How to Measure Your Wealth
Years ago, I vaguely remember hearing someone comment that it was interesting how differently we measure wealth today compared to British society at the end of the 19th century. This made me realize that most people don’t even know there is a difference; that there are primarily two ways you can think about measuring your wealth and which you choose for your own household will influence how you behave, the capital structure you employ, and how you approach risk.
The first approach is what I call the “American” method of wealth measurement. In the United States, when discussing the concept of wealth, you might hear someone say, “He has a net worth of $5,000,000.” Ideally, and in its most extreme form, this tells you how much money should be left if the person in question sold his or her assets, settled all debts, and deposited the remainder into a checking account at the local bank. (For a substantial net worth, one wouldn’t do that, of course, as it would be far safer to hold U.S. Treasury bills but that isn’t the point of the exercise.) This method of measuring net worth became popularized in the public imagination by the rise of men like Rockefeller and Carnegie, who saw the quoted market value of their holdings march skyward during the industrial revolution as they benefited from scale and efficiency that had never before been witnessed in the history of human civilization.
The second approach, in contrast, is what I call the “British” method of wealth measurement. If you were discussing the concept of wealth a century ago in Great Britain, when London served as the financial capital of the world, you would have heard, “He has a private income of £500,000 per annum.”. This refers not to the estimated net worth of the individual (assets minus liabilities) but, rather, to the household income generated by his portfolio of investments. It represents the money the owner could spend without touching his principal (though this is not, strictly speaking from an economic perspective, identical to a sustainable maximum withdrawal rate; a mistake inexperienced sometimes make when planning for retirement). The total absolute and relative amount of income you earn determines your place among the hierarchy of the rich. Culturally, this particular approach to measuring wealth made sense as estates in the nation were frequently tied up in complex inheritance systems and where, often, the underlying source of wealth – the land – could not be sold or accessed in the same way unrestricted common stock of fixed-income securities could be.
Personally, I believe that the British way of thinking about wealth – focusing on private income – is much more conducive to becoming successful and financially independent. It can also help you stay that way. To use an extreme example, consider the overwhelming number of lottery winners who go bankrupt. If these individuals thought of wealth in terms of private annual income, instead of net worth, it is unlikely they would have spent their principal. The British method forces you to think of money as a tool that produces cash flow, not a pool of finite resources to be expended.
In addition, when it comes to accumulating, maintaining, and growing wealth, all that really matters is purchasing power. A private income allows you to wear nicer clothes, donate more to charity, expand your investment holdings, send your children to college, keep fires in the fireplaces, and food on the table. The higher the private income your portfolio generates, the more goods and services you can afford. Provided you never take on excess debt, your financial stress should be almost non-existent absent extraordinary circumstances.
This can be especially useful when thinking about your portfolio of stocks and bonds. As I have discussed with James, or timmerjames, on the site before, when you get a dividend check from, say, McDonald’s, that is literally your portion of the cash generated by selling Big Macs and fries. When you get a dividend check from Microsoft, you are collecting part of the profit generated from licensing copies of Windows and Microsoft Office.
Taking a private income approach would have made it all but impossible to get creamed by the dot com bubble collapse or the real estate debacle. In the latter case, “cap rates” on rental properties in California had collapsed to near all-time lows long before the market reflected this in the form of falling prices. When you suddenly found yourself taking on the risk of real estate ownership for 5% pretax instead of the usual 10% or better, you would have looked for greener pastures. I heard about several major home builders selling their personal properties before the crash because cap rates had fallen too low for their comfort. They, instead, moved their money to bonds, which offered about the same returns with much less risk and no leverage!
Approach Your Portfolio from a Private Income Perspective
If you approach life looking at companies, real estate, and other productive assets through the lens of attempting to buy private income streams – preferably those that are sustainable and likely to grow at or in excess of the rate of inflation while having a low probability of permanent capital impairment, and you do it while avoiding major liabilities, it is probably only a matter of time before you are rich. This is especially true if you live below your means and shovel a lot of the private income you generate back into the portfolio to buy even more assets that produce additional private income along with regular contributions from your paycheck. It’s a function of the mathematics. From that base, absent non-expected catastrophes, amazing things can happen over 10, 20, or 50+ years. There are no guarantees in life, of course, but these things matter over the years and decades.
As a general rule, most academic literature seems to indicate that a safe per annum withdrawal rate may be 3% to 4% of your principal. That is, the evidence appears to support the thesis that if capital is properly invested and diversified, someone with $10,000,000 in principal should be able to spend and/or withdraw $300,000 to $400,000 a year while sleeping well knowing there is a low probability of his or her treasury running dry. Anything above that and a person runs the risk of ending up broke like the folks on “VH1 Behind the Music”. There are always exceptions and the real world is far more complicated but it’s at least a good starting point to discuss with your investment advisors, tax professionals, estate planning attorneys, and other qualified experts until you can develop a personalized plan.
Update: On May 29, 2019, I released this post from the private archives as part of a special project. In the early years of the blog, this was one of the essays I wrote to help people by sharing the tools and techniques that had allowed my husband, Aaron, and I to become financially independent and spend most of our twenties effectively semi-retired despite having to put ourselves through college, receiving no inheritances or material economic support, and essentially being first-generation everything, all in the midst of the worst recession since the Great Depression.
In the eight long years that have passed since it was first written, a lot has changed in our lives. We relocated from the Midwest to Newport Beach, California in order to have kids through gestational surrogacy. We divested the operating companies we owned at the time in order to launch Kennon-Green & Co.®, a fiduciary global asset management company through which we manage money for other successful individuals and families, including doctors, engineers, entrepreneurs, academics, and executives. As a result of the latter, when re-releasing this post, it was necessary to make a few non-material edits for me to be comfortable with it. Some of those edits included updating the post to the blog’s new template with higher resolution images and improved formatting.