People often say to me about someone else they know: “He’s got a lot of money,” or “They’re loaded.” Does that sound all too familiar?
In the course of normal, everyday conversation, careless adults will bring up someone — a neighbor, friend, colleague, or acquaintance — whom they refer to as “having a lot of money.” They use words like "rich," "loaded," and "well off." And they use these words to imply “financial wealth,” essentially. And since there are different types of wealth, I will refer strictly to what these people are attempting to convey: genuine financial prosperity and balance sheet wealth.
Of course, I quickly process the individual’s words, kick into the skeptic mode, and try to validate the statement. I stop the course of the conversation and ask, “How is that so? What makes you think they are loaded?” I ask the person what facts exist that led him to say this, what does he think wealth means, or, what’s the nature of that person’s personal balance sheet? Are the assets encumbered by debt, or, is there really substantial equity? At this point, he is checkmated. He has not, of course, looked at the balance sheet of the "loaded" individual he speaks of. He knows nothing about the origins of the accumulated assets or the funding behind the ultra-consumption. You can see glitzy assets and observe the consumption, but without a balance sheet you do not know to what extent the consumption and assets were financed and to what level the personal equity has been zapped to fund purchases. And I do not do this to knock people down; I consider it a necessary educational process to get folks to start defining their terms as opposed to speaking in marketable sound bites.
The typical replies are: “Oh, but they have a Lexus and an Escalade, and you should see the clothes she wears….” or “They live in the ______ subdivision of _____ and go to _____ every year for vacation….” or “He’s an engineer for GM, and she is a ______, and they have got the most beautiful summer home up in ______…” We hear this kind of muddled thinking from folks all too often. The explanations for why people are perceived as being “rich” are always tied to vacations, things, adult toys, cars, bragging by the person in question (the most obvious sign of hype), and of course, the house. The house, in fact, defines a persons existence.
The critical mistake people have a tendency to make is forming conclusions about someone’s wealth based upon their observations of visible material items. People who have lots of "things" usually have them because they don’t save, they over-consume in relation to their income, and more often than not they incur debt — lots of it — to get the stuff. The last couple of times I heard about someone’s "loaded" friend with great houses, and even better vacations, I acerbically asked, “What do they do for a living?” The first one was a schoolteacher, and the other one was a nurse. Amazingly, people just don’t know how to do the quick math on their common sense calculator.
It is remarkable that people — especially college-degreed types — can’t make the distinction between accumulation or consumption and personal wealth. Whereas someone would define someone else as being “rich,” I, upon seeing a balance sheet, would know that this person is oftentimes the opposite of rich: plenty of declining assets, in debt, negative personal equity, and little or no savings. Remember, purchases of assets — the plasma TV, sports car, or the new construction house — if made from cash savings, is merely a reclassification of assets and is not a step up in personal wealth. And these assets — durable consumer goods — decline rapidly in terms of value. The Jamaican or Paris vacation, paid for in cash, is a decrease of an asset, an increase to an expense, and a negative hit to equity. The 100% financed Lexus — which is typical on a middle-class income — is an equal increase to an asset and a liability that only increases one’s debt-to-equity ratio. A shiny, new car, but there’s definitely no wealth increase here. The purchase has only created a weaker balance sheet and the illusion of prosperity (think of Wall Street financial firms) that is being conveyed to those who don’t understand basic financial concepts.
Clearly, uninformed people have made a mockery of defining wealth and prosperity. Their immediate perception is their reality, and their perceptions are clouded by ignorance and a lack of desire for the facts. Instead, they prefer exaggerated tales that make a bold statement about something they do not understand. Unfortunately, spreading misinformation makes for a far more interesting conversation — think sound bites and hook lines — than putting forth the time and effort to pursue the truth.
The accumulation of things, however, cannot ever be equated with personal wealth. A book to read to understand the difference between having “things” and having wealth is The Millionaire Next Door: The Surprising Secrets of America’s Wealthy. Here’s the Amazon review of the book:
How can you join the ranks of America’s wealthy (defined as people whose net worth is over one million dollars)? It’s easy, say doctors Stanley and Danko, who have spent the last 20 years interviewing members of this elite club: you just have to follow seven simple rules. The first rule is, always live well below your means. The last rule is, choose your occupation wisely. You’ll have to buy the book to find out the other five. It’s only fair. The authors’ conclusions are commonsensical. But, as they point out, their prescription often flies in the face of what we think wealthy people should do. There are no pop stars or athletes in this book, but plenty of wall-board manufacturers — particularly ones who take cheap, infrequent vacations! Stanley and Danko mercilessly show how wealth takes sacrifice, discipline, and hard work, qualities that are positively discouraged by our high-consumption society. "You aren’t what you drive,” admonish the authors.
If you want to determine your individual wealth, merely looking at income or assets (stuff) is not the answer. Acquiring things via revolving credit may add to your assets (a plasma TV or a killer surround-sound system), but it adds to your liabilities as well, so there’s no increase in your equity. Hence, there’s no "wealth" created here. Essentially, you aren’t what you drive but you are what you save. Think of personal wealth in this sense: Total assets minus total liabilities = equity. Real wealth is reflected in your equity on your personal balance sheet, not from your subdivision location, vacations, or driveway.
In America, we are witnessing a record-breaking number of foreclosures. A foreclosure — or worse yet, homelessness — occurs because people live paycheck-to-paycheck. That means they don’t have the cash savings to make one more payment to buy them one more month in their home. They have things, including the home and its contents, but little or no equity to fall back on. What a reckless way to live. Unlike with General Motors, regular folks can’t keep sliding by on massive negative equity without suffering devastating consequences.
Equity, then, is akin to a pillow-top mattress for a creaky back. An equity cushion means strong financial health and a good night’s sleep. In bad times, equity is a means to self-preservation. Your equity is your safety net and your window to real prosperity. Equity on your balance sheet is your real wealth.
Karen De Coster [send her mail] is a Certified Public Accountant, has an MA in Economics, and works in finance and accounting. See her website and her blog. She drove the same GMC truck for 14.5 years until the engine pooped out, and she buys Brie and sushi at Wal-Mart. Her house is not an investment. She does go coupon shopping at Bath & Body Works, but she does not capitalize skin care products on her balance sheet.