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Probably every reader has heard this puzzle that if Bill Gates (or some other wealthy person) sees a $100 bill lying around, would he pick it up? The answers to this puzzle is often hovering around the questions – how much does Bill Gates make every second and how much time would be spent to pick the money up.
I am using this common puzzle to discuss the common misunderstanding among people about how wealth is built. I would like to call it – “Linearity Assumption”. The misunderstanding is that wealth is created linearly and by active engagement. The idea is that to become “rich” you have to work all the time and if you do not work for a day, you lose wealth. The extension of this fallacy is that the path to riches is making more money per unit of time and also working longer. Now, because the number of hours is limited, the only way to grow wealth, according to the above assumption, is making more money per unit of time i.e. a higher salary or wage– greater value for your time.
The CEO of Berkshire Hathaway, Warren Buffett made a salary of US $100,000 last year according to salary.com1. He is worth US $91.5 billion2 according to the Forbes.com. By a linearity assumption – that would have taken him 915,000 years without even considering any expenses.
Welcome to the ‘Balance-Sheet’
When it comes to personal finance, most people are quite mindful about their incomes and expenses – elements of Income Statement (of the statement of profit and loss), but quite naive at managing their balance sheet – i.e. assets and liabilities. The elements of Income Statement often require active involvement, but the elements of balance sheet requirement good sense of asset allocation – i.e. investment acumen and not active involvement.
Now, coming back the Bill Gates puzzle. Yes, a rich person would pick a $100 bill and would not lose anything because their assets, not themselves, do all the hard work. My intent is no way to suggest that the wealthy do not work. My point is that wealthy people work hard to build assets and make decisions about growing those assets and managing liabilities. The assets can be in the form of own companies, investments is other companies, real estate etc. – something that represents ownership. If managed well, assets grow rapidly due to the compounding effect and has a far more impact on a person’s finance than income.
Most people take quite a different approach – they generally take a liability first, do not necessarily build assets or do not care about growing assets and then spend most of their lives to earn cash for payment required for the liabilities.
Are you aware of the growth of assets compared with the growth of your liabilities ?
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Not Another Income, You Need to Build Assets
We hear it many times that one income is risky, you should build another income through your investments. The problem is that people respond to that guidance by investing in income-assets instead of growth-assets – even when they have a very secure source of income. Investing in income generating assets means slower growth of your assets. Investors either spend the excess income from the investments or struggle to reinvest it and that income ends up in savings account sitting idle.
Instead, understand your personal balance sheet. Evaluate your liabilities and asset composition. Are your liabilities growing faster than assets? Are you actually building assets using liabiltiies or just adding liabilities?
Are You Telling That Income and Expenses are not Important ?
Not at all. My intention is not to encourage people to ignore income, expenses and savings. Ultimately, for most people savings will provide the funds to create assets. We cannot ignore to grow income and manage expenses. But, income and expenses alone does not complete your financial picture. Mismanagement of the personal balance-sheet will end up eating away all your hard earned income even after you took immense pain to save.
Another important factor is that assets can grow much faster that income and generally enjoy tax benefits compared with income.
Wealth is not cash, it is ownership. Your income provides you the cash, but to build wealth you have to build assets and manage liabilities well. Every now and then we hear some film star or sports star going bankrupt. Those people were the topmost earners in the world, but failed to balance their assets and liabilities.
Hi, My name is Sam Ghosh and I am the founder of Wisejay Private Limited and a SEBI Registered Investment Advisor. I have an MBA in Finance from University of Calgary, Canada and completed all three levels of the CFA program offered by the CFA Institute, USA.