Let’s talk about the one force that is both the #1 wealth destroyer and #1 wealth creator and why you need to understand this force forwards and backwards if you want to create and protect your wealth.
The promise of this primer is that you gain some insights into the game of wealth that you may never have had before.
I’ve got two very important questions for you:
- What is net worth? Is it just your assets, or is it your assets minus your liabilities?
- What really determines your standard of living? Is it how much money you have? Or is it how much your money will buy for you?
The core focus of understanding how wealth gets transferred between groups is really understanding the answers to these two questions very, very well.
- If you can grasp that your net worth is equal to your assets minus your liabilities, you’re on the right track.
- If you can grasp that your standard of living is determined not by how much money you have per sé, but how much you can buy with it, you’re getting even warmer.
Because the truth of the matter is that your real future net worth will be determined by how many assets you have as much as how many liabilities you have, as well as how much both your assets and liabilities are worth after you adjust for this thing called inflation.
(Taxes are also a part of the adjustment, but I’m not going to discuss taxes here).
Conventional investment advice and planning doesn’t take inflation into account. At best you get told you want your assets to keep up with inflation, at worst it’s treated as an afterthought.
What I’m telling you here is that inflation is the #1 threat and opportunity to your wealth and your future standard of living. If you don’t understand its impact, at best you might do ok by accident, at worst you’ll get annihilated and you won’t even know what hit you (and I’m serious about that).
Inflation is the #1 determinant of your future standard of living.
To show you what I mean, I’m going to use an example and add to it to demonstrate the impact of inflation in action.
Here is something accountants call a Balance Sheet. You have your assets on the left, your liabilities on the right, and your net worth:
Here we have a monetary asset. We start with $100,000 in assets, and $0 in liabilities, so our net worth is $100,000. Very straightforward.
Now let’s add inflation into it:
In this example, we have an 80% rate of monetary inflation, and when I refer to monetary inflation I’m talking about the money supply. And this is a monetary asset, it’s cash, which has no inherent value in and of itself.
So we start with $100,000 in cash, and after 80% inflation, we end with $100,000.
But that’s not the real value anymore. Because the dollar is now only worth 56 cents because of inflation.
So what’s the new real value of our cash?
That $100,000 is now only worth $55,556 in purchasing power terms.
What happened to the value of our asset?
If we look at the value of our asset from the perspective of what it will buy for us, we just lost $44,444, even though on the surface it still looks like $100,000.
We just lost 44% of our net worth to inflation.
Now let’s say we were smart and instead of holding our net worth in cash, we instead bought something real with it. A real, tangible asset. And we’re going to assume that this time, we keep up with inflation:
Here we start with a $100,000 tangible asset. Our rate of monetary inflation is 80%, and our rate of asset inflation is also 80% (monetary inflation and asset inflation are different). Our asset keeps up exactly with inflation, and after 80% inflation, it’s worth $180,000 in nominal, surface terms.
So on a nominal, surface level we made $80,000.
Until we adjust for the dollar being only worth $0.56.
That means that our real asset value is still worth $100,000 after inflation. So on real, inflation adjusted terms, and what money will really buy for us, we didn’t make anything.
Now, I’m going to show you something that is super simple, but that most people don’t understand (and when I first learned this, I was like, “duh! Why didn’t I think of that?”).
So here, we have $200,000 in tangible assets. We still start with a $100,000 net worth, but this time we have a $100,000 liability.
Monetary inflation is 80%. Asset inflation is 80%, so again, the asset goes up at the same rate of inflation as money does.
So we go from $200,000 in nominal assets to $360,000 in nominal assets, for a nominal profit of $160,000. Not bad, right?
Except that again, the dollar is only worth 56 cents. So what’s the real value of our asset?
It started at $200,000, and it ended at $200,000. We didn’t make any money in real terms. We did keep up with inflation, a whole lot better than if we had kept our asset in cash, but we still didn’t really make anything in purchasing power here.
But let’s see now what happens with our liabilities:
We started off owing $100,000, and we ended up owing $100,000.
But you know how inflation deflates the value of assets? Well, it deflates the value of liabilities, too!
In real, purchasing power terms, a dollar is worth 56 cents. So now, what’s the real value of that liability?
