Stuff Does Not Equal Wealth
People often say to me about someone else they know: “He’s got a lot of money,” or “They’re loaded.” Does that sound all too familiar?
In the course of normal, everyday conversation, educated adults will bring up someone – a neighbor, friend, colleague, someone they know – whom they refer to as “having a lot of money.” And they use this word to mean “personal wealth,” essentially. And since there are different types of wealth – which would have varied economic, accounting, personal meanings, etc. – I will refer strictly to what these people are attempting to convey: genuine prosperity and balance sheet wealth.
Of course, I quickly process the individual’s words, kicks into the skeptic mode, and then I try to verify the statement. So I always stop the course of the conversation and ask, “How is that so? What makes you think they are loaded?” I ask them what signs exist that lead them to say this, what do they think wealth means, or, what’s the nature of that person’s personal balance sheet? Are the assets encumbered by debt, or, is there really substantial equity? At this point, they are checkmated. They have not, of course, spied the balance sheet of the ‘loaded’ individual they speak of. They have no clue as to the source of the accumulation of assets or the funding behind the ultra-consumption. You can see assets and observe the consumption, but without a balance sheet, you do not know to what extent the consumption and assets were financed and to what level the personal equity has been zapped to fund purchases. And I do not do this to knock down people; I consider it a necessary educational process to get folks to start defining their terms.
The typical replies are: “Oh, but he has a Lexus and a Ford Crew Cab, and you should see the suits he wears….” or “They live in the ______ subdivision of _____ and go to Jamaica every year…..” or “He’s an engineer for GM, and she is a ______, and they have got the most beautiful cottage up in ______…” You all probably hear that from folks very often, I’m sure. The explanations for why people are perceived as being ‘rich’ are always tied to vacations, things, adult toys, cars, bragging on the part of the person they are talking about, and of course, the house. The house defines a person’s existence. Peoples’ perceptions of wealth are – in most cases – based on that which they observe in the form of visible material items.
But certainly, this is all poppycock. These types of people, as we know, usually have “things” because they don’t save, they over-consume in relation to their income, and more often than not they incur debt – lots of it – to get the stuff. The last couple of times I heard about someone’s ‘loaded’ friend with great houses, and even better vacations, I acerbically asked, “What do they do for a living?” The first one was a schoolteacher, and the other one was a nurse. Ahem. Amazingly, people just don’t know how to do the quick math.
I am still puzzled by people – especially college-degreed types – being confused between accumulation or consumption and personal wealth. Whereas someone would define someone else as being “rich,” I, upon seeing a balance sheet, would know that this person is oftentimes the opposite of rich: plenty of declining assets, in debt, negative personal equity, and little or no savings. Remember, purchases of assets – the plasma tv, sports car, or the new construction house – if made from cash savings, is merely a reclassification of assets and is not a step up in personal wealth. The Jamaican or Paris vacation, paid for in cash, is a decrease of an asset, an increase to an expense, and thus a negative hit to equity. The 100% financed Lexus – which is typical on a middle-class income – is an equal increase to an asset and a liability that only increases one’s debt-to-equity ratio. A shiny, new car, but there’s definitely no wealth increase here. The purchase has only created a weaker balance sheet and the illusion of prosperity (think of Wall Street financial firms) that is being conveyed to those who don’t understand basic financial concepts.
The accumulation of things, however, cannot ever be equated with personal wealth. A book to read to understand the difference between having wealth and having “things” is The Millionaire Next Door: The Surprising Secrets of America’s Wealthy. Here’s the Amazon review of the book:
How can you join the ranks of America’s wealthy (defined as people whose net worth is over one million dollars)? It’s easy, say doctors Stanley and Danko, who have spent the last 20 years interviewing members of this elite club: you just have to follow seven simple rules. The first rule is, always live well below your means. The last rule is, choose your occupation wisely. You’ll have to buy the book to find out the other five. It’s only fair. The authors’ conclusions are commonsensical. But, as they point out, their prescription often flies in the face of what we think wealthy people should do. There are no pop stars or athletes in this book, but plenty of wall-board manufacturers–particularly ones who take cheap, infrequent vacations! Stanley and Danko mercilessly show how wealth takes sacrifice, discipline, and hard work, qualities that are positively discouraged by our high-consumption society. You aren’t what you drive,” admonish the authors.
If you want to determine your individual wealth, merely looking at income or assets (stuff) is not the answer. Income flows to equity but incurring liabilities for consumption expenses can reduce equity. Acquiring things via revolving credit may add to your assets (a plasma TV or a killer surround-sound system), but it adds to your liabilities as well, so it’s a wash on your equity. Hence, there’s no “wealth” created here. Essentially, you aren’t what you drive but you are what you save. Think of personal wealth in this sense: Total assets minus total liabilities = equity. Real wealth is reflected in your personal balance sheet, not your closet, vacations, or driveway.
America is currently awash in foreclosures and shelters are reporting maximum usage. A foreclosure, or worse yet, homelessness, happens because people live check-to-check. That means they don’t have the cash savings to make one more payment to buy them one more month in their home. What a reckless way to live. Unlike with General Motors, regular folks can’t keep sliding by on massive negative equity with out devastating consequences.
Equity, then, is akin to a pillow-top mattress for a creaky back. An equity cushion means strong financial health and a good night’s sleep. In bad times, equity is a means to self-preservation. Your equity is your stability, your safety net, and your window to real prosperity. Equity on your balance sheet is your real wealth.