Being ‘Rich’ vs. ‘Wealthy’

We often hear the terms rich and wealthy thrown around interchangeably, but they have different connotations. Someone who is rich tends to have plenty cash (this is subjective and depends on your background) at the current moment. On the other hand, a wealthy person tends to possess assets that generate money passively.

It is possible to be rich, but not wealthy. These are individuals who make above average incomes, but tend to immediately spend their money. There’s nothing wrong with this, but it generally makes life a little more challenging down the road. Spending your money immediately vs. being disciplined by saving and investing it guides people towards challenging financial situations. Having the patience to allocate a portion of your capital towards savings and investments helps generate wealth and increases your net worth. Building wealth is inextricably tied with building your nest egg (definition #2, not #1).

A relevant analog would the be the great Stanford Marshmallow experiment. This simple study examined the effects of delayed gratification. A population of young children had two choices – either receive one marshmallow (or whatever your favorite vice is) now, or wait a short period of time and receive two of them. Being patient and decisive with your money nets larger benefits in the future, particularly thanks to compounding.

Why choose wealth over being rich?

Let’s put this in perspective and look at this simple example with 2 people. We’ll look at their financial nest eggs during their careers and retirement.

  • Person #1 aka Bob:
    • Post-tax income of $100k
    • Annual expenses of $90k
  • Person #2 aka Juan:
    • Post-tax income of $100k
    • Annual expenses of $80k
  • For both:
    • 20 year careers
    • Post-tax income stays constant for simplification
    • 7% return on their nest eggs (average historical, real stock market returns)

Working Years

Years workingBobJuan
1$10,000$20,000
2$20,700$41,400
19$373,790$747,579
20$409,955$819,910

Note that this is a simplified example, but it conveys the point. Bob and Juan have identical career paths and income (it’s quite amazing really…). The main difference is that Bob spends $10k/year more for the 20 years of their careers.

Bob and Juan are both considered rich in most parts of the US, but after 20 years Juan is wealthier as his nest egg is about 2x. These two don’t plan on working forever, and after they hit the 20 year mark in their careers, they want to look forward to greener pastures. Let’s examine what happens in the next phase of their lives.

Retirement Years

  • Person #1 aka Bob:
    • 3.5% return on nest egg ($409,955)
    • Annual expenses of $45k
  • Person #2 aka Juan:
    • 3.5% return on nest egg ($819,910)
    • Annual expenses of $40k
Years in RetirementBobJuan
1$409,955$819,910
2$379,303$808,607
12$7,132$671,364
13-$37,618 (out of money)$654,862
36$66,283
37$28,603
38-$10,396 (out of money)

During retirement, let’s say they each spend about half of their current annual expenses during this period – so $45k for Bob, $40k for Juan. Let’s assume they earn 3-4% on their nest egg during retirement and shift towards a risk averse portfolio consisting of fixed-income assets.

Here are the main takeaways:

  1. The 3.5% rate of return implies Bob gets a retirement income of ~$14k while Juan has an income of ~$28k during their first year of retirement. This number decreases as money is withdrawn from the nest egg, but Juan clearly benefits from his higher savings rate during his working years.
  2. Bob runs out of money in 13 years! Assuming both he and Juan retire at 65, Bob will be out of money by 78. Juan on the other hand will run dry after 38 years of retirement, or when he hits 103. Juan with his higher savings rate yields about 25 extra years of retirement without financial worry.

Even with the simplifications in this analysis, there’s no doubt that the effects of being able to grow your nest egg, and wealth, are hard to argue against. Being able to forego luxuries in the near time will improve the odds of you living a financially secure future. The other important realization is that even with a lower income, if you can maintain a healthy savings rate, you can become wealthy.

Remember – two marshmallows are always better than one.

Guide: Money Management Basics

Overview

We’ve created a simple flowchart of what to do with a paycheck. This won’t be perfect for everyone, but provides a good starting point for being smart with your income. Following these steps will help get you on the right track (if you already aren’t) or accelerate your saving & investing goals.

