In the last post, I discussed how wealth and income are mostly interchangeable, as debt allows one to convert income into wealth, and investing allows one to convert wealth into income. I noted one primary advantage of wealth (at least in the United States): income from invested wealth is taxed at about half the rate of income from labor. For answering hypotheticals like “would you rather have a guaranteed job that earns $250k/year or a lump sum of $3 million?” the difference in tax rates might be one of the most important factors to consider. But from a more pragmatic “how should I make financial decisions in my day to day life?” perspective, there is another, more important reason why wealth is more powerful than income.
The main reason that wealth is more powerful than income is that it is more robust. It’s relatively easy to lose your source of income: for many people the majority of their income comes from one job, and losing that job means you’ve suddenly lost all your income. There are many reasons you might lose your job, and they’re often out of your control. You may be able to find another job quickly and recover your income, but it could also take months or years to find a new job, and/or you might need to take a pay cut. So income is far from guaranteed over the course of your working career.
Wealth, assuming it is invested in a well diversified portfolio, is much more stable since it doesn’t depend on a single industry or company like income does. There are times when your wealth will decrease, but the worst recessions in recent history have at most cut wealth (or more precisely: stock index values) in half, and in all of these cases the markets recovered within the next decade. This doesn’t mean there will never be a market destroying apocalyptic depression, but if that happened, it would wipe out all sources of income as well.
Wealth is also more robust than income because converting it to income through investing results in a positive feedback loop of building more wealth. If any of the income that you generate is disposable, you can invest that excess, and your wealth will grow through the power of compound interest. Converting income to temporary wealth through the use of debt doesn’t have a comparable positive feedback loop. Your debt being paid off has no influence on your underlying income, so after you’re able to pay off debt you’re typically back where you started. And in the unfortunate case where you lose your income before your debts have been paid, compound interest will be working against you. Your debts will keep growing while you can’t make payments on them, without providing you any additional value.
So, from a personal finance perspective, it is important to accumulate wealth. But you should do this by accumulating true wealth, slowly saving money from your disposable income over time. Leveraging income to borrow large sums of money won’t truly make you wealthy – it may feel like it while you get to spend money you don’t have, but if you ever want to retire you can’t depend on income alone.
