Specifically, today, you might hear someone say, “He has a net worth of £5,000,000.”. This tells you how much should be left if the person in question sold all of his assets, settled all of his debts, and put the remainder in a checking account at the local bank. This was popularized by the rise of men like Rockefeller and Carnegie, who captured the public imagination. As a result, I call it the “American” way to measure wealth.
[mainbodyad]In contrast, 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 to the household income generated by the investment portfolio and represents the money the owner could spend without ever touching his principal. Due to its origins, I refer to this as the “British” way of measuring wealth. The total absolute and relative amount of income you earn determines your place among the hierarchy of the rich.
I believe that the British way for thinking about wealth is much more conducive to becoming successful and financially independent. Think of all of the lottery winners who go bankrupt. If they instead thought in terms of be money they would earn each year from their wealth, instead of the total wealth they won, it is unlikely they would have spent all of this principal.
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.In addition, all that really matters is purchasing power. A private income allows you to wear nicer suits, give more to charity, expand your investment holdings, send your children to college, keep fires in the fireplaces and food on the table. The higher your private income, the more 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, McDonalds, 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 sales of Windows and Microsoft Office.
Taking a private income approach would have made it 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 off their personal properties before the crash because the yields had gotten to low. They 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
[mainbodyad]If you go through life looking at companies and trying to by the most private income with the least amount of risk, and you do it as you simultaneously avoid liabilities, it is probably only a matter of time before you are rich. Not only do you pour your income back into your portfolio to buy more investments, but truly successful companies are able to raise their dividend at a rate that exceeds the rate of inflation. Add in regular contributions from your paycheck and it is simple to see how you could create a source of significant private income after 20, 30 and 40 years of investing.
By every statistical study I’ve ever seen, the “4% rule” holds true. That is, you could spend 4% of your net worth each year without worrying about running out of money if it is properly invested and diversified, even if we went through another Great Depression. Someone with $10,000,000 in investments should be able to spend $400,000 a year without worrying about the Treasury running dry. Anything above that and you risk ending up like the people on “VH1 Behind the Music”.