In thermodynamics there is a concept called “entropy.” It explains things such as why things tend to come to the same temperature when placed together. It also explains why one cannot create a perpetual motion machine, such as a hybrid car that could regenerate enough power as it went from its own motion to travel indefinitely.
In thermodynamics, the generation of entropy involves the conversion of energy into less useful forms until it no longer is useful for anything. For example, if you start out with water in a lake, you have potential energy. This energy could be used to turn a turbine to make electricity. That electricity could be used for any number of uses. The energy is in a very useful form. If you take the water and generate electricity, you create entropy in doing do. If you had a perfect turbine that turned all of the water’s potential energy into electricity, no entropy would be created. But friction in the turbine, sound made as the water strikes the turbine, and all fo the turbulence created in the water as it falls cause entropy to be created. When you are finished you have some useful energy (electricity) and useless energy such as sound waves, turbulence in the water, and hotter air around the turbine.
If you then use that electricity in a space heater to heat your home, you turn that electricity into hot air. At that point there is little else to be done with the energy – you can’t very well put it back into the power grid. The energy that started out in the lake is still there – energy cannot be created or destroyed – but it is no longer in a useful form.
Wealth is similar to energy, except that wealth can be created. The first way that one creates wealth is through work. One does something someone else considers useful in order to get paid cash. The wealth received t that point – cash – is in a useful form, but decreases in usefulness with time due to inflation.
If one spends that money on food, clothes, cars, or other things that decrease in value with use, the wealth is placed into a less useful form and begins to be destroyed. Eventually the wealth that was created will be entirely destroyed once the thing purchased is worn out and no longer useful. If one uses all of ones wealth to purchase such wasting items, one may see millions of dollars worth of wealth pass through ones hands and yet have nothing to show for it at the end of one’s life.
If one wants to become wealthy, one needs to minimize the use of wealth in ways that will destroy it and place as much wealth as possible in forms that will preserve it, and ideally in forms that will make more wealth in a useful form. Wealth in a form that creates more wealth is called an asset. An asset is something like a profitable business, a share of stock, or a bond. In this form the wealth could be used in any number of ways. One could sell a stock and buy a new car. One could take a loan against a profitable business and go on vacation. If one uses money that is earned in a wasteful way, in the end there will be nothing left except perhaps for a few memories. If one uses an asset to create wealth that is then used, however, one will have both the memories and the asset.
If one approaches financial choices in this way – minimizing the destruction of money earned through work – one would make different choices. For example, if one buys a couch, that couch will be worthless in about 10 years. One would therefore not spend more on a coach than it absolutely necessary. Something like a wood table, however, would tend to hold its value (especially if bought from another individual without the retail mark-up). One would therefore be willing to spend more on a table or some other piece of furniture that would hold its value.
It would be even better if one never spent any money earned through labor for anything but assets, paying for such things using money generated by assets. For example, instead of taking a big vacation the first year after starting work, perhaps stay home the first year and put the money that would have been spent on that vacation into stocks. The next year do the same, except allow yourself to spend whatever money is generated by those stocks on a vacation. Continue this for the next several years. Some years things may not work out well and you’ll need to stay close to home. With time, however, the amount generated by the stocks will be enough to take a nice vacation. Eventually there will be enough left over to funnel back into investments.
Yes this will take some initial sacrifice, but the rewards will be more than worth it.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.