The Wealth Formula
Wealth can be expressed as the following mathematical formula:
Wealth = Assets x ROI ^ Time - Liabilities
As a sentence, the formula reads: Wealth is equal to the value of your assets multiplied by the return from your investments (generated by those same assets) compounded by time and finally subtracted by liabilities (loans and expenses).
Okay, maybe that still doesn’t sound like plain English. This may still feel rather complex but it is very intuitive once we break the formula down piece by piece:
Wealth - the net worth you will have in the future
Assets - the value of all the things you own now
Liabilities - the value of all the things you owe other people
ROI - return on investment, in other words how quickly each dollar generates another dollar
Time - usually measured annually, but also can be measured quarterly or monthly
Okay, hold up. I know a lot of my fellow finance professionals are probably freaking out right now and petitioning to have my economics degree revoked since this formula is not the standard one taught to us in Econ 301. However, the standard academic approach is designed for corporate finance, which makes it unnecessarily complicated when applied to personal finance.
Wealth Formula in Action
Suppose you have a house worth $1,000,000 that is increasing in value by 3% a year. You also owe a mortgage on the house which requires you to make payments totaling $800,000 over the next 30 years. So how do we calculate your wealth?
Apply the formula: Wealth = 1,000,000 x (1.03 ^ 30) - 800,000
After growing at 3% in value per year for 30 years, your house is worth $2,427,262. Take away the $800,000 you used to pay off the mortgage, and you are left with $1,627,262. Not that complicated right?
This example is obviously oversimplified, and in reality, there would be things like taxes, inflation, and depreciation to consider. However, there are two reasons why this formula is great for an introductory understanding of personal finance:
It helps you understand what are the big factors that influence your future wealth
It essentially lays out how the game is played
As expressed in the formula, Assets, ROI, and Time grow your wealth, while Liabilities shrink it. Therefore, all you really need to focus on are four objectives:
Increase the amount of assets you own
Minimize your liabilities owe
Pursue the highest ROI that is appropriate for you
Keep your assets invested for as long as possible
These 4 objectives lay out the entire gamebook for mastering your personal finances. Remember the two goals we laid out earlier during the introduction (maximizing reward while minimizing risk)? We will now explain how each of these four objectives plays into them.
Playing the Money Game
Assets:
The economic definition of assets is everything you own, no matter how big or small. The reason is that, theoretically, everything can be sold. However, we doubt anyone is rushing to sell their worn-down running shoes that were used a week before laying abandoned. For the purposes of this discussion, assets refer to things of significant value that can be bought or sold with relative ease, such as cars, houses, money, investments, etc.
In later sections, we will do much more in-depth discussions about the most common types of assets you can own and their importance.
Liabilities
While people mostly think of car loans and mortgages, liabilities really should be defined as all the money you need to spend to live your current or desired lifestyle. That broadens the range to include things like rent payments, utility payments, phone bills, money spent on groceries, money spent on entertainment, etc. Not taking these types of expenses into account when thinking about your finances will result in some nasty surprises which are best avoided.
ROI:
The topic of what return on investment (ROI) you should strive for is a tricky one. After all, who doesn't want a high rate of return, but, as we know now, risk & reward are inseparable. Earlier in the four objectives, we recommended “pursing the highest ROI that is appropriate”, appropriate being the keyword. If you want to aggressively grow your wealth, then taking some high-risk bets for the chance for a big win may be smart, but if you tend to be more conservative, then it might be better to accept a slightly lower ROI for a lower chance of losing money.
Time:
When we suggest you stay invested as long as possible, we are not saying you should keep your money invested forever. Your investment time horizon should correspond to what you will spend money on. If your primary focus right now is to save up for a car down payment, then your time horizon will be shorter than someone looking to achieve financial freedom in 20 years.
Wealth Tailored for Your Life
The first thing you must do is be introspective and examine the motivations for growing your net worth (hopefully you have already done this while reading the previous post, if not, click here to read).
A great way to approach this is to ask yourself: how would I spend the rest of my life if all my basic expenses are already covered? In other words, you don’t have to worry about rent, mortgage payments, groceries, utilities, etc. Your answer should give you some pretty good insights.
For example, you might say you want to travel the world with your family, or you might focus on making more money to pay for a Tesla Roadster (great choice 😏). Some people choose to relax when basic expenses are no longer an issue, some choose to pursue greater levels of wealth or adventure. Most people fall somewhere in between, a blend of relaxation and higher ambitions.
Now that you have a better idea of your motivations, we calculate two things:
How much money you will need, and
When you will need it
Up Next…
In the next post, we will make all this theory more concrete by using a personal example from one of us, and how a seemingly impossibly luxurious lifestyle might not be too out of reach for most people…
