Income is not wealth, but wealth can be income - why it matters

A person earning less than you could actually be wealthier than you because he has made a greater effort to convert his income into wealth. After all, income is a flow and wealth is a stock.

Apr 27, 2018 06:04 IST India Infoline News Service

Negative Market Money
Have you ever wondered why many people who earn stupendous incomes during their active working life, almost end up penniless in later years? If you were to just look across at some examples in Hollywood or even in Bollywood, you will find many such cases. People blame lifestyle, addictions, bad decisions etc. The real reason is that they do not really appreciate the difference between income and wealth. A person earning less than you could actually be wealthier than you because he has made a greater effort to convert his income into wealth. After all, income is a flow and wealth is a stock. To convert income into wealth, therefore, you need thrift, patience and intelligent investing. Let us understand how.

The curious case of Tom, Dick and Harry

To understand the transition of income into wealth, let us look at 3 successful professional artists Tom, Dick and Harry who earn roughly the same levels of income.
Particulars Case of Tom Case of Dick Case of Harry
Monthly Income Rs.180,000 Rs.170,000 Rs.160,000
Monthly Savings Rs.10,000 Rs.40,000 Rs.70,000
Where they invest Safe Liquid Funds Debt Funds Equity Funds
Average Annual Return 6% 9% 16%
Investment period 25 Years 25 Years 25 Years
Total amount Invested Rs.30 lakhs Rs.1.20 crore Rs.2.10 crore
Wealth after 25 years Rs.69 lakhs Rs.4.52 crore Rs.27.76 crore
Wealth Ratio 2.30 times 3.77 times 13.22 times
Corpus Invested in Liquid Funds Liquid Funds Liquid Funds
Monthly Income earned on Liquid Funds Rs.34,500 pm Rs.2,26,000 pm Rs.13,88,000 pm
The above comparative illustration is a clear indication that to create wealth how much you save out of your income matters more than how much you earn. There are 4 aspects about the relationship between income and wealth that emerge from the above case:
  • Thrift has a made a big difference to wealth creation. In the above case, Tom had the highest income but he hardly saved anything. Harry earned less than Tom but created wealth largely because he could run a tighter ship and saved money intelligently.
  • How you invest the money makes a big difference to your eventual wealth creation. For example, Tom invested all his money in low yielding liquid funds as he was keener on safety. Harry realized that the biggest risk over 25 years is not taking risk and hence he allocated money to equity funds. The results speak for themselves.
  • When you save more and allocate these funds into productive equity investments, the power of compounding works immensely in your favour. Consider how the power of compounding has made a difference. Over 25 years, Harry invested 7 times the amount of money that Tom invested but his eventual wealth created was 40 times the wealth created by Tom. That is the power of compounding at work.
  • The above table also proves that income cannot assure you of wealth but wealth can certainly assure you of income. Twenty five years ago, Tom, Dick and Harry started off with the same corpus. When their eventual corpus is invested in safe liquid funds, just look at the difference in the income that Tom and Harry generate. Harry’s wealth is generating 40 times the monthly income that Tom’s wealth is generating with the same level of risk.
The moral of the story is that income is not wealth but it can be converted into wealth. A combination of thrift, allocation to equities and the power of compounding can help create wealth.

Key takeaways from the Income versus Wealth debate

There are 3 very interesting aspects about wealth that you need to remember:
  • Income is something you work for. You basically use your skill to generate income during your productive working years. But income by itself will not make you wealthy. Just as you work hard for earning income you need to make money work hard for you if you want to convert it into wealth. Effectively, you work for earning income but wealth works for you. That is why income lasts during your working life but wealth lasts through your lifetime.
  • Contrary to what is popularly believed, income is active while wealth is passive. To earn income you have to actively pursue your skills on a continuous basis. Wealth happens if you are able to combine thrift, calculated risks and the power of compounding. When these 3 are combined in a disciplined manner, then wealth automatically happens. You do not have to work too hard for it.
  • A key consideration in the conversion of income into wealth is taxes. One of the advantages of equities is that it is tax efficient. Even after the recent 10% tax on LTCG, it is still extremely tax efficient. Taxes can take away a substantial portion of your wealth creation and you need to build that into your wealth model.

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