Re-Thinking Wealth Building

Wealth building has become a key topic of conversation in the financial media.  Traditional financial advisors frequently talk about equity and debt.  (aka ‘stocks and bonds’)  This is certainly a part of wealth building, but the current world has become highly complex.  In order for people to achieve their financial goals, they need to think about wealth building differently.  Many people go through booms and busts but never manage to get ahead.  This is especially important for people who over-invest in buying a home and under-invest in other financial assets.

This serves as an excellent backdrop for a deeper discussion on what wealth really is, and what wealth building is really about.  A useful first step in changing the way we think about wealth is to take the dollars out of the equation.  Instead of thinking about our personal wealth in terms of a dollar value, we should think of it in terms of what we own and what is produced by those assets.  To frame the difference between asset types that comprise our wealth, we like to separate wealth into three tiers of assets.  The characteristics of your wealth portfolio in terms of where the assets land on the wealth tiers exerts a high degree of influence on how your personal financial future will unfold.

Tier 1 Wealth-Building Assets:

Tier 1 wealth-building assets are physical assets that generate real cash flows.  Examples of these assets are mines, energy exploration contracts, income-producing real estate, and other such physical property.  The reason for positioning these assets in the top tier is because their physical nature and residual cash flows make them the most dependable and least volatile.  For most people, it is not always practical to have full ownership of physical assets such as this, so it can make sense to invest in companies or investment trusts that own and operate these types of physical assets and pay out a significant portion of earnings to investors in the form of dividends.

Tier 2 Wealth-Building Assets:

Tier 2 wealth-building assets are income producing business enterprises.  The reason why these assets are ranked below physical, cash producing assets is that their returns are typically more volatile.  The upside of volatility is that it frequently exhibits greater growth characteristics, but the downside is that it frequently carries more risk.  By fully owning income from a business enterprise, it allows you to exhibit a significant degree of influence on its financial success.  Many people build their wealth with Tier 2 wealth-building assets in the form of a business and diversify into Tier 1 wealth producing physical assets.

Tier 3 Wealth-Building Assets:

The third asset tier holds investments where the returns are completely dependent on market sentiment in regard to the asset value.  Metals such as gold and silver fall into their asset tier, along with growth stocks that don’t pay dividends.  Home equity is also a tier 3 wealth-building asset, and this is where its danger lies.  When the value of an asset is completely dependent on the sentiments of other people in the marketplace, there is an omnipresent risk of value collapse if market sentiment turns south.  Almost every market bubble takes place in Tier 3 wealth-building assets, as people purchase with the expectation that others will purchase for perpetually higher prices.

What This Means To You

The way to apply this construct to our personal investment portfolio is to determine where our wealth fits on the asset tiers.  Unfortunately, most people have an extremely high percentage of their wealth concentrated in Tier 3 assets that fluctuate in value based on market sentiment and rely completely on value increases from that same market sentiment to deliver their future returns.  When your wealth is concentrated in Tier 3, you will be highly exposed to collapsing bubbles that destroy market valuations as people shift out of a ‘buying frenzy’ into a ‘selling frenzy’ that collapses asset prices.

The most prudent advice for 21st-century wealth building is to push your wealth as far up the ladder of asset tiers as possible.  If you own Tier 3 assets that are highly volatile, seek to shift more of them toward Tier 2 assets that you can influence or Tier 1 assets that are more stable.  By and large, assets in lower tiers tend to be more volatile, offer the potential for higher short-term profits, and involve higher transaction costs.  Many people who are successful in building businesses will achieve better safety and security if they diversify their wealth portfolio to include more Tier 1 wealth-building assets.

As intelligent investors, we should seek to build our wealth around vehicles with strong fundamentals.  We should also seek to minimize the proportion of our assets that exist at the lowest tier.  We should also be mindful to avoid the temptations of “easy money” from Tier 3 assets that are experiencing temporary price spikes.  Attempting to speculate on the movement of volatile assets is an inherently risky business.  In the end, our best opportunity for long-term prosperity comes from sticking to fundamentals and building a high-tier wealth portfolio.