It goes from $100,000 down to $55,556. We made $44,444 on the liabilities side.
And I know that this is really counterintuitive and not exactly how we’re designed to think. But I’m going to show you how these numbers work.
So we started with a $100,000 nominal net worth. $200,000 in assets minus $100,000 in liabilities.
And we ended with a $260,000 nominal net worth. $360,000 in assets minus $100,000 in liabilities.
Our nominal net worth has gone from $100,000 to $260,000.
But you’ve got to remember that 1 dollar is now only worth 56 cents.
So our ending real net worth is now $144,444 in real purchasing power. We are up 44% in real terms.
Does this makes sense?
If not, it’s ok, because we’re going to reconcile this using what accountants call double entry. Meaning that every financial transaction has equal and opposite effects in at least two different accounts.
So let’s reconcile this on the front end:
In real terms, our real assets still equaled $200,000. Because they were tangible assets that kept up at the same rate as monetary inflation, we didn’t gain or lose anything on the asset side.
But because our liability was a monetary liability, its value also went down with the value of money, so after inflation, that $100,000 liability we had is now only worth $55,556.
So $200,000 in real assets minus $55,556 equals $144,444.
Here we’re not doing double entry accounting per sé, but what we’re doing is reconciling the before and after inflation effects on both the nominal amounts as well as the real amounts. This stuff is not intuitive and easy to understand at first, but it’s important to learn how to think counterintuitively if you want to build wealth. So if they reconcile and the numbers equal each other, you’re good to go.
So, in this example, what was the real source of wealth? What really increased our wealth in real, purchasing power terms?
Most people, to the extent that they think about inflation at all, see the value of their homes going up and just assume that the homes are good investments. Or they look at their retirement and brokerage statements and just assume that their stocks and mutual funds are going up in value.
But is that really the case? Or is there something else working underneath the surface and outside the vision of the majority of people that is creating wealth for the people who use it?
If you can answer that question with something other than the dogma that most people use, then you’re light years ahead of most. Because the very first step in creating wealth is to have your moneyvision clear and look at things from different perspectives that most people will never consider.
Most conventional financial advice and financial planning wisdom says to get out and stay out of debt and invest as much as you can in your retirement accounts, the stock market, etcetera and you’ll do just fine.
However, that conventional advice hasn’t turned out well for a lot of people. In fact, a lot of people have gotten burned by market crashes, and many, many more people haven’t done nearly as well as they would have hoped, even though they’ve done exactly what they’ve been told to do by every mainstream financial advice you could possibly hear.
Because inflation is the #1 determinant of your future standard of living, and most financial advice ignores inflation, or at best treats it as an afterthought, you better get to understand this mechanism if you want to create and protect your wealth.
And to understand this mechanism of inflation takes vision, because if you’re blind to this force and to what is really happening all around you, then you’ll likely be one of its victims.
I’m not trying to be morbid. In fact, I’m a fairly positive person (that doesn’t mean I don’t have bad days). I’m trying to be real with you and really clear your moneyvision to the threats against your wealth and money. There are many, many more that I can and will teach you about, but this is the big one.
Having said that, if you can clear your moneyvision and see what’s really going on here, then what’s next?
Well, what we can do is to do what most people don’t do, and that is to take what we are learning here and determine how we can use this to our advantage.
Because if inflation is the #1 determinant of your future standard of living, and understanding that inflation destroys the value of certain types of assets and liabilities, but not all of them, then we can step aside and ask ourselves “well, if inflation is going to be affecting my life anyway, how can I use it to my advantage to create and protect my wealth?”
If you can ask yourself that, if you can change your basic moneyvision to understand these basic forces of economics and turn our new understanding into our benefit, instead of decoying everything that you’ve worked for, if you can use this newfound understanding to improve your own personal financial performance, then I’d say you’re really onto something here J
If you’ve gone through this and are feeling challenged by what you’ve just learned, that’s great! It’s exactly what I was hoping for, because this is not something most people ever consider.
And we will learn and go even further on clearing our moneyvision, but first we have to shift our pattern so that we can see things that others can’t. Because governments all around the world have been creating money, trillions of it, out of thin air, and while we haven’t been hit with a massive inflation storm, that doesn’t mean we’re out of the woods, because we can be hit at any time.