Imagine your financial life as a satellite orbiting around the Earth. The altitude of the orbit is determined by the amount of money circulating in your life. The more money you have, the higher the orbit you revolve in. For most human beings a key agenda is to add more money into their financial lives and consequently keep moving to a higher and higher orbit.
To effectuate this, we take actions to earn an active income (from a job that pays a regular amount at fixed intervals) or active profit (from a business or a professional setup that may pay variable amounts at irregular intervals). These earnings act as fuel to push up our satellite into a higher financial orbit. However, some inefficiencies come in the way before our earnings can do what we want them to do for us.
Earnings are first reduced by income tax. This reduction is built-in the structure of earning money through active means (income or profit). Think of income tax as a force that pulls your satellite down, similar to gravity.
Whatever money is left with you after tax is further reduced by your essential consumption (which is necessary to live a normal life). Since consumption reduces the money available to fuel your satellite, think of it too as a drag force that is slowing your satellite down, and bringing it down.
After consumption, what is left are savings. If savings are kept in the bank (in a fixed deposit or a savings account) then these are again reduced by the rate of inflation. Inflation too is another force that pulls your satellite down by reducing the amount of money effectively available to you in your financial orbit.
Another way through which more money can be added to your financial orbit is by investing and growing it. When you invest, you earn higher returns than you would have by keeping the money in the bank. These returns become additional fuel and propel your satellite like a rocket engine.
Unfortunately, if your investment’s rocket engine is disturbed untimely, it can result in a loss of capital. This capital loss removes money from your financial orbit and results in a drop in altitude. This loss happens when we react in a way that we should not have when our investments were facing turbulence.
Good things happen when we let our investments run their course. These investments can generate passive incomes (like rentals, coupons, interest payments, etc.) or passive profits (like dividends, royalties, etc).
If we choose not to consume these passive outcomes of our investments and reinvest them then our rocket becomes a spaceship. A spaceship is capable of going into much higher orbits. Given time and discipline, this spaceship can even leave orbit and go to the stars!
When you let your investments become big enough, they become a self-sustaining source of perpetual passive income and profits. At this stage too there are structural forces that pull the star inward (like capital gains tax). However, the star can sustain itself for a very long time due to it feeding on its own produced fuel.
Going from satellite to rocket and from rocket to spaceship is a long process that needs time. Going to the stars takes a very long time. However, there are shortcuts available to traverse the journey faster like wormholes in space that shorten the journey (wormholes are theoretical, but these shortcuts are not!). These shortcuts are the special tools used by the rich to become richer.
The rich do not get richer by focussing on saving just income tax or working harder to make more money available in their cycle. Instead, they focus on removing other inefficiencies that remove money from their financial orbit. Three of these actions to remove these inefficiencies are as follows:
Firstly, the rich limit consumption by fixing their lifestyle to a comfortable level and thereon being frugal.
Frugality does not mean becoming a miser. It is just being prudent in spending, especially when you are making more and more money. The key is to make this extra money available in your financial orbit and not squander it by consuming the same things at a higher price (Bigger cars, bigger houses, and branded bottled water eventually only provide transport, give shelter and quench thirst respectively. The human brain quickly adapts to elevated experience levels and all is the same afterward).
The rich derive satisfaction from the experiences they are already having and do not push the baseline of these experiences higher by spending more money on them. This makes more money available to them.
The second thing the rich do is take risks. Taking risks gives them the exposure to earn higher returns than inflation on their capital through their investments. By not letting inflation eat into their savings they earn more than just the bank interest.
However, risks need to be selected carefully and endured patiently to get better returns. Over a period of time, taking appropriate risks pays much more than bank savings. Taking risks comes at the price of “peace of mind”. The rich happily pay this price and become even richer!
Finally, the rich do one more thing that keeps moving their financial orbits higher and higher — Compounding. The rich do not consume the profits of their investments. They simply put them back into fresh or same investments.
Compounding acts like nuclear fuel. It keeps on feeding on itself to produce more and more money like a chain reaction.
Compounding also helps the rich to avoid capital loss and capital gains tax. If they do not pull their money out, there is less likelihood they will make a loss (and the likelihood goes down with time) and they will not pay capital gains tax either (the rate of which also goes down with time). This helps them compound their money even faster.
Simply put the rich counteract the forces that pull their financial orbit down through some smart shortcuts:
Frugality to counteract Consumption.
Risk-seeking to fight Inflation.
Compounding to avoid Capital Loss & Capital Gains.
The financial orbit is an analogy derived from the Personal Finance Cycle from the book What MY MBA Did Not Teach Me About Money.