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|
|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.
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.