Recession

NBER (National Bureau of Economic Research)

Recession [noun] — a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

ELI5

The NBER definition explains that a recession is a drop in economic activity apparent through GDP (gross domestic product) decreasing for more than a few months. GDP is simply the financial value of all goods and services (cars, planes, candy, IT consulting, etc.) created within a nation’s borders. Intuitively, this makes sense as when the economy struggling, you expect to see a decrease in overall productivity. Typically the GDP growth rate (how much it increases from one month/quarter/year to the next) is negative.

More importantly — what exactly happens during a recession? Here’s a short list of typical scenes.

    • Unemployment – This will tend to increase during a recession. Companies start to struggle as demand for goods and services will decrease thus reducing the number of employees necessary to make goods and services.
    • Home prices – Home prices tend to drop as well. People might struggle to pay their mortgages due to financial hardship, and foreclosures become commonplace. An oversupply of homes and dwindling demand leads to a decline in housing market prices.
    • Interest rates – The Federal Reserve will decrease interest rates during a recession to help incentivize people to borrow money and spend. Lower interest rates makes it ‘cheaper’ to acquire a loan. This is a move made to help stimulate the economy during a downturn.
    • Consumer & business spending – Just as unemployment increases and consumers have less cash to spend, businesses also tend to become more cautious just as consumers during a recession. They tend to refocus on cash generating aspects of the company cutting on departments such as R&D and taking steps to reduce risk.
  • Government debt – As business spending decreases, the government tends to ratchet up spending to help with unemployment benefits and other social welfare programs to assist those in need.

Recessions are a natural part of the economic cycle we live in, but most people are probably just wondering — how do I protect my family’s fiscal health during one? Here’s a short list of actions to take before and during one.

  • Before
    • As mentioned in the budgeting section, ensuring you have an emergency fund with at least 6 months of money will help you get through this downturn. It’s worth increasing your savings rate during a recession to handle any unforeseen mishaps.
    • Tackle as much debt as you can before the recession. Job loss is one of the toughest parts of a recession so making sure you are in a position to handle loan payments successfully is critical.
  • During
    • If you don’t have enough money to last through the recession, it’s crucial to cut down on discretionary spending. Look at the budgeting article to get an idea of what to drop. Some low hanging fruit would be eating out and entertainment costs.
    • Be a stellar employee – keep your head down, ignore what might be happening to your portfolio, and get your work done. Battling through a recession is as much mental as it is material. If you can put yourself in the right mindset and brace yourself for impact, you’ll be better off for it.
    • Do not panic sell your investments. Stock market drops significantly before and during a recession. Put some money into fixed-income investments that will provide cash flow through dividend and yield income.
      • In fact, periodically investing your money into the market can have significant upside during a recession. The S&P 500 has gone up ~275% since it’s low point in 2009 (that’s a 2.75x return)! Don’t try to predict the ‘lowest point’ of the stock market in a recession, it’s like catching a falling dagger, just be disciplined and invest with a schedule.

Detailed Definition

What causes a recession?

In the US economy, there is typically only a small fraction of cash circulating. Most goods and services aren’t purchased with cash — they are acquired with credit. This enables individuals and businesses to accelerate their growth by having access to money that they don’t have right now.

The creation of credit is balanced by the creation of debt. Of course, the individual or business will have to repay their loan with interest. With the distribution of more credit, the economy becomes more and more leveraged. Businesses will grow as inflation and interest rates tend to rise while the market ‘heats up.’ With prices for goods and services rising quickly, demand for them might start to wane if income doesn’t increase concurrently.

There are situations where industries or markets (i.e. subprime mortgages) pass a tipping point and become over-leveraged when folks aren’t able to make their payments on time. This leads to an increase in the default rate with banks not acquiring their expected payments during a loan period.

As a result of banks having a liquidity shortage, and they end up reducing their level of lending which makes makes borrowing more challenging for businesses to start, grow, or sustain themselves. Since businesses aren’t as productive as they once were, this typically contributes to a decreasing GDP since fewer goods and services are being produced – marking a recessionary period if this occurs for at least a few months.

When individuals and businesses overextend themselves and become too aggressive with their spending plans, it creates a credit crunch that serves as a catalyst for an economic recession.

