November 27, 2014

Is $650,000 the Magic Tipping Point in Wealth Creation?

I think the major tipping point in terms of wealth creation and financial freedom probably comes somewhere around $650,000 in productive assets with little or no debt.  That isn’t an arbitrary amount of money.  It comes down to a function of economics.  That is an important distinction – your house, car, and furniture aren’t productive assets so it is more specific than assets less liabilities equalling net worth.

The median household in the United States earns $52,000 per year, which is achieved by someone having to sell their time to an employer in exchange for a paycheck.  If they stop working, they stop getting checks. But with $650,000 invested, it only takes an 8% rate of return to achieve the same income.  If the $650,000 is parked in tax-free retirement accounts or other tax-sheltered investment vehicles, it works out to considerably more money because the money that would have gone to the government instead gets reinvested to generate more dividends, interest, and capital gains.

In other words, $650,000 invested at 8% is the point at which the money earns as much as the average American family does working full-time.  If the money is held in tax-advantaged accounts, it is considerably more because a huge portion isn’t going to taxes.

$650,000 in Investments

I'm beginning to believe that for the average household, having $650,000 or more in investments is probably a major tipping point. The reason? The median household earns $52,000 per year in salaries and wages. If they had $650,000 in retirement accounts and that money earned 8%, they would be collecting more after-tax dollars from their investments than they did from their day jobs. They could spend their income on big screen televisions and trips around the world, but still watch their balance sheet grow and strengthen over time. Image © Thinkstock

For most people, who have the desire to be productive but don’t want to experience financial stress, that is going to be the point at which they breathe easier.  I don’t think they’d feel “rich”, as I explained in my theory.  It’s not let’s-go-order-a-bespoke-Brioni-coat-for-fun money.  But with that asset base, provided it is in productive investments, someone with financial discipline should be able to always enjoy a stocked larder, full stomachs, fires in the fireplaces, warm blankets on the bed at night, a nice car, regular vacations, a good education for their children, and the independence to do what they love, not just take jobs that pay the bills.  They’d still go to work, spend their salary, but watch their net worth grow higher as time passed and compounding built their treasury.

To see what I mean, think about the average married couple in your life with kids.  If they are fully employed, have a college education, earn a good living, but at the same time their investments are generating as much income as they do from working and that money is getting plowed back into their balance sheet to grow each year, they are going to be fairly content because psychology tells us that it is not – as stupid as it sounds – our absolute level of comfort and security that matters, it is the illusion of improvement and our relative station compared to our neighbors.

Of course, we already know that $75,000 per year is the price to buy happiness so if someone wanted to give up work completely (very few people do – we need a purpose in life), it would require between $900,000 and $1,000,000 depending upon the rate of return that could be earned on the money.

  • JJ Furman

    I like your optimism, but by some accounts, $650K is too low.  For one, I would go with 4% instead of 8% to account for inflation etc… so target $1,300K.  But for that $75K annual income, $1,875K at least.  Back to work :)

    • Joshua Kennon

      If you are talking about standard of living, and wanting to earn $75,000 per year in investment income, then, yes, you might need a larger capital base depending upon the asset class in which you specialize.  For example, if you were trying to hit the $75,000 household income from blue chip stocks, the $1.875 million figure would be near perfect.  You could find stocks with dividend yields between 3.5% to 4.5%, spending every penny of the money that was mailed to you.  The inflation issue would be taken care of by the company’s own retained earnings and expansion.

      I think that is why you see so many small investors who want passive income prefer real estate over equities, even though the latter tend to compound at much higher rates over long periods of time due to the inherent ability of a good business to expand, raise prices, and cut expenses in excess of the inflation rate.  Almost all of the income from an apartment building or townhouse project is in cash, providing far higher yields, allowing a much smaller capital base to reach meaningful figures like $50,000 or $75,000 a year in income.  Give me $650,000 and I can turn it into a $75,000 annual income if I restrict it to real estate only.  You won’t be as rich in 40 years as you would have been otherwise, but it could be done without an excessive amount of risk.  You wouldn’t even need to be particularly bright or clever to hit that level; just find some niche need in a Midwestern community.

      Personally, I am talking about wealth creation, not necessarily money you spend to enjoy a higher standard of living.  I think the $650,000 is more meaningful from an academic perspective (where it would take the $1.875 million to see a huge day-to-day shift in standards of living) because the former is the point at which the money is growing at the same rate as the median American family’s income.  That is, Mom and Dad go off to work every day and after a year have made a bit more than $50,000.  At the same time, their portfolio would have gone off to work all year and made the same $50,000.  It is the point at which, if you are median, your money is making as much money as your labor.  It wouldn’t even be necessary to back out inflation for comparison because you would also have to back it out of the household income from labor, which would put the two figures on parity, resulting in the same $1-from-labor-$1-from-investments paradigm.

      It is the household equivalent of another important tipping point for people who use dollar cost averaging and dividend reinvestment programs.  If you save $500 per month in a basket of blue chip stocks, the point at which your dividends equal, and are being reinvested at a rate of, $500 per month, matching your contributions dollar-for-dollar is a major deal.  Your money is now working as hard as you are.

  • http://twitter.com/phmarco Marco Moreira

    Been reading this blog for several hours after discovering it today. You make so much sense by keeping away from the populist bullshit and just focusing on how to get things done. We desperately need more of that clarity of thought and objective thinking in your writing. Cheers

    • Joshua Kennon

      Welcome to the site!

  • Pablo Seto

    I really like this article! I have seen a lot of bloggers who have become financially independent around this mark like Mr. Money Moustache or Early Retirement Extreme (@ 1/3 of that amount!)

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