The Concept of Financial Escape Velocity

We listen to CNN in Spanish, trying to improve our Spanish while driving to work. At first, we barely understood one word in 10. Now, we’re probably at one in 4.

This morning, we thought we heard the following story.

Researchers asked rich people how much money they needed to be rich. A million dollars didn’t get you very far in the eyes of these rich people. They said you needed $7.5 million, minimum.

Why so much? How much does it cost to live well?

Well, it depends. When we began our career, we worked for $100 a week. That became $100 a day after a few years. And then, it became $100 an hour. And so on. We don’t recall being any less happy at $100 a week than we were at $100 an hour. And today, we would readily trade: make us 25 years old again…and we’ll work for, well, $100 a day.

But as our income rose with our years; so did our expenses. At about $40,000 a year, we bought our first new automobile – a Datsun pickup truck. At $100,000 we had a Volvo and a Ford pickup. And a farm in the country. Every increase in earnings came with a price tag attached. Whenever we thought we were getting ahead, we found some new necessity…something we had to have.

That is why so many people with high incomes have no money. As soon as they get a raise, an entrepreneur offers them something they can’t live without.

In our experience, you can live “as though” you were rich on, say, $350,000 per year. That’s about what two good lawyers…or doctors…or small business people…might earn, together. They pool their earnings. They can enjoy “the good life.” Vacations. A nice house. Nice cars. All the gadgets.

But wait, if you could get a steady rate of return of 3% on your money, that would require $11.5 million in capital. And if you had $11.5 million in real capital, most people would agree – you would be among “the rich.” But you can’t BOTH live off $350,000…as though you were rich…and also accumulate enough money to really BE rich – not unless you’re earning a lot more.

If you only had $7.5 million, for example, at 3% yield, you could only expect income of $215,000. That may seem like a lot of money, but it is hardly the kind of money that would give you and your family a lavish lifestyle. After taxes, health insurance, tuition, autos, mortgage payments, and other real necessities, there wouldn’t be that much left. Wealthy? Yes. Rich, not quite.

But even putting together $7.5 million requires a bit of luck. We’ve been meaning to explain a concept we developed many years ago. It’s called “Financial Escape Velocity.” It describes what has to happen in order for you to build up any serious money.

The general problem is the one we mentioned above. Your cost of living tends to go up with your income. Wants and needs rise to meet the income available to them; that is a financial law as rigorously enforced as the Law of Diminishing Returns or the Law of Supply and Demand. That’s why it’s so hard to be rich and get rich at the same time.

The way to beat this phenomenon is either to exercise remarkable self-control…or to outrun your wants and needs with “escape velocity” wealth. That is, wealth that rockets up so fast, you can’t shop fast enough to keep up with it.

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.

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% per year (just to keep the math easy). You will earn $200,000 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 5 years you’d have $3.2 million – giving you more than 50% more income.

Another place compounding works is in business. Often, businesses reflect the kind of compound growth you might otherwise get from an investment – only, it is less obvious. Accumulated effort compounds like dollars and cents. Work, capital investment, growing expertise and a little luck is a great combination. Earnings can creep up on you. One year, your business earns $100,000. Ten years later, it earns $1 million. And if you’ve been putting your earnings back into the business, you would not have gotten accustomed to spending more and more. Your spending wouldn’t have kept up.

If you had taken your earnings out, the business would have been unlikely to grow. Instead, your expenses would have grown, making it even harder to ever build up any real capital.

But let the business grow, and one day you could realize that you’ve reached the point where your earnings and capital can grow faster than your expenses – financial escape velocity.

And when that happens, best to keep it to yourself.


Bill Bonner
for The Daily Reckoning

The Daily Reckoning