How the wealthy become wealthier with little effort, while the poor become poorer the same way...

It was not until the last few years that an interesting realisation hit me.....

The Net Worth of both my wife and I was increasing year after year even though we were not actually working. We are getting wealthier each and every year by doing very little.

It was a strange realisation, and I had to recheck all the numbers multiple times just to be sure as I was skeptical of my findings - but it was true.

Let me briefly explain...

After a few decades of working, investing, generating investment income and reinvesting it etc (you've read the story), we have amassed an asset portfolio that produces more income per year than we can spend.

We will use some simple, conservative theoretical numbers to show what has happened.

Let's say, after 25 years of investing, one's property portfolio reaches $5,000,000 and their share portfolio reaches $1,000,000 - a total of $6,000,000 in income producing assets (BTW, these are NOT unrealistic numbers).

Let's say that $6M is invested at an average of 5% yield - producing $300,000 income each and every year. $300,000 is way more than most households need each year (assuming their home is paid off). In fact,that income is more than many working households earn in a year.

I'm sure you would agree that $300,000 is a good income for a couple in retirement.

However, the $300,000 is just the start of the wealth generation for the year.

Remember, there is that $6 million invested in assets that are also appreciating in value.

Now from experience, I can tell you that our investment assets have grown at an average of 8%pa for the last 23 years. That being the case, today's $6M in assets will be worth $6.48M next year, $7.0M in two years, $7.56M in three years time, and in just 5 short years, it will become $8.82M in total value!

Do NOT forget that each and every year, one earns around $300,000 income ON TOP of the growth!

That's a 5% income yeild on our capital, PLUS an 8% average growth on our capital !!! Impressed? Well, don't be just yet, there's more.....

Remember, we average an annual return of 5% just for the income.

So in year #1, one's income was $300,000. However, year #2 the income jumped up to $324,000 (5% of $6.48M). Year 3 income jumps up to $350,000 and by year 5 the income is at $441,000. This is because as investors, we would be ensuring a good return on our invested capital.

Not only is one's net worth increasing at 8% per annum, but so is their annual income!

Impressed? Well, don't be just yet, there's more.....

Though the income is taxable, the capital gains are not and hence tax free as long as no asset is sold. However, why sell an asset that makes you money if you don't need to? The capital gain is tax free wealth generation at it's best!

Impressed? Well, don't be just yet, there's more.....

Let's say that a retired couple are quite happy to live on (say) $300,000 per year. So what happens when they earn more income than they can spend? Simple.... they just reinvest it, buying more income producing assets which generate more income and more capital growth!

Can you see what is happening here? Once you get started, and get to the tipping point where you can generate more passive income than you need to spend, you have created a perpetual money making machine that continues to grow and outpace inflation and one's spending habits.

Now, imagine that instead of just $6M, your investments reach say $10M in total, or $20M or even $50M in total. Can you see how the numbers just go wild to the point that it becomes silly? However, none of what I'm saying here is unrealistic. It is actually achievable, and when you get to that tipping point as I mentioned, you have created generational wealth.

THIS is how the rich get richer.

However, the sad flip side of this is that the poor are getting poorer by almost the same rate as the wealthy are getting wealthier.

You see, the people that choose to "live for today" and choose not to invest for their future are doomed to poverty. The poor often fail to recognise that the purchasing power of their savings is reduced each and every year by the rate of inflation. In other words, if they have $100 in the bank earning (say) 4%, their net situation after 1 year is that they have earned $4 in interest income giving them a total of $104, but since inflation is 7.8% (as per the RBA website at time of publishing), their $100 from last year only has the purchasing power of $92.20 plus the $4 interest - total $96.20.

Whereas a wealthy person who has the same $100 invested will see an 8% growth in their capital plus a 5% income yeild minus the inflation rate. This turns out to be a purchasing power of $104.58. The difference is that the wealthy increase their net worth, their purchasing power and their income each year (on average) while the poor decrease their net worth, decrease their purchasing power and income is stagnant each year.

Impressed? Well, don't be just yet. There's more.....

The poor person is generally poor because they choose to be ignorant and lack financial education. This means that they do not "think outside the box" at all.

Friends and relatives of mine two years ago were complaining that they were earning less than 0.5% interest on their money in their bank accoounts. I told them I was earning an average of 7% tax free yeild on my money by owning the same bank shares instead of just depositing my money into a savings account as they did.

So when they were earning $0.35 pa after tax on their $100, I was earning $7.00 tax free - financial education is important.

Impressed? Well, don't be just yet. There's more.....

I have friends that have around $300,000 in a term deposit with a bank earning 3.8%pa over 12 months. Applying the example of the $100 from above, we can see that after 12 months, their $300,000 will grow to $311,400 after 12 months as a result of the interest payments. After paying 30% tax on the interest earned, their total is reduced to $307,980. However, because the inflation rate errodes the purchasing power of cash, their total purchasing power has been reduced to $283,958 - and they don't even realise it!

At the same time, a person with reasonable financial intelligence invests the $300,000 and manages to get a modest and conservative 8% capital growth with a 7% income yeild (I can achieve this and much more today without issue), then after 12 months my $300,000 has earned $21,000 income and a capital gain of $24,000. After paying the 30% tax on the income component, the end amount is $338,700. Now if we apply the inflation rate to that figure, the purchasing power of the investment has increased to $312,281.

That's a difference $28,323 in returns - simply due to a bit of financial intelligence.

Impressed? Well, don't be just yet. There's more.....

The poor people who choose to be financially ignorant, the ones that fail to consider the errosion of capital due to inflation and taxation, are most often also the ones that cannot help buying "stuff" with that $300,000. So as soon as that term deposit matures, they will likely update their car and TV, maybe take a holiday and then reinvest the remainder in another term deposit. However, this time the term deposit will be maybe $200,000.

Are you understanding the mindset difference between the rich and poor?

You can decide which side of the fence you want to be on. Just remember...

• Financial intelligence is important.

• Consistent saving and investing is the key to wealth creation.

• Understand that time and compounding effects will do their thing to make you wealthy, if you do your thing (save and invest - consistently) to make you wealthy.

• Understanding the effects of compounding, inflation and taxation are important.

• Getting your mindset to understand that you work hard for every dollar you earn, be sure it works hard for you in turn to produce more dollars, which can be put to work to produce even more dollars.

• It's all about the numbers. You must consider inflation and taxation, NOT just interst or income.

• The more you learn, the better investor you become. The better you become, the more you learn. It's a never ending spiral to wealth creation.

• Every investment you make will be a lesson. You will win some, you will lose some. The important thing is you become stronger, smarter and better at it.

• Never risk more than you can afford to lose.

• It is absolutely true.... "You do not have to do extraordinary things in order to achieve extraordinary results" - Warren Buffett.