July 28, 2014

The 5 Levels of Building Wealth

Early in life, I developed a theory that there were five levels of building wealth that most self-made men (and women) go through to reach financial independence. 

It was started by my love for Carl Barks Scrooge McDuck comics.  When I started reading the Federal Reserve reports of consumer wealth, empirical studies, and other sources of data, and discovered that 90% of those in the United States who are millionaires made the money on their own - that is, they did not inherit it – I started refining my theory.  It helped guide me when I lived in a series of small towns throughout my childhood, saving nearly every penny I could from working after school and pouring it into my investments.

Level 1. A hard working man gets a job in construction and is paid by the hour.  In effect, he sells his time in exchange for a set rate.  When he is done, he collects his wage and that is it.  He will never again receive a penny unless he agrees to sell more time to someone else in the future.  He is always at the whim of the economy and an employer.

Scrooge McDuck Carl Barks Money Bin

When I was a child, I would read Scrooge McDuck comics by Carl Barks and Don Rosa. I realized that, while everyone else worked, Scrooge owned everything from the banks to the ice cream factory and the profits kept rolling into his money bin day and night. I realized that's how I wanted my life to be so I could focus on doing the things I enjoy and can give a lot of money away later in life.

Almost all millionaires started here because 90% of high net worth individuals in the United States came from those who inherited little or no money.  The only way to ever make a decent living from this level is to increase the rate at which you can charge for your labor.  By going to law school, medical school, or business school, someone can demand $100 per hour instead of $9 per hour working at a discount store because their skills are harder to find (rarer) and in demand by the public.  The term “wage slave” has been used to describe this level.

Level 2. The hard working man takes some of his savings, built up by spending less than he earned over several years, and starts a new limited liability company to hold his investments.  He contributes the money to purchase the materials to build a house.  He works on it himself to lower costs or, if he doesn’t know construction, hires someone.  He rents the property out to tenants.  Whereas at Level 1, he could only hope to make money from the time he spent on the project, he will now begin collecting rental income that will flow into his household’s income statement every month for years, if not decades, into the future barring some unforeseen disaster.  That is, he is collecting cash each month even if he doesn’t get out of bed in the morning.

Most people never get to this stage because it is difficult to have the discipline to save money and come up with enough money to get off the ground.  It’s a painful, slow process that can cause a lot of burnout, especially if you have no one to guide you and show you how easy it can be.  Instead, they give up and stay at Level 1 forever, always worried about hanging on to employment or making enough to cover the monthly bills.

Carl Barks Scrooge McDuck Money Bin Celebration

There is a "tipping point" that is reached when you're building wealth. The first $100,000 in savings is the most difficult, painful, horrible experience for most people because your money isn't big enough to start earning money for you. If you can get beyond that threshold and start collecting cash generating assets, no different than someone collects stamps or baseball cards, the rest will take care of itself. Your job then becomes risk management.

Level 3. The tipping point is reached when the hard working man no longer needs to live off the rental income generated from the property.  This means that he is contributing savings from his job as a construction worker plus the after-tax earnings from his rental house to his limited liability company.  Before long, he is able to construct or purchase a second property.  Suddenly, like a tree planted in a field, the first young oak tree, which began as a sapling, begins to throw off acorns.  The wealth is still small, but it’s becoming self-generating and that is the key.

Level 4. Through years of reinvestment, pouring more money into his investments, and intelligently putting money to work at the highest risk-adjusted rates of return, the small limited liability company our hard working man founded now generates so much money that he can write checks for new properties, hotels, car washes, or whatever else he believes will generate a decent return out of the annual after-tax profit.  Should he choose, he could live off the income generated from these investments without ever working another day in his life (that hardly ever happens because, as I told you yesterday, once you get to this stage, business should be fun or you’re doing something very, very wrong).

Financial independence has finally been reached.  The hard working man can give shares of the company to his children or grandchildren, or he can donate them to a family foundation, using the dividends each year to support charitable causes that are important to him.

According to the Federal Reserve survey of consumer finances, this represents the top 0.9% of wealth in the United States and typically requires a household income of $400,000 to $600,000 per year (that’s a monthly income ranging from $33,333 to $50,000). I wrote an article about this in 10 Secrets of the Capitalist Class at my Investing for Beginners site at About.com, a division of The New York Times.

Working for the money by selling your labor doesn’t really count, in my opinion.  It has to be passive income from assets that you own. Otherwise, you can’t pass it on to your family or support charitable causes after your death.

Level 5. This is simply Level 4 on steroids.  By most empirical evidence, it begins at roughly $20 million in net worth, which generates roughly $2 million a year in household income.  That’s nearly $167,000 per month.  This is the kind of money that you can begin saving up to develop hotels, endow chairs at universities, travel comfortably in private jets, or (as many of them do) continue to live the same way you always have and continue to expand the investments.  Warren Buffett still lives in the same house he bought when he was in his 20′s.  Back then, he had a few thousand dollars.  Today, he’s worth more than $60 billion.