Consumer confidence predicts how likely consumers are to spend their money. When consumers sense a recession coming about, this metric declines as people choose to save their money rather than invest. Individuals begin to sell assets and store cash while divesting from the market. More people see stocks tumbling and consumer confidence dropping it creates a positive feedback cycle.

How does country overcome a recession?

Now how do you combat a recession now that it’s in full swing? The government and Federal Reserve are the primary fighters in this battle. That’s right the Federal Reserve is actually a completely independent entity from the government! They end up serving both public and private markets and act as an in-between of sorts.

There is a blend of fiscal policy and monetary policy. Fiscal policy involves the government cutting taxes and increasing spending while monetary policy is the Federal Reserve decreasing interest rates and increasing the money supply to steer the economy in the right direction (the cases I listed are generally true, but not always). For a much better detailed explanation of the two policies, check out this link. which details the the various levers of the government and Federal Reserve during a recession.

Other than the subprime mortgage crisis, two other debt markets susceptible to defaulting are ballooning credit card & student loan debt. Credit card debt levels surpasses $1 trillion while student loan debt bumped passed $1.5 trillion in 2018!

Time Value of Money (TVM)

This one’s going to be all ELI5. Tried to keep out the gory math details for this. Goal is to provide intuition on this topic and help provide a basis for future discussions.

There are a couple of fundamental concepts with regards to money that are useful to understand. One of the most important is the time value of money. This sounds a lot more intimidating that it actually is. The definition is that a sum of money now is worth more than the same amount in the future. Let’s make it concrete and look at a couple scenarios.

Example #1

You have the following two options in this case —

  • Option #1: You take $100 now with a (almost) risk-free 2.5% interest rate investment.
  • Option #2: You take $100 one year from now.

If you can place your money in an investment like a 1-year US Treasury bond for an interest rate of 2.5%, you take Option #1. You’d invest your money in this bond, and at the end of the year receive $102.5 ($100 + 2.5% * $100). If you took Option #2, at this same time you’d only get $100. You end up making $2.50 more with Option #1.

We’re capitalizing on the earning potential of money. Money that rests as cash, isn’t living up to its full earning potential, so generally we invest that money to make use of its potential.

The two follow up ideas are present value (PV) and future value (FV). The present value of money is the current value of a future sum of money based on a discount rate. In contrast, the future value of money is the future value of a current sum of money based on a growth rate.

In the example above where we were looking at time value of money, we were actually calculating the future value of money. In Option #1, the present value of $100 has a future value of $102.50 at the end of a year based on an interest, or growth rate, of 2.5%.

Example #2

Now, let’s take our example above and spice it up. Here’s case #2 —

  • Option #1: You take $100 now with a 2.5% interest rate investment.
  • Option #2: You take $105 one year from now.

Now the question really is – how do we compare the two options? Which one’s better? There are a couple ways to do it.

Method #1

Compare the future value of Option #1 with Option #2. From the earlier case we know the FV of Option #1 is $102.5. This is less than Option #2, so we’d rather go with Option #2.

Method #2

Instead of comparing the future values, we can also compare the present values. PV for Option #1 is $100. What’s the PV for Option #2? In other words, how do you determine what the value of $105 in a year is right now?

Similar to the interest rate which projects forward in time, we also have the discount rate which projects backwards in time.The discount rate helps us translate some future value of money to the present value. We can determine the PV with some very straightforward math. We can start by using the formula from Option #1 actually.

P = Principal (initial investment amount) 
i = Interest Rate
V = Value after one year

Simple interest formula for one year investment. 

V = P + P * i 
V = P (1 + i) 
P = V / (1+i)

In our example, V is $105 and I is 2.5% for the 1-year Treasury bond.
Let’s swap out V and i with these values.

P = $105 / (1 + 2.5/100)
P = $105 / (1.025)
P = $102.44

That’s it! Not too much math. The present value of $105 at the end of one year is equal to $102.44 at present. Now, we can ask ourselves is it better to have $100 or $102.44 now? Hopefully you answered the latter. Even with this method, we arrive at Option #2 being the best case. It’s important to note that this factors in present value for one year. Things get a little more interesting when looking at multiple discount rates, varying cash flows and discount rates. Let’s table that for later.

