I have always wanted to come up with an ultimate wealth formula. I first got interested in the idea when I discovered Scott Adams’ Happiness Formula. According to his formula, happiness consists of the four parts (in the order of highest priority)
Happiness = Health + Money + Social Life + Meaning
Each of the main components of the formula is then subdivided into more components, which further explain each component. You can click on each of the components above to see what each one of them consists of. For the money part, the formula would be:
Money = Income + Investments - Expenditures
Even though the above formula seems to make a lot of sense, it did not look sufficient enough for me to be used as a description of the ultimate wealth formula. I wanted something more precise; a formula that could explain this process. Initially, I wanted to create the formula myself but I found it in the MJ Demarco’s book. It turns out there are actually three formulas: one for the poor, the middle class and the wealthy. Each of them reflects very well the financial behavior of the three social classes. I hope that by looking at each of these formulas, you’ll be able to identify which one of them pertains to your own life and make any corrections if necessary.
To start off, let’s see how the poor perceive the wealth formula. For the poor, the formula looks like this:
Wealth = Income + Debt
If you look at the above formula, you will see that the poor generate most of their income from their primary income source, which is usually a job. From What The Wealthy Buy On Payday, we know that the poor love to buy “stuff”. That is, the poor buy things they don’t need without giving any thought to their financial future. Whatever they can’t buy with their income, they borrow. They don’t care about the debt they incur because they live for today. An interesting point to observe here is that a person could be earning a very high income from their job and still be poor. The world is full of people who are earning six figure salaries just to spend it all on “stuff”, which are the things they don’t really need. If they run out of money and can’t get the latest fad, they use their credit cards as income extension. As a result, not only do they spend all their earnings, but their debt is growing as well, thus entrenching them even deeper into the poverty hole.
The wealth formula for the middle class looks like this:
(1) Wealth = Intrinsic Value + Compound Interest
By “Intrinsic Value”, MJ Demarco means the primary income source, which is usually a job. By “Compound Interest”, he means the market investments that the middle class invest in. We, therefore, can rewrite the formula to look like this:
(2) Wealth = Primary Income Source: Job + Wealth Accelerator: Market Investments
From the formulas above, you can observe that the middle class relies primarily on their job to generate income. However, what makes them different from the poor is that they don’t spend most of their money on “stuff”, but spend it instead on typical middle class investment products such as stocks, bonds, mutual funds, CDs, etc. If a middle class individual wants to increase his/her wealth, their only choice is to increase their “intrinsic value” by increasing their skills and getting a higher paying job. That’s why so many middle class individuals go back to school to get a Master’s or Doctorate degree. They want to increase their “intrinsic value”, or “human capital”, in order to increase their income potential that will hopefully result in getting a higher paying job or promotion. Unfortunately, if you are a middle class person, the amount of money you can earn is limited by time. The reason for that is that the “Intrinsic Value”, or the job a middle class person holds can be further expressed by the formula:
Intrinsic Value = Hourly Wage * Hours Worked
Intrinsic Value = Yearly Salary
You can see from the above formulas that no matter how much a middle class individual works, his or her income is always limited by 1) the number of hours they are physically able to work each week or their yearly salary 2) The annual percentage increase in their market investments (compounding). As a result of these restrictions, there’s always a fixed cap on the amount of money that can be earned by a middle class person, no matter how high their intrinsic value is.
We finally get to the wealth formula for the rich. Their formula looks like this:
Wealth = Net Profit * Asset Value
The “Net Profit” and “Asset Value” in turn can be expressed further as:
Net Profit = Units Sold * Unit Profit
Asset Value = Net Profit * Industry Multiple
The “Net Profit” is simply the profit produced by the assets owned by the rich. That is, the rich are building or buying business assets that will generate a profit equal to the units sold multiplied by the profit they make per unit. As they do this, the “Asset Value”, or the net worth of their businesses grow as well. The more profit the business generates, the more “Asset Value” it acquires. From this formula, you can notice that there’s no cap on how many units can be sold. That is, the rich have what is called “leverage”. That’s why the rich can grow richer indefinitely because their income is not limited by time as it is for the middle class. They are in control of their business assets and use leverage to grow their wealth.
I hope you get a general idea of what the wealth formula looks like for the poor, the middle class and the rich. Unfortunately, I couldn’t fit everything into this post so I had to be as brief as possible. If you want to learn more about the formulas and see a more detailed analysis, check out the The Millionaire Fastlane by MJ Demarco. I hope you found this post informative. Cheers!