In Thermodynamics, a field devoted to the solution of problems by keeping track of energy flows, the first law is the conservation of energy. The basic form is that for energy:
Storage = (Inflow-Outflow) + Production.
This could be used for something like determining the amount of energy needed to charge your laptop (energy in minus energy lost to heat equals the change in storage in the energy in your battery) or the temperature of your coffee if you were to drop some reacting plutonium in it (change in temperature, related to the amount of energy in the cup, would be a function of the energy produced by the plutonium reaction minus the energy lost due to radiation, steam escaping, etc…).
The same principle can be used to understand how to grow wealth is money is substituted for energy. If we are trying to increase the amount of money we have, we need to increase the amount of it we have stored. The change in the storage of money is equal to the difference in what comes in from what goes out, plus the amount of money that is produced by the money itself.
In our investing accounts, the inflows typically come from work, but could come from selling things (which really is just a change in how they are stored). Usually it is what we put away from each paycheck. Outflows are our liabilities – all of the little contracts and interest payments and expenses that we pay month-after-month. Production is money created by our investments. This term could be negative if we are investing poorly and losing money. The Storage is the amount of money in all of our our accounts – our net worth.
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For most people, there is little or no storage of money. In fact, often there is a negative storage of money, in that the amount of loans outstanding exceed the amount of cash in investments, bank accounts, etc…. Also, the outflows generally are increased until they equal the inflows, such that every dollar that comes in is spoken for before the check is even written. Because the storage is negative, production may also be negative since we’re paying interest on those loans instead of receiving interest and capital gains — net worth is being destroyed by interest and payments.
The secret to building wealth is to create a positive storage term, which in turn creates a positive production term. This means that even if inflows equal outflows, the change in storage will always be positive – net worth will be growing each month. We can further increase the growth of net worth if we reduce outflows (or never take additional outflows on) such that the inflows always exceed the outflows. Because this will cause storage to increase, and because production is directly related to the level of storage, this will result in an amplifying effect that builds on itself. In thermodynamics, this might be a chemical reaction that releases more energy as heat is created, getting hotter and hotter. In investing, this is becoming rich.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.