A couple important concepts to extract from this. In the equation, the bolded value of 1.025 is the discount factor. It’s a factor that lets us figure out the PV from the FV. The discount rate is the % value of 2.5%.

It’s important to realize the present value calculation depends heavily the discount rate. This number is an estimate – there’s no way to be completely certain what this will be in a year and even less so ten years from now. However, this method is useful in providing a way to compare and evaluate investments.

Hopefully you gained some intuition from the example, but you might be asking what’s the use of this? If you know of potential cash flows in the future, like the $105 you’d receive in a year, you can effectively compare them with your current investment options. If the present value of these future cash flows is higher than the initial amount you have, then it’s a good option.

Budgeting

Oxford Dictionary

Budgeting — [noun] An estimate of income and expenditure for a set period of time.

ELI5

Many people associate budgeting with something that needs to be done when money is tight – which is true. However, there are many people including those making more than the median income that choose to budget as well. Lifestyles will vary based on your job, your family, and other needs and budgeting is a useful way to help maintain that.

A budget, for personal finance, is setting a limit in spending in various categories of life expenditures – whether short-term, mid-term, or long-term. A monthly budget, for example, would include an expected spending limit for rent, food, utilities, insurance, etc. Another budget could be a savings budget for the downpayment on a house. The term is used quite flexibly, but it’s really a method to help someone gain more control of their finances and understand what’s coming in and what’s leaving.

Even though building a budget seems like an added burden – keeping track of income and expenses closely, it can provide greater freedom and flexibility in the future. Preparing to purchase a new car, house, or putting a child through college are events that generally require patience to save for — and something a budget can help expedite. In addition, by ensuring you have money in the bank, i.e. an emergency fund, you can spring back from sudden mishaps or unforeseen accidents such as a hefty medical bill, car maintenance, etc.

 

Detailed Definition

There are some basics steps to budgeting that include: understanding what you are saving for, estimating income and expenses, building an emergency fund, and growing a nest egg.

Like mentioned before you can have different types of budgets – a monthly one to understand how money is flowing in and out of your account or a long term budget to help save for a car or child’s college tuition. Depending on what you are saving for and the timeline, the strategy for how aggressively you budget will vary.

For a medium term item, such as saving up for a downpayment for a car, building a budget will help an individual think about what expenses can be pared down to facilitate the savings growth. After reviewing the last couple months, you might notice that a great sum of money is spent on eating out. By switching to a home-cooked diet you can shave off a couple 100 dollars and be able to get that brand new Tesla that much sooner without breaking your wallet!

Now that you’ve thought about what your budget is for, the next step is to do a deeper dive into the money flow. Hopefully, you have a good idea of how much money you are bringing in per pay period — this counts as income. Disposable income is the money left over after taxes. There are typically two types of expenses in personal finance – fixed and variable.

Fixed expenses are recurring costs such as rent, insurance, and subscriptions that you can expect on monthly or annual basis. These payments are useful while budgeting cause they stay constant, but also inflexible since most individuals have little control over them once they are set.

Variable expenses are dynamic costs that tend to change month-month and these include food, utilities, entertainment, and discretionary spending. Given our gig-economy with great services such as Grubhub, Doordash we quickly can find ourselves overspending on delivery for example. Unchecked variable expenses can quickly place people in tight financial situations. At the same time, people have more control over variable expenses — instead of doing delivery every night, they can save some money on groceries without too much added effort.

It’s a useful exercise to review the last couple months expenses to figure out what your fixed expenses and variable expenses are. There are fantastic services such as Mint and YNAB that enable people to quickly gain an understanding of their finances by connecting bank, investment, and retirement accounts in one centralized location — so you don’t have to keep track of receipts and credit card statements.

In the world of budgeting, a critical concept is being ready for unforeseen, mandatory expenses — i.e. a hospital bill for an injury or a sky-high car repair. An emergency fund is generally agreed to be 3-6 months of living expenses saved in a highly liquid account (checking or savings) so it can be withdrawn almost immediately. Having this allows an individual to not take out an emergency loan with high interest which can quickly place a person in a tricky financial state.

