We all know the adage:
“You need to have money to make money.”
Despite the rags-to-riches stories that dominate popular press and popular culture, having money is one of the surest ways to make more money.
The rich get richer than the average population due to two key factors – investment growth and compound interest.
Allow me to explain.
Average wage growth is roughly 2-3% per year.
It usually pegs itself to increases in costs of living, otherwise known as inflation.
Inflation makes it more expensive to buy goods, so wages rise to help keep the standard of living at a consistent level.
So if you put your annual wage rises into savings, in real terms you will be worse off.
Compare that to investments.
Throughout history, the value of investments has averaged a far greater return that wages.
If someone is able to earn a yearly return on investments, after tax, of 5%, they will be 2-3% ahead of wage growth, and will be in a relatively better position.
So while wage growth will help everyone keep up with inflation (in theory), those with investments will gradually get richer.
And that impact is magnified by compound interest.
Compound interest is the mathematical construct that earns interest on your interest.
Let’s take the above example of the 5% interest you earned in one year.
Apply that to $100 of savings, and you have $105 at the end of 1 year.
If you earn 5% again, this time you will earn $5.25, and after 2 years you have $110.25.
After 20 years, that $100 has turned into $265.
If you only earned 5% per year, not compounded, you’d have $200.
Now change the $100 starting amount to $10 million. That would grow to $26.5 million in the same 20 year period. The rich will certainly get richer than the average person.
A caveat to note is that very few investments will give you a consistent return. But compound interest, especially over long periods of time, is a key driver of growing wealth for the rich.
Check out the MoneySmart Compound Interest calculator to see this tool in action.
This is one of the more popular, but less verifiable ideas about the rich.
It goes that the rich are in the ears and pockets of politicians, swinging deals that create favourable conditions for their businesses.
This idea might be blown out of proportion, but the super wealthy have long had a romanticised ability to influence government policy.
And if you can swing deals that create favourable conditions for your business, it stands to reason that you will continue to get richer.
This statement, generally, is incorrect.
But there are two interesting points about experience and opportunity worth noting.
Those that have created their own wealth in their lifetime have plenty of experience in making money. They may not be smarter than other people by many measures, but are finely attuned in the art of wealth creation.
The rich, potentially, can also afford the highest quality education and professional advice for both themselves and their children.
Wealth potentially provides opportunity to pursue broader experiences, like travel, from a younger age.
The rich get richer than the rest of the population, because their investments (generally) grow at a faster rate to wages. Sure, they might be able to get in the ear of impressionable politicians and learn some important life lessons that help them create more wealth, but a lot of the growth in investments comes from having investments to start with.
What’s the key lesson?
Save what you can, early and often, and invest wisely so that investment returns and compound interest build your wealth.
Why do the rich get richer? by Glenn Hamblen