Scrooge McDuck drowning in cash

Charlie Munger said it best when he opined about Berkshire Hathaway, "We want to own businesses that drown us in cash." Once you get enough of them under your belt, compounding starts to take over and suddenly your businesses generate enough money for you to buy more businesses.

Summary. As a kid, I’d study wealthy people and classify them by how they generated their money.  Even a musician follows the same path as an industrialist.  Take Elton John.  He is estimated to make $40 million per year by Forbes.  Of this, approximately 50% comes from selling his time in the form of concerts.  The other 50% comes from his ownership of the song rights on the music he composed.  That is, every time someone plays “Bennie and the Jets” on television or in a movie, he gets a check.  Every time someone covers one of his songs, he gets a check.  Every time it sells on iTunes, he gets a check.

Elton never graduated beyond Stages 1 and 2 but Oprah Winfrey, on the other hand, used her money to buy up local cable television businesses.  Most people don’t realize that her “investment company, Harpo, now owns countless local stations and it’s possible you are paying part of your cable bill directly to Ms. Winfrey.  Her money makes money for her now, so even if she never recorded another show, the stream of earnings would keep on rolling into headquarters.  That’s why she earned $250 million versus Elton’s $40 million.  That’s a big difference.

  • michaelclay29

    Awesome! Your articles on about.com and here have inspired me to move from Level 1 to Level 2 (and further, of course..). Thanks, Joshua!

    • http://www.joshuakennon.com Joshua Kennon

      Thanks! And good luck. It can be a wonderful adventure if you don’t lose sight of the fact that the money is the means to and end and not the goal.

  • Jacob Mast

    Enjoyed the article!
    I’m at level one but I have begun saving towards making investments of some type. You could say that I’m sick of always having to go to work and not having the time or money to do things that I really want.

    • http://www.joshuakennon.com Joshua Kennon

      Then you are already light years ahead of everyone else. There’s a great saying, “until the pain of change exceeds the pain of staying the same, nothing will happen in your life.” Like you, I hated the idea of having to answer to someone else, show up to work at a certain time, be back at the office after lunch at a certain time, etc. That was a big motivating factor for me. The thing is, I love work, I just go in “bursts”. I’ll finish several months of work in 2 or 3 weeks and then not want to do anything but read or play video games for a month.

      It’s always interesting to me to see how people get from Levels 1 to Levels 2 and 3. Some borrow large amounts of money (and the risk of bankruptcy that comes along with it) to buy real estate, then pay down the debt and get conservative thereafter. Others save for years and then jump into their first investment conservatively, using it as a vehicle to buy more. Still others create companies that require very little money but can grow into big cash generators. Some use a combination of all three. Still others raise money from investors, take a small cut, and put the cash to work; e.g., if they raise $10 million and collect 2% of assets, they immediately earned $200,000 pre-tax the first year.

      There is one truth that is inescapable, though (and I speak from experience): The early levels are a bitch. They are hard sometimes. They can wear you out emotionally and physically. Money, though, is like gravity. Once you start to make it, it starts to attract more money. Imagine if you owned a $5 million hotel in a suburb. It would probably generate about $500k per year in profit, whether or not you showed up to work a single day (most hotels are manged by management companies in exchange for a cut of sales). That means you would have nearly $41,700 coming in every month to invest in other projects. You would have access to much larger financing sources, such as issuing private bonds.

      That is why you see so often biographies of people where it took them 25 years of hard work to get the first few million dollars and then over the subsequent 10 years, they make $30 million or $50 million from their money working for them. Getting your hands on that first capital is key. It’s also why most people never get rich.

      Oh! That reminds me of a story … Rose Blumkin, who sold her Nebraska Furniture Mart for tens of millions of dollars to Warren Buffett in the 1980s despite not being able to read or write English, made her initial capital in a brilliant way. She got a friend of hers to loan her a large sum of money, got a bunch of furniture, and marked it all only 10% or so above cost so the savings were unbelievable. In a single weekend, she rented out a huge space in Omaha, sold through all of the inventory so that nothing was left, and repaid the loan. The profit that remained, although small in a margin basis, was huge because the volume was so large. She paid off ALL of her personal and business debts, expanded the furniture mart, and never borrowed another penny again.

      She did it in a SINGLE weekend. It changed the course of her life forever.

  • Shaun Connell

    I absolutely love your content on this site and your about.com site.

    I would like to put money into a mutual fund managed by yourself, or buy stocks in your holding company whenever you decided to offer that option. Is there any way I could join a mailing list or something and receive notification if this ever becomes possible? I’m serious!

    I’m between level 3 and level 4. I like the levels concept.