There are only four ways to increase your net worth. No matter how difficult or complex growing your personal fortune may seem, at the very core of the process of building wealth and saving money is a great truth. To increase your net worth, you must do one of these things:
- Increase the assets you own
- Making your assets more productive by putting your capital to work at the highest risk-adjusted rates of return. If you need to live off your investment portfolio and won’t ever require principal to be sold to fund your lifestyle, you might be able to sell bonds yielding 3% and instead buy real estate outright, debt-free, yielding 10%. For every $100,000 in assets you own, this move would increase your net worth by an additional $7,000 each year (10% new yield – 3% old yield – 7% additional yield) as the earnings came back onto your balance sheet in the form of cash rents and property appreciation (if applicable). Likewise, if you use $5,000 in cash to buy a new living room furniture set instead of shares of your favorite blue chip dividend stock, you’ve made the assets “non-productive” in a financial sense. I once wrote about the six ways I classify assets personally in an article called The Six Different Asset Types – The Hierarchy of Capital Allocation (in truth, there are a few more but I had to simplify it for the beginners).
- Decrease the liabilities you owe
- Making the liabilities you owe cost less by repackaging or refinancing the debt you must service. If you own a business and you can consolidate $500,000 in debts into a single small business loan, and cut your weighted average interest rate from 12% to 8%, not only would you save yourself $20,000 each year in interest expense, but your absolute payment would likely decrease, freeing up cash for you to build your liquidity or invest in additional assets or debt reduction.
Everything else we discuss – stocks, bonds, company structures, tax rules, etc. – are merely ways to accomplish those four important objectives. Each time you do one of them, your net worth grows (provided you’ve actually done it correctly and been smart about risk management). If you can fire on all cylinders, you can create a virtuous cycle where your net worth grows exponentially.
Look at Microsoft. Early on in its history, it paid off all debt and maintained a debt-free balance sheet so there were little or no liabilities to manage! None of the profits were leaving the income statement as interest expense. This meant Microsoft could focus on increasing the assets it owns and then in turn, making those assets more productive.
When people talk about getting a “good job” what they are really expressing is a desire to receive more compensation for their human capital (experience, credentials, intelligence, and reputation). They want to make their asset – their human capital – more productive by allowing them to demand a higher income for every hour of their time they sell. The demand for brain surgeons is high relative to the supply so they can earn $1,000 or more an hour whereas someone washing dishes can’t hope to make more than minimum wage.