Credit & Debt

Oxford Dictionary

Credit — [noun] The ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.

Debt — [noun] A sum of money that is owed or due.

ELI5

Credit is a concept which exists through a handful of more practical ideas. This includes credit cards, auto and home loans to name some. Ultimately, utilizing credit can enable you to access something now that you can’t entirely afford with the money you currently have. This can be useful when you want to buy a house or purchase your first car. These items might not be attainable with the limited cash one has. However, by engaging in a credit contract where you agree to borrow the rest of the money needed from a creditor (or lender) and agree to pay them back at some point plus some extra amount (known as interest), you can acquire the desired item. At this point, you are in debt and are responsible for paying back that money to the creditor. It is important to not overuse credit and end up violating the payment terms of the credit contract.

There are many types of credit – mortgages, automotive, student, etc. A standard example would be a first-time car buyer. Let’s say John is going to buy a blue Honda Civic for $19,000. He only had $5,000 to put down, so he will have to go to a bank to get the other $14,000 (known as a loan) needed for the car. In doing so, he is using credit to acquire an item of value now, and he will have to repay the $14,000 plus the interest (which ranges from 3-10%, so $420 to $1,400 in this case).

The information above focuses on the personal finance definition of credit. When dealing with accounting, credit has a slightly different definition we’ll discuss later.

Detailed Definition

Credit, more formally, is an agreement where a borrower receives an object or item of value and agrees to pay back the lender (or creditor) at a future time typically with interest. Interest is the additional fee or charge the lender requires the borrower to pay in exchange for using the item of value at present. As mentioned above, credit allows you to stretch from your current cash position by letting you use money or gain something you don’t have at the present.

Credit Score – How It’s Calculated

To make things more concrete and useful — practical indicator of credit involves an actual ‘score’ or your creditworthiness. This conveys how safe of a borrower you are to a lender, i.e. how consistently and quickly you are pay off the debt you are in.

This number is calculated from a variety of factors with some weighing more heavily than others. Typical factors that weigh on your credit score: payment history, credit utilization ratio, length of credit history, credit inquiries + new accounts, and type of accounts.

Payment history (~35% of score) demonstrates how consistently you can pay a loan over time. Generally, people who engage in some form of credit and pay off the loan in a timely manner have higher credit scores than someone with no credit history.

Credit utilization (~30%) is the other heavy-hitting component of your credit score. It is the ratio of your total credit card balance divided by your total credit card limit. A lower credit card utilization is typically better – it means you are more likely to be able to pay off your balance and less likely to default.

Length of credit history (~15%) of your score. The longer an individual’s credit history the more trustworthy lenders view the individual. This consists of how long certain credit accounts have been open and how frequently they are used. Type of accounts (~10%) can also cause your score to fluctuate — there are two types of credit accounts installment credit and revolving credit. Installment credit is like an auto or home loan that has fixed payments every month (typically). Revolving credit tends to be more risky as you are allowed to borrow up to a certain limit and forced to pay interest (i.e. credit cards).

Credit inquiries (~10%) can adversely affect your credit score. If a lender or landlord inquires about your credit this is recorded on your credit report. When this occurs several times, it will hurt your credit score. New accounts are trickier — while it is good to have a handful of credit accounts that are being paid regularly and not accruing too much interest, opening several in a short time span will hurt your credit. Imagine someone is short of money and they need to access credit to pay off a large new boat. They could acquire multiple credit cards and max out their credit limits on each, and then be charged significant interest on those cards quickly placing them in a tough financial situation.

Public records that contain information about filing for bankruptcy or being repossessed can negatively affect your score.

How is a credit score used?

The credit score provides a quick way for a bank or lending institution to evaluate you as a reliable borrower — if you will pay back the item of value with interest. Before you buy a house or a car, the bank will examine your credit score to assess how reliable you are with credit and will give you a lower or higher interest rate on the loan. Third party agencies such as FICO, Experian, etc. will provide approximations for a credit score. Scores typically range between 300-850, with 300 being a very poor score and a total credit risk and 850 being extremely high and no credit risk. As a lender, the higher the score for a credit applicant, the more likely you are to let the individual borrow money.

