What do you consider rich?

[Stolen_Rutters]

What do I consider rich? A person with lots of money.

To my nephew and nieces, I am rich. I own a house, and have not quite six digits of net worth. A twelve year old can only dream of this. For me, rich is not the goal, exactly because I know it is a relative value.

If you are talking “spiritually rich”, that is a completely different question. If you are talking “health as rich”, that is different again. Both of these concepts will get a completely different answer from me, though in truth, all three require effort on my part, prayer and study for one, exercise and diet for the other. (Rich = effort? Interesting thought. That would almost imply you would need to keep all three on the radar to really fulfill your ambitions. You could almost think of money as a secondary tool to help reach your other goals.)

 

[stinkcat_14]

I’m still trying to understand how I can borrow money at a high rate of interest, buy a Lexus with it, and somehow increase my income.

Ok, let’s try again. Suppose it is May 1, and your net worth consists of a $1 million dollar stock portfolio. Suppose that by May 28, your portfolio has gone up by 8%, so now your portfolio is worth $1,080,000. What that means is that you can now spend $80,000 and your net worth will be the same as it was at the beginning of the month. This is no different than if I had a $1,000,000 stock portfolio and its value did not change, but I earned $80,000 in my job that month.

Now, let’s suppose that I want to buy the lexus. It is May 28, so I take out an $80,000 margin loan. What is my net worth? It is $1,080,000 (stock portfolio) - $80,000 (loan) or $1 million which was the same as when I started the month. Now at the current broker call rate of 7%, this loan will cost me about $15 per day, so my income will be a little less, but unrealized gains still represent potential consumption.

 

[vern_humphrey]

Ok, let’s try again. Suppose it is May 1, and your net worth consists of a $1 million dollar stock portfolio.

This still doesn’t tell me how I can increase my income by borrowing money at high rates of interest and buying a Lexus.

Suppose that by May 28, your portfolio has gone up by 8%, so now your portfolio is worth $1,080,000. What that means is that you can now spend $80,000 and your net worth will be the same as it was at the beginning of the month. This is no different than if I had a $1,000,000 stock portfolio and its value did not change, but I earned $80,000 in my job that month.

But to do that I have to sell $80,000 worth of stock. That is, to make it income, I must convert if from unrealized wealth to realized wealth.

Now, let’s suppose that I want to buy the lexus. It is May 28, so I take out an $80,000 margin loan. What is my net worth? It is $1,080,000 (stock portfolio) - $80,000 (loan) or $1 million which was the same as when I started the month. Now at the current broker call rate of 7%, this loan will cost me about $15 per day, so my income will be a little less, but unrealized gains still represent potential consumption.

Nope – you had to borrow. The money you borrowed isn’t yours. If it were your money, you wouldn’t be making monthly payments of payment and principle.

You cannot increase your income by borrowing and spending – you can, however, drive yourself into bankruptcy that way.

 

[Minnesota_Mary]

I think your on to something! That 90% of the world’s population that live off a few dollars a day just don’t work hard enough; those lazy scoundrels!

So should I solve the world’s poverty by divesting myself of my money? Get real. Quit distorting.

 

[Minnesota_Mary]

Your right. It just frustrates me to see how ignorant people are of the poverty that exists in the world. Let me formulate my post in a more mature manner.

Those that live in desperate poverty (around 90% of the world’s population) have to work to their limits just to survive; if these people did not work as hard as is humanly possible they, and their family, would die. It is entirely unreasonable to suggest that those living in poverty simply don’t work hard enough

What else could they possibly deny themselves of? They have no food, dirty water and sub human living conditions. Yes, they could save money if they were to deny themselves; but they would also die.

So what is your advice to the poor of the word? What do you recommend be their course of action to get out of poverty? You seem to be so smart. I want to hear what your solution to the world’s poverty is!

 

[stinkcat_14]

This still doesn’t tell me how I can increase my income by borrowing money at high rates of interest and buying a Lexus.

But to do that I have to sell $80,000 worth of stock. That is, to make it income, I must convert if from unrealized wealth to realized wealth.

Nope – you had to borrow. The money you borrowed isn’t yours. If it were your money, you wouldn’t be making monthly payments of payment and principle.

You cannot increase your income by borrowing and spending – you can, however, drive yourself into bankruptcy that way.

The Haig Simons definition of income does not say that you can borrow and increase your income, nor was I saying that. What I was saying was that the increase in the value of the stock portfolio allows one to increase their consumption without lowering their net worth.

You most certainly can increase your income by borrowing money. Let’s consider the case of the stock portfolio once again. I borrow $80,000 at 7%, which is secured by $80,000 worth of stock. Large cap stocks have average a return of 10-11% per year. So if the average holds out, the $80,000 in stock will be worth $88,000 at the end of one year, for a gain of $8,000. The interest cost is $5,600 (.07*$80,000), but the interest is tax deductible, so for someone in the 25% tax bracket, the cost would actually be $4,200. This would be a net gain of $3,800. Now, it would be more prudent to buy more stock with the $80,000 rather than the lexus, because then you would have the gain on the extra $80,000. But the point is, that you can borrow money and make money as well, banks do it all the time.

There is the element of financial risk, if stocks go down in value, you do risk losing money. But it is not a guaranteed way to bankruptcy.

 

[Minnesota_Mary]

Ok, let’s try again. Suppose it is May 1, and your net worth consists of a $1 million dollar stock portfolio. Suppose that by May 28, your portfolio has gone up by 8%, so now your portfolio is worth $1,080,000. What that means is that you can now spend $80,000 and your net worth will be the same as it was at the beginning of the month. This is no different than if I had a $1,000,000 stock portfolio and its value did not change, but I earned $80,000 in my job that month.

Now, let’s suppose that I want to buy the lexus. It is May 28, so I take out an $80,000 margin loan. What is my net worth? It is $1,080,000 (stock portfolio) - $80,000 (loan) or $1 million which was the same as when I started the month. Now at the current broker call rate of 7%, this loan will cost me about $15 per day, so my income will be a little less, but unrealized gains still represent potential consumption.

What if that $1 million stock portfolio takes a big hit and drops by 1/3 to 1/2 as many did in 2000? And how did we get from a “rich” $500,000 total net worth to a $1 million stock portfolio?

 

[stinkcat_14]

But to do that I have to sell $80,000 worth of stock. That is, to make it income, I must convert if from unrealized wealth to realized wealth.

Even the IRS doesn’t count income this way. Corporations do not base their income on cash receipts but on the accrual basis. So if Hewlit Packard ships a bunch of computers to Best Buy, it is counted as revenue, even though the computers have not been paid for yet. It counts as sales, even though no cash is received, just an IOU has been received.

 

[stinkcat_14]

What if that $1 million stock portfolio takes a big hit and drops by 1/3 to 1/2 as many did in 2000? And how did we get from a “rich” $500,000 total net worth to a $1 million stock portfolio?

I am trying to teach vern about how economists measure income, and lets just say that he is a slow learner.

 

[vern_humphrey]

The Haig Simons definition of income does not say that you can borrow and increase your income, nor was I saying that.

You’re the one who introduced borrowing into this discussion.

What I was saying was that the increase in the value of the stock portfolio allows one to increase their consumption without lowering their net worth.

By selling stock – which is to say, turning unrealized wealth into realized wealth.

You most certainly can increase your income by borrowing money. Let’s consider the case of the stock portfolio once again. I borrow $80,000 at 7%, which is secured by $80,000 worth of stock. Large cap stocks have average a return of 10-11% per year. So if the average holds out, the $80,000 in stock will be worth $88,000 at the end of one year, for a gain of $8,000. The interest cost is $5,600 (.07*$80,000), but the interest is tax deductible, so for someone in the 25% tax bracket, the cost would actually be $4,200. This would be a net gain of $3,800. Now, it would be more prudent to buy more stock with the $80,000 rather than the lexus, because then you would have the gain on the extra $80,000.

On the other hand, as you point out below, you can also lose your shirt.

But the point is, that you can borrow money and make money as well, banks do it all the time.

Banks create the money they lend – you can’t do that.

There is the element of financial risk, if stocks go down in value, you do risk losing money. But it is not a guaranteed way to bankruptcy.

Nothing is guarenteed – but if you keep doing that you’re going to get caught short.

 

[vern_humphrey]

I am trying to teach vern about how economists measure income, and lets just say that he is a slow learner.

You’ve taught me one thing – I was wondering why you said you didn’t have $80,000 worth of stock. Now I know.

 

[vern_humphrey]

Even the IRS doesn’t count income this way. Corporations do not base their income on cash receipts but on the accrual basis. So if Hewlit Packard ships a bunch of computers to Best Buy, it is counted as revenue, even though the computers have not been paid for yet. It counts as sales, even though no cash is received, just an IOU has been received.

Does the phrase, “cash flow” mean anything to you?

 

[stinkcat_14]

Does the phrase, “cash flow” mean anything to you?

Yes, in my finance classes I teach the statement of cash flows, which is considerably different from the income statement.

 

[stinkcat_14]

You’ve taught me one thing – I was wondering why you said you didn’t have $80,000 worth of stock. Now I know.

I should have clarified, I don’t own individual stocks in the amount of $80,000. I am a big fan of index funds, and so that is where my portfolio is. Having a Ph.D in economics has been quite useful for my personal finances.

 

[stinkcat_14]

**
Banks create** the money they lend – you can’t do that.

Nothing is guarenteed – but if you keep doing that you’re going to get caught short.

Correction, the the banking system creates money, not the individual banks. A bank cannot lend what it does not first borrow. As an individual, I can do the same. For example, I could take out a mortgage on my house if I wanted to (but I like the imputed rent too much ) and put the money into index funds. In twenty years, I would be likely to do quite well with such a strategy, because my cost of borrowing is less than my expected return. No different than a bank.

 

[vern_humphrey]

Yes, in my finance classes I teach the statement of cash flows, which is considerably different from the income statement.

And we agree that cash flow can send you into bankruptcy, even if you have a nice income from the accrual method?

 

[stinkcat_14]

And we agree that cash flow can send you into bankruptcy, even if you have a nice income from the accrual method?

Certainly, lack of cash flow can throw one into bankruptcy, but cash flow and income are two separate things.

 

[vern_humphrey]

Correction, the the banking system creates money, not the individual banks. A bank cannot lend what it does not first borrow.

Actuall, a bank can lend what it does not first borrow, you know.

As an individual, I can do the same. For example, I could take out a mortgage on my house if I wanted to (but I like the imputed rent too much ) and put the money into index funds. In twenty years, I would be likely to do quite well with such a strategy, because my cost of borrowing is less than my expected return. No different than a bank.

Much different from a bank.

A bank can (and almost always does) have more in outstanding loans than it has cash on hand – usually several times more.

And the bank does not put the money lent into index or other funds. Nor would you be lending money to the index fund when you invested.

 

[stinkcat_14]

Actuall, a bank can lend what it does not first borrow, you know.

Much different from a bank.

A bank can (and almost always does) have more in outstanding loans than it has cash on hand – usually several times more.

And the bank does not put the money lent into index or other funds. Nor would you be lending money to the index fund when you invested.

How does the bank get the money to lend? It has to borrow it, pure and simple. The main source of borrowing is the deposits. Some of these deposits they keep in reserves, the rest they lend out. Deposits do not represent cash on hand, they represent cash on hand plus loans and other government securities, etc.

The bank does not put money into index funds, but they put the into loans, which is just another type of asset. Putting the money into an index fund is similar to me borrowing money and buying a rental property. I am borrowing the money to buy an asset, which I expect to make me money.

 

[vern_humphrey]

Certainly, lack of cash flow can throw one into bankruptcy, but cash flow and income are two separate things.

But not unrelated.

The point remains, your house is unrealized wealth, an asset. And that isn’t income – any more than those shoes you bought last month are income.