You know someone who has a very nice home and fancy cars and you think, “They must be rich”. But are they really rich? And how would you define rich? Is rich and wealthy the same thing?
Too many people confuse a high income with being rich or wealthy. There are a lot of people with very high paychecks who use their income to buy a large, beautiful home, pay for private schools, expensive vacations and fancy cars but have little to show in the form of net worth. Their home is mortgaged, their cars are leased. They look rich to outsiders, but they’re actually relatively poor and if they have an unexpected incident, such as bad health, they will quickly teeter on the edge of financial disaster.
To help sort through the topic and give context to the definitions of wealth and rich, I’ve developed the 5 Stages of Wealth.
Certainly, there are people we could all agree are ‘wealthy’ but who are at the same time ‘cash poor’. These are often people with large land holdings which produces cash flow that’s insufficient to easily pay all their bills. For my purposes of defining wealth, I’ll focus on sustainable cash flow needed to meet current and future lifestyle goals.
Wealth Stage 1 – At this stage you are earning enough money to pay all of your bills and fully fund investing for your retirement along with any other short/medium-term goals such as saving for children’s college. Your focus here is on personal financial management. You’ve calculated what you need to systematically save for retirement and other goals and are managing your money so as not to accumulate additional consumer debt other than, possibly, a home mortgage.
Wealth Stage 2 – At this stage you’ve saved and invested enough money so that the (long-term average) annual earnings and growth of your portfolio could reasonably expect to be equal to your annual savings for retirement. For example, you’re saving $24,000 per year for your retirement. If your retirement accounts totaled approximately $500,000, they too would be expected to have earnings of approximately $24,000. This is what I call “one-to-one”…where your portfolio earnings are ‘matching’ your annual savings. This is an important milestone in your journey to financial independence…your money working for you rather than you working for your money. The focus continues to be on personal financial management but now you must also pay close attention to investment management.
Wealth Stage 3 – At this stage, your earnings and growth from your investments are equal to or greater than your paycheck. Congratulations! You have reached financial independence! You now have the choice to continue working at your current job; choose a job more to your liking; or retire from working altogether. Research suggests that only about 5% of people ever reach this stage. If you choose to retire, your focus shifts from rapid accumulation (mostly stocks), to capital preservation. Generally speaking, you’ll want to be more conservative within your investment allocation. If you’re not confident in managing a large portfolio, consider hiring a professional to assist you.
Wealth Stage 4 – With Wealth Stage 4, your earnings and growth from your investments are equal to or greater than two-times your annual lifestyle income needs. You now have a very large cushion over-and-above your bill-paying and lifestyle income needs. At this stage, you are considered wealthy and have the opportunity to increase your lifestyle if desired. Less than 1% of people get to this stage. At this stage you want to focus significant attention to portfolio risks and asset allocation. Many at this stage will choose to get help from a financial/investment professional.
Wealth Stage 5 – If you want to be rich, this is the stage for you! Here, your portfolio earnings and growth are expected to exceed your lifestyle income needs by a multiple of five-times or more. Most people at this stage are well-known philanthropist and are free to pursue projects that interest them. Most will utilize a team of experts in estate planning, financial planning and investment management.
Calculate Your Wealth Stage
$________ Total value of all of your investments
÷ $________ Target Portfolio Goal (annual income ÷ .05)
= ________ Wealth Index Score
Wealth Index Scale (Score)
< 100 Wealth Stage 1&2: You must continue to work and invest.
100 Wealth Stage 3: You are financially independent.
200 Wealth Stage 4: You are considered wealthy.
> 500 Wealth Stage 5: You are considered rich.
Note that you get to define what wealth and rich means to you. You don’t have to rely of other people’s judgment regarding the state of your financial affairs.
What Wealth Stage best represents your current financial situation? If the answer is, “None of the above”, you’re most likely in the “Help! I’m living paycheck-to-paycheck!” stage and are under a decent amount of financial stress. While this is a very large club (estimated at 78% of full-time workers), it’s not one where you want to be a member.
No matter where you are, answer this question, “What action would I need to take now to move towards the next Wealth Stage?” Build a game plan and get started. It’s time for you to take control of your financial destiny!