What is money?

Oxford Dictionary

Money — [noun] A current medium of exchange in the form of coins and banknotes; coins and banknotes collectively

ELI5

Money – we use it everyday and barely think about it other than trying to figure out how much to tip the waiter or how much to pay a roommate for rent. It is an object that has some agreed upon value and can be used to exchange for other goods or services.

In the old days, the barter system was the primary form of getting your groceries. I’ll give you 5 bananas for 10 apples. Now, let’s say you are looking for some rope as well, and the craftsmen will only accept onions. You have the 5 bananas I gave, but they are useless in this situation, and without this rope…things aren’t looking good for you. This is where money comes in — it acts as a middle-man by everyone agreeing that it is of some worth and can be easily exchanged. One note – apples, bananas, and onions are all forms of money actually, but they are considered commodity money.

Now let’s switch the previous example to coins. I’ll pay you 20 coins for the 10 apples. The rope is only 10 coins which you can directly give the craftsmen instead of trying to find these precious onions — it makes the whole system much more efficient. In the case that the rope is higher quality — you might have to pay 15 coins, thus the price in coins indicates value of the good as well.

Detailed Definition

Money ultimately has three major purposes in the world today: medium of exchange, value indicator, store of value.

Commodity Money

We most commonly think of money as (typically) round pieces of metal or paper notes containing some inspiring or historical information about a country or government. Several millennia ago, farmers would utilize their surplus to trade for other goods. The grain or wheat that they would trade for fruit and vegetables is a form of a different type of money called commodity money — since the item being used as money has significant intrinsic value. Traveling from one area to another with a cart full of grain or livestock only to haul back some other unwieldy good proved inefficient and inconvenient. There are still many downsides to a commodity based coin system since the worth of the coin is inherently tied to the commodity it is comprised of.

Permanent Store of Value

King Alyattes of Lydia (modern day Turkey) was likely the first to introduce a coin based system of money. The coins contained a lion’s head emblem providing guarantee of value by the government and a level of accountability. The Lydian staters, as they were known, were composed of electrum – a naturally occurring gold-silver alloy diluted by copper which actually gave them the gold hue. Both gold & silver are trusted and valued commodities so people had faith in the coins retaining a more permanent store of value. This was extremely convenient compared to commodities – imagine several silos containing your surplus of grains getting spoiled due to a large flood, etc. The stater were easily transported and could be stored in a safe place to protect against weather or robbers.  

Value Indicator

Another critical aspect of this system was that each coin was standardized to a weight of about ~220 grains of wheat. When going to the market, a farmer didn’t have to spend time weighing gold and silver ingots as done before coinage was developed — a merchant knew that the Lydian stater represented this fixed amount providing an indication of value.

Lydians are the first known group of people to use a coins, but similar systems were developed in China [necklaces with bronze pendants — essentially creating a wallet while also showing off how wealthy you are] and India [where shells were used instead of coins].

TRANSITION TO FIAT MONEY

The next big transition in money comes during the transition of commodity money to representative or fiat money. Fiat money holds no significant intrinsic value unlike a commodity — a copper-plated zinc coin (i.e. a penny) or rectangular piece of paper with values and pictures printed on them isn’t worth more than a few cents. However, when the government issues these notes and decrees “This note is legal tender for all debts, public and private,” it makes things more interesting. If the entire US government sees these pieces of paper as worth some value — businesses and individuals are more incentivized to use them.

In fact up until 1971, in the US every dollar was backed by some gold or silver by the government. This forced the government to accrue a larger supply of gold whenever it had to print out more notes — self-limiting the supply of currency. That means based on the price of gold or silver, you could exchange a certain amount of your greenbacks for a physical commodity. After 1971 when Nixon officially seized the ‘gold standard’, that piece of paper can’t be exchanged for anything — but since such a large quantity is in supply today and widely accepted as a form of exchange with a store and indication of value it’s challenging to imagine it not being worth anything.