The Money Equation

This is the basic money equation. I cribbed it from the first law of thermodynamics, an energy equation. This is not much a reach for me since one of the ways I view money is as a form of energy.

∫ (Money In) d/dt = ∫ (Money Stored + Money Spent) d/dt

(This equation is integrated over your lifetime)

There are two sides and three parts to this equation. I thought it might be useful to reflect on what it all means.

When I talk about Money In, I mean your salary over the course of your working life. One of the ways to optimize the money equation in your favor is to make this number very large when compared to your expenses. As I have mentioned before, the strategy that I used over the course of my working life was, “Get another degree. Get a better job.” It worked pretty well. A few years before my retirement, my income finally inched up into the top quintile. Sadly, “the good job” is a vanishing commodity in this country. There are too many people with too many degrees and just not enough stable wealth creating jobs. Today everyone needs to start thinking more like an entrepreneur. More than ever, you are your product. Even with relatively scarce degrees like a MSRN or a degree in engineering there are no guarantees of lifetime employment. In fact it is unusual for a person in their twenties or thirties to remain with the same company for more than four or five years. The world is changing too fast. Today the newspapers are full of stories about high school dropouts earning $100,000 a year programming in some new language. Tomorrow there is an oversupply of people with that skill. Something else is hot. What you can do for an employer especially if you are your own employee is more important than credentials. Some authors, especially motivational teachers like Tony Robbins specialize in equipping their students to deal with the psychological demands this new world. Some like Ramit Sethi in his I Will Teach You to Be Rich blog offer practical strategies for getting jobs or raises in a lousy economy.

Money Spent is the specialty of authors who major in frugality. Trent Hamm author of the Simple Dollar (book and blog) does an excellent job teaching his readers how to enjoy life more while spending less. Leo Babauta author of Zen Habits does a very good job simplifying life generally. Of course both Dave Ramsey and Suze Orman are famous for their rants attacking $5.00 lattes as well as the more egregious excess of American consumerism. I was born into a family that jokes that we squeeze a nickel so hard the buffalo bellows. I understand how to use frugality to control the outflow of money. I am sure you are tired of my endless rants against cable TV, cell phones as well as other excesses. Remember the book, The Millionaire Next Door. These men buy their clothes from J.C. Penny’s, their watches from Timex, and they drive used Buicks.

I have chosen to describe the most complex section of the equation, the one that really matters, Money Stored. This is where compound interest either makes you rich or destroys you. Your choice. That unpaid credit card balance is listed as a negative number when calculating your net worth. The interest generated by that debt flows out of Money Spent with no benefit to your life or your bottom line. This is where your savings and your investments generate compound interest that over time generates wealth. Most of us are not so poor that we need to live paycheck to paycheck. Most of us are not so rich that we can neglect at least reasonably responsible financial behavior. We are somewhere in the middle where our decisions concerning compound interest will put us in a net worth category that is below our salary or above our salary. Debt is your enemy. It must be avoided if at all possible. Nothing else will so damage and limit your future. In my next post I will discuss approaches to using compound interest to your advantage through investments.

Danko and Stanley, author of The Millionaire next door proposed a simple test of how well you are doing in the all important Money Stored category. It works very well for people 40 and older, not so well for younger folks.

Current Pretax Salary Multiplied By Your Age Divided by 10

Consider this example:

A man earning $100,000 a year who is 50 years old should have a net worth of $500,000. That would include the equity in his home, his 401K, his cars, furniture, and savings accounts less any miscellaneous debts. If his net worth is half that amount he has a problem. If it is twice that amount the authors consider him a “prodigious accumulator of wealth.”