Vincent’s Blog: Funny Money – The Net-Worth Illusion!

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High net-worth investors, yes I am talking about you, are a demanding group. You like to drive hard bargains, must invest your capital, are focused on absolute returns and don’t mind taking a bit of risk now and then. You listen to your financial advisor, but, at the same time, keep a close eye on developments and new opportunities around the globe. Your advisor tries to keep you up-to-date with new financial products like “Smart Beta”, “Reverse ETFs”, “Waterfall pre-IPO Lock-Ups”, etc. We forgot the ones we last burned our fingers on, like the acronym CMO (Collateralized Mortgage Obligations). Oh well, such is the life living with assets and you gladly concede to any willing ear: “nobody said it was easy!”

But, there is a constant silent killer at work behind the scenes of your capital. It eats into your capital’s value while your absolute return numbers tend to rise. Contrary to what you believe, see and feel, you hardly take this killer into your overall considerations. In its worst form it goes hyper and will uncontrollably vaporize your capital.

A few years ago, you and your advisor missed the chance to become billionaires and, just by sitting still in cash for half a year, become trillionaires. “When and where did this happened and why did I miss this chance?” you ask yourself. The year was 2008 and the place was Zimbabwe. The Zimbabwean Central Bank printed a significant amount of money and inflation went hyper, by something close to 500 billion percent a year. Wow, impressive right? No… the value of any cash, which anybody held in Zimbabwean dollars, was ruined. Don’t despair, rather sooner than later, we will record the first trillionaire in U.S. dollars and it might well be Bill Gates, since he is the closest to it with a net-worth of $76 billion. It will take a bit longer than half a year but inflation will certainly assist him in getting there faster than we think

You see, there is something ironic in the way we look at our capital. We think in absolute terms, but often forget to take inflation into account. Inflation has awkward consequences, especially when it comes to value, taxes and after-tax returns. Let’s assