The Federal Reserve Bank of St. Louis recently wrote about the tendency of households to grow wealthier as they age. There are lessons in the story that many could apply, to their benefit.
Incomes, of course, influence wealth. Think of income as a faucet running into a tub. The drain at the bottom is where expenses go. The water level in the tub is your store of wealth. You can increase the water level by improving the flow in or restricting the flow out. You can increase wealth by increasing income or reducing expenses.
But there are three more subtle things going on, according to the study. Liquidity, having adequate wealth in safe and liquid forms, buffers against emergencies. It helps people avoid selling assets at bad prices because they need money. And liquidity helps prevent expensive debt defaults and other issues with credit.
Diversification is important, too. Over time, households tend to accumulate more wealth in financial assets and business holdings as well as real estate. When wealth is spread across a number of kinds of assets, a shock in one area is less likely to upset everything.
Leverage, or the relationship of debts to assets, can be an indicator of wealth. Too much debt increases the risk from a negative surprise. Borrowing can be expensive, too. Caution with leverage is generally correlated with household wealth.
Notice how the idea of resilience runs through these more subtle factors. It isn’t that households with more wealth always avoid bad luck or negative surprises. Everybody has those from time to time. Rather, those households are better equipped to deal with adversity because they have liquidity and diversification, and leverage has been kept in check.
Most people do not start out in life with plenty of resources and extra income and an ideal financial position. Many need a working lifetime to accumulate wealth on which to retire. Over the years, liquidity and diversification become larger factors and use of leverage usually declines. These are the factors that explain why households usually become wealthier over time.
As always, call or write if you would like to discuss some aspect of your situation.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.