An article was recently published by Reuters entitled: “The New American Dream is Renting to Get Rich.” The thesis of this article is that home ownership is not the fast-track to wealth that it used to be. It also makes the point that many people would be better off renting and investing their surplus income in wealth-building investments than by sinking all of their income into owning a home. The article also went on to explain how many people who had purchased homes during the boom lacked the financial resources to pay for building wealth through other investments, and became solely dependent on their home equity for their net worth.
This serves as an excellent backdrop for a deeper discussion on what wealth really is, and what wealth building is really about. A useful first step in changing the way we think about wealth is to take the dollars out of the equation. Instead of thinking about our personal wealth in terms of a dollar value, we should think of it in terms of what we own and what is produced by those assets. In order to help articulate the difference between asset types that comprise our wealth, we like to separate wealth in to three tiers of assets. The characteristics of your wealth portfolio in terms of where the assets land on the wealth tiers exerts a high degree of influence on how your personal financial future will unfold.
Tier 1 Assets:
Tier 1 assets are physical assets that generate real cash flows. Examples of these assets are mines, energy exploration contracts, income producing real estate, and other such physical property. The reason for positioning these assets in the top tier is because their physical nature and residual cash flows make them the most dependable and least volatile. For most people, it is not always practical to have full ownership of physical assets such as this, so it can make sense to invest in companies that own and operate these types of physical assets and pay out a significant portion of earnings to investors.
Tier 2 Assets:
Tier 2 assets are fully owned business enterprises. The reason why these assets are ranked below physical, cash producing assets is because their returns are typically more volatile. The upside of volatility is that it frequently exhibits greater growth characteristics, but the downside is that it frequently carries more risk. By fully owning a business enterprise, it allows you to exhibit a significant degree of influence on its financial success. Many people build their wealth with Tier 2 assets in the form of a business and diversify into Tier 1 cash producing, physical assets.
Tier 3 Assets:
The third asset tier holds investments where the returns are completely dependent on market sentiment in regard to the asset value. Metals such as gold and silver fall into their asset tier, along with growth stocks that don’t pay dividends. Home equity is also a tier 3 asset, and this is where its danger lies. When the value of an asset is completely dependent on the sentiments of other people in the marketplace, there is an omnipresent risk of value collapse if market sentiment turns south. Almost every market bubble takes place in Tier 3 assets, as people purchase with the expectation that others will purchase for perpetually higher prices.
The way to apply this construct to our personal investment portfolio is to determine where our wealth fits on the asset tiers. Unfortunately, most people have an extremely high percentage of their wealth concentrated in Tier 3 assets that fluctuate in value based on market sentiment, and rely completely on value increases from that same market sentiment to deliver their future returns. When your wealth is concentrated in Tier 3, you will be highly exposed to collapsing bubbles that destroy market valuations as people shift out of a ‘buying frenzy’ into a ’selling frenzy’ that collapses asset prices.
The most prudent advice for 21st century wealth building is to push your wealth as far up the ladder of asset tiers as possible. If you own Tier 3 assets that are highly volatile, seek to shift more of them toward Tier 2 assets that you can influence or Tier 1 assets that are more stable. By and large, assets in lower tiers tend to be more volatile, offer the potential for higher short-term profits, and involve higher transaction costs. Many people who are successful in building businesses would be well advised to diversify their wealth portfolio to include more Tier 1 assets that produce stable cash flows without the necessity of their direct participation.
As prudent investors, we should seek to build our wealth around vehicles with strong fundamentals. We should also seek to minimize the proportion of our assets that exist at the lowest tier. We should also be mindful to avoid the temptations of “easy money” from Tier 3 assets that are experiencing temporary price spikes. Attempting to speculate on the movement of volatile assets is an inherently risky business. In the end, our best opportunity for long-term prosperity comes from sticking to fundamentals and building a high-tier wealth portfolio.
Sincere Thanks, Douglas J Utberg, MBA
Founder – Business of Life LLC: http://BusinessOfLifeLLC.com/
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