| (page 2 of 2) Let’s work through an example. A recent college graduate might have a starting salary of forty thousand dollars, for a business or econ major. Humanities would be lower; engineering would be higher. Let’s forecast a working life of 40 years. Thus, if they never got a raise, they would collect at total of $1.6 million in salary over their working life. Instead, let’s project raises of 8% a year for the first 25 years and 3% a year thereafter. The power of growth is such that they would earn $8.2 million over the full forty years. However, we are not immortal, so combining this with standard mortality experience from the CDC website, an average person in this situation would be expected to earn about $7.7 million during their working life. This needs to be discounted. At a 10% interest rate, the present value of compensation portion of that recent graduate’s wealth is $980,000, which is just shy of a million, pre-tax. Tax rates can go up and down. I’ll assume that, on average, taxes eat a third of your income, leaving our hypothetical recent grad about $650,000. To get a complete picture of their wealth, you would deduct the value of any loans outstanding, and add in the value of any investments and the present value of any future transfer payments, assuming social security doesn’t go bankrupt first. What can you do to make yourself wealthier? You can raise your expected income or lower your personal discount rate. There are two main ways to raise your expected income: saving money will increase your future investment income, or investing effectively in yourself by education to increase your value in the job market. Your personal interest rate is subjective. If you engage in unsafe sex with dubious partners, smoke, drive after drinking, or drive a Yugo, the number of years you will earn an income is uncertain. Therefore, the interest rate you should use to discount your future income is higher, so its present value, your wealth, is lower. Cut those and other destructive behaviors out, and exercise, and your wealth increases. The proverb that speaks to this is, “without your health, you have nothing”. Another influence on your personal interest rate relates to your patience and self-discipline. If you are a credit card junkie, paying high APR’s, then it is hard to argue that your interest rate is lower than what you are willing to pay. If we recalculate the recent graduate’s wealth using an 18% interest rate, it plunges to about $270,000, or less than 42% of what it was when we used 10%. An “I really want it NOW” attitude is going to cost you, big time. By this definition of wealth, are you a millionaire? Even without any money in the bank, the answer could be “yes”, if you are young enough, with a good enough income and good prospects for advancement. But unlike the traditional definition, under this one, you still have to work to earn your wealth. And, of course, a million isn’t what it used to be. The point is not to brag about achieving a particular milestone, but to help you plan and keep track of your progress. If you are young or are giving advice to some who is, there is a temptation to think that at that age, their choices don’t matter, when in fact, the consequences are magnified as they carry forward throughout their lifetime. Like the ad says about what some luxury will cost you in future retirement savings, you will still be paying for that sports car you bought when you land that great job well after the last payment has been made and well after you have traded it in. There are two types of mistakes people make, undervaluing and overvaluing themselves. If you are young and cash poor, don’t undervalue yourself and treat yourself shabbily, particularly when it comes to taking needless risks. Don’t drive around in a car with bad brakes and bald tires. Measure your wealth as the present value of your future income and you will decide that you can afford to take better care of yourself. Later, when you have more money in the bank, ask yourself if drinking Dom Perignon at $150 a bottle is a good idea, when you have always thought Veuve Cliquot, at a quarter of the cost, was an excellent champagne. You can “live a little”, but just because you have amassed some dollars, don’t lose your sense. Don’t get carried away by either extreme. |