Building a Great Fortune

My last two articles about playing financial offense and defense laid out two different pathways to get rich.  If you make six figures, congratulations!  You can live a life off your income with luxuries that would make John D. Rockefeller jealous.  If you are like most Americans though, your road to wealth lies in saving a high amount of income.  If what you want in life is to build a great fortune that will be studied and envied by billions around the world, you have to be able to combine the two.  A high income plus a high savings rate are two of the four variables that control the wealth you will eventually build.  The third is the rate of return, and the fourth is time.  When you break down these variables, interesting stories and examples abound in America as to how some groups of people build wealth while others don’t.

Doctors and their Wealth in America: Examining the Variable of a High Savings Rate

Look around the web.  How many wealthy 9 figure doctors can you name? My guess for you is not many.  Why not though?  Everyone knows that doctors in the US make hundreds of thousands of dollars a year.  So what gives?  How come doctors don’t build a lot of wealth relative to their income even though they make such large amounts of money?  The answer may surprise you, but many doctors ignore or lose access to the variables that build great fortunes.

When you study psychology, and the role it plays in society with doctors, the results are quite fascinating.  When you visit, how do you judge your doctor’s success?  Not many people I know can tell you the intricacies of successful surgery, nor do I know many who do a deep search on their doctors history to look at malpractice claims.  What most people look at is how well a doctor dresses, and the shiny baubles that he/she possesses.  In technical terms, doctors are bound by something known as signaling theory.

Imagine all the communication that we go through.  Verbal, non-verbal body movements, choice of clothing etc.  Think of yourself broadcasting everything about yourself as something equivalent to the electromagnetic spectrum.  Chances are you only think of verbal communication.  That is the equivalent of the visual spectrum that humans can see in.  In reality though, both are very small parts of the spectrum.  Something like 90%+ of communication is non-verbal.  Your choice of clothing can be seen as the ultra violet, and the way you walk is in the infra-red.  You are aware that it exists, but the influence it exerts, and the assumptions that people build around it are staggering.  When you examine doctors through this lens, interesting things pop out,

Because of signaling theory, doctors know that a large proportion of their patients judge their success not by how well they perform surgery, but by whether they wear a Rolex.  People automatically assume that if a doctor can afford a Rolex, he must be a good surgeon.  In more than a few cases, this can be a valid observation.  Doctors, knowing this, accordingly spend tens of thousands of dollars showing off the best and flashiest because they know their prowess is determined by what they display.  They know that in order to continue making hundreds of thousands of dollars a year, they have to drive the latest Lamborghini to bring in clients.

The reason then, why doctors don’t build high levels of wealth is because many can’t successfully exert proper influence over one variable to building a great fortune: a high savings rate.  Rather than saving a hundred thousand dollars a year that can turn into hundreds of millions of dollars during their retirement, doctors are spending it on high prestige cars, clothes and wine.  If you want to get the full scoop on how far this goes, the book, The Millionaire Next Door, goes into a lot of detail on this.

The Roles that Rate of Return and Time Play in Building your Wealth

When you look at how rate of return impacts your investments simple math can give you the answers you need.  The difference of someone who gets a 9% rate of return vs 12% is staggering once time comes into play.  After 50 years, the person who got 12% will have triple the wealth.  That still introduces too much time into the equation for our purposes though.  Let’s take a look at an American business titan you might know, Sam Walton.  I have talked a lot about 20 year-olds making  good decisions that lets them build a multimillion dollar fortune by the time they turn 65.  What makes the story of Sam Walton so amazing is that he essentially had to start his life over in retail in his forties when his store was taken from him by his landlord.

By getting return on equity figures of 60% plus on his business strategies at Wal-Mart when he was starting, Sam Walton was able to become the richest American of his day.  By making his mission low prices, extremely high inventory turnover, and revolutionizing the distribution system for retail, Sam Walton created an empire that will be studied for centuries.  That incredible return on equity drove extremely high shareholder returns.  Consider that if you invested $10,000 for twenty years and were able to generate a return of 60% annually, you would have more than one hundred twenty million dollars.  That is not a typo.  While ROE and a stocks compounding rate aren’t the same thing, getting a high sustainable ROE makes life infinitely easier when trying to figure out which stocks will make you wealthy.  Rate of return is one of those things where, if it is supercharged, can make up for a lot of shortcomings on the other variables that build a great fortune.

It takes a lot of work to get high rates of return though.  Time on the other hand happens wherever you go, and time is what makes compounding in the words of Einstein, “the eighth wonder of the world.”  What is that interesting fact about Warren Buffett that comes up about his fortune every couple of months?  Oh yes, the fact that that 99% of his wealth was made after he turned 50.  Pretty shocking, but that is the miracle of compounding.  The difference between dying at age 60 and age 90 can have consequences for your balance sheet that are worth millions of dollars.  The lessons there may not make me popular, but they are valuable.  Take care of your health, don’t drink and drive, and avoid dangerous situations.  The extra 30 years of life may mean that your descendants don’t have to worry about paying their student loans, or struggle to put food on the table.  When you go through all of the miracles of compounding, it can and will, be the most important factor as to how much wealth you build.

Building a Great Fortune by Combining the Variables

The variables that will ultimately determine your net worth in life are time, rate of return, your savings rate, and the amount of money you make that you can put to work.  The two most important variables in this equation are time and rate of return.  I can not stress how important it is to take care of your health.  Forget the financial aspect for a moment.  Being in shape means you can go on that 100 mile backpacking trip with your child’s scout trip.  You can play pickup basketball games at work and make friends.  There aren’t many things in life that will make you happier than being healthy.  Bringing finances back into play, it means far less stress and energy have to be exerted because time is a heavy-lifter when you are building wealth.

The next big variable, rate of return, can be a big workhorse if used well.  Combined with time, you have a massive one two punch.  Warren Buffett is in his eighties, and has a massive 80 billion+ fortune.  That is the power of time being combined with a high rate of return.

The next variable: a high savings rate, is of high importance.  If you are spending 99% of your salary on cars, consumer electronics, and food, you will not get wealthy.  Period.  Warren Buffett still lives well below his means, and a significant part of the reason why he is so wealthy is because he saved such a high percentage of the money he made when he was younger.

The least important variable is how much money you make.  While still important if you want to build an eight figure plus net worth, it is the least important variable of the four.  If your goal in life is to build a great fortune, focus on your savings rate by couponing and shopping for deals.  Devote your energies to the projects that have the highest risk adjusted rates of return, and most importantly, take care of yourself so you enjoy life for as long as possible.  If you do all of those, the high income will follow, which will act as fuel to the fire which will aid you on your journey.