people make when trying to build wealth is looking for a raise. At first blush, it seems this would help someone build up their savings and, consequently, wealth. But it tends to do the opposite, since people tend to increase their spending with their raise (after all, you’ve got more money now, right? Not exactly) Because you were saving at a lower rate, you won’t have enough saved to keep up with the increase in spending, even though you are now earning more money! You may have just decreased your wealth!
If I am earning $60,000 per year (the median American pre-tax household income; we are ignoring tax for the ease of math) and saving 20%, then I am saving $12,000 per year and spending $48,000 per year. If I have total savings of $100,000, then I have a wealth of a little more than 2 years. ($48,000 per year for 2 years = $96,000; I would actually have a wealth of 2 years and 1 month, exactly)
After I get a $10,000 raise, I am now earning $70,000 per year, saving $14,000 at 20% and spending $56,000 per year. I have to work for nearly a year before I am as wealthy as I was before my raise. At $56,000 per year, I need $112,000 to have a wealth of 2 years. ($56,000 per year x 2 years = $112,000) At the time of my raise, I only have $100,000 saved. It will take me over 11 months to save a further $12,000. Because I am spending the same portion of my income as before, once I have caught up to my previous level of wealth, I don’t build wealth any faster, either.
A $10,000 raise has set me back an entire year of savings; simply because I did what everyone does and increased my spending with it. The larger the raise (and corresponding increase in spending), the larger the setback. A smaller raise (most people hope for a 2-5% raise each year to keep up with inflation) creates a shorter and less noticeable dent in wealth, but it is there nonetheless and adds up with a small raise every year. A common rule-of-thumb to combat this is to save an additional 50% of the raise; in this case; that would mean saving $17,000 per year and spending $53,000 per year after the raise. This minimizes the setback by increasing the rate at which you are building wealth.
The only way to be better at building wealth is to increase the amount you are saving compared to what you are spending.