By Brad Thomason, CPA
Smith and Jones live on a planet in a galaxy far, far away. It costs $100 a year to live on this planet.
Smith makes $100 a year. Jones makes $200 a year.
Question: Is Jones twice as well-off as Smith?
Answer: No. Jones is infinitely more well-off than Smith.
That’s because Jones has an opportunity to build wealth, and Smith does not. The fact that Jones has a higher income than what he needs for immediate bills breaks the seal on a source of incredible economic power. The money he has above and beyond what gets depleted in the same period that it’s earned, is money of a completely different type. That money has productive capacity – the ability to replicate and multiply itself by way of investment returns.
In time, the amount of money that Jones possesses will come to far exceed the simple sum of each year’s extra portion. The extra $100 he received in the first year may come to be $500 or $600 at some point out in the future, as the result of compounding returns on the original seed amount. Maybe more. Maybe a lot more. And the excess from each successive year is a candidate for getting on the same path to expansion.
One day in the future Jones could have a pile of money that he will never outlive, even if he quits his job. Smith, on the other hand, will not be able to afford such an option. He’ll have to keep matching current income to current bills.
Sometimes we get caught up in very complicated lines of thought when we are engaged in managing our finances. But many of the most important things to remember are also the most basic. Having some investment capital in the first place is the pebble in the pond which sets up all the rings which will grow in the future. For most of us, that capital will come from not spending everything that we earn.
Entry to the club really is that simple. Or maybe straight-forward would be a better term. Because sometimes it is difficult to end up with a little bit of surplus each year. But there’s no mystery about how you become an investor and start the process of building wealth, even if doing it may require some effort, or even discomfort, in another part of your life.
Note also that this dynamic persists all throughout your working years. At any point along the way that you make money which doesn’t get immediately spent, you get to tap into this power source over and over again, in ways that are cumulative at an ever-accelerating rate.
Which, if you stop and think about it for a minute, is pretty dang cool.
Our planet is a little more complicated than the one that Smith and Jones live on. The possibilities for what a person might make, and the range of things that a person might spend that money on, are far more varied. But the financial underpinnings are the same. If you can find a way to turn some of what you earn into productive capacity, you are on the road to being more like Jones. Which, to me, seems a lot better than being more like Smith.
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