Most people measure financial success in terms of having “money in the bank”. As such, whenever most people try to accumulate wealth the entirety of their effort is comprised of hoarding cash. Although the ability to save money and be frugal is crucial, I believe that saving money in and of itself does not work; rather, it is merely the first step in the process. The strategy of simply putting cash in the closet cannot result in accumulation of wealth for two reasons: inflation and the velocity of money.
When President Richard Nixon decoupled the U.S. dollar from gold in 1971, our money became a currency deriving its’ value from a government fiat. A fiat currency by definition does not possess intrinsic value and functions only as a medium of trade. Unlike a gold coin which has value because of the metal it is made out of, the dollar’s value is due to nothing more than our government say-so.
Since the dollar has been decoupled from gold as the underlying collateral, our government can print as much paper currency as our politicians (in their infinite wisdom) deem necessary. This is like allowing a prescription drug addict the run of the pharmacy. As a result, not only are we facing a national debt which is mathematically impossible to repay, but every time they print more currency our wealth is being stolen from us due to the erosion of the buying power of our savings.
Here is an example of what I mean. During a recent conversation, a gentleman happily told to me that his employer’s 401k money market fund returned 4% in 2011. He was understandably excited having earned 4% on his money in this economy. Unfortunately, the inflation rate in 2011 had also clocked in at around 4%, which means that all of the growth in his money market fund was eroded in terms of his money’s buying power. In order to actually generate wealth, his return would have had to be grater than the inflation rate. (Much greater if it was necessary to pay income taxes on the earnings.) Thus, the U.S. monetary policy which results in chronic currency supply and price inflation has been placing people trying to save their way to wealth at a great disadvantage.
The other reason why it is disadvantageous to build wealth with currency is that currency, by design, has to move – it is a medium of exchange. In fact, one of the ways the economists measure the health of our economy is by how fast currency flows from one person or company to the next. Currency moving is an indication that people are confident with their financial circumstances to the point where they engage in spending money. In a consumer-based economy like ours, if people stop buying then companies can’t make a profit selling goods, which leads to companies decreasing output, eventually resulting in lay-offs. This, in turn, leads to even less consumer spending, since when people loose their jobs they become “entrenched”. This is the vicious cycle which leads to the velocity of money slowing, and if it gets too slow, the entire economy crashes. Thus, currency in a consumer-based economy is designed to move, which means that those of us trying to put money in the bank are hoarding something which is not meant to stay in one place – a losing battle!
Thus, the vehicle within which you store you wealth needs to accomplish two objectives. First, it needs to be a hedge against inflation, while at the same time it needs to increase the velocity with which currency travels through your bank accounts. The more currency comes in, the more settles with you. Therefore, putting dollars into the bank and keeping them there is the opposite of what you need to be doing. Instead, it is prudent to convert currency into assets which not only possess intrinsic value, but also produce cash flow. In doing so, not only will those assets hedge your wealth against inflation, but they will increase the speed with which currency travels through you. This is the key to understanding why the rich are getting richer while the middle class is taking it on the chin. The middle class is busy hoarding dollar bills, while the rich are hoarding cash flowing assets. One of the best examples of such an asset is investment real estate!
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