Trapping yourself in wealth

This morning I woke up and sat down to continue reading “Family Fortunes – How to Build Family Wealth and Hold Onto It for 100 Years” by Bill and Will Bonner. This really is a fantastic book highlighting the differences between old money and new money. It really is an eye opener and definitely worth your time.

One of the challenges we face is our expenses tend to rise with our income. As our income increases over time, we end up moving to a larger home. We buy more expensive cars. We buy more expensive clothing. We take more expensive vacations. We consume this extra income instead of preserving it.

In the book, the authors explain why old money favors real estate and business ownership as common investments. The main reason is these investment opportunities do not typically allow their owners the ability to easily consume their wealth.

They wrote:

“Typically, people reach “financial escape velocity” when their wealth surprises them. A family may own a farm or an apartment building. The asset is not very exciting, so they forget about it. And then one day, they wake up to the fact that it is in the path of a major development, and they are being offered far more than they expected for it. That’s the beauty of real estate. It does not go up any faster than anything else, but it is hard to spend. As it increases in value, its owner has no more income to dispose of. He is trapped. He gets rich in spite of himself. Nor does he pay current taxes on his rising wealth. This allows him to build wealth on a pretax basis, greatly enhancing the return.”

To see this in action, compare someone who has a net worth of $500,000 in stocks to someone who has the same net worth in 5 single-family homes. Stocks are easy to sell and this makes it a lot easier to lose and/or consume your money. Spend a Sunday touring larger new homes and before you realize it you’re selling off some of your stocks to buy a lovely new home. Hear a news story predicting a big stock market crash and you can log into your account and sell all of your stocks in seconds destroying the long-term compounding.

It is not easy to sell your 5 single-family homes. You cannot log into your account and sell your homes with a few mouse clicks. Real estate forces us to live and spend with discipline. We can’t consume our real estate wealth quickly.

The Bonner’s continue…

“Another way to reach financial escape velocity is by using the miracle of compound interest. You make a small investment. You add to it. You keep at it. Compounding works its magic. After a few years, you may notice that your wealth has raced ahead of your expenses. If you are lucky, you will be able to hide the fact from the rest of the family, allowing the compounding more time to reach escape velocity.

Imagine for example that you have an account that has grown to $2 million, compounding at 10 percent per year. You will earn $200,00 from the account this year. If you take it out and spend it, the compounding effect will stop. You’ll have $200,000 to spend. But your wealth will cease to grow. And your family will have a chance to bring its spending habits up to the level of your income. Better to say nothing and let it run. After another five years, you’d have $3.2 million – giving you more than 50% more income.”

Because real estate is not liquid it forces us to keep our living expenses low allowing our wealth to compound over long periods of time.

The real estate investor won’t be driving a $100,000 car. They’ll be driving a $20,000 car.
The real estate investor won’t be living in a McMansion. They’ll live in an average home in an average neighborhood.
The real estate investor won’t be flying to France for their next vacation. They’ll be renting a house in North Carolina.

“You don’t do an appraisal or even an up-to-date balance sheet very often. When you do, you’re surprised by how much your assets have appreciated. You may feel as though you should increase your spending, but since the assets are not easily converted to cash, you’ll be reluctant or even unable to do so.”

Assets that cannot be sold easily force us to become the millionaire next door. All we have to do is continue holding them year-after-year through all of the ups and downs trapping ourselves in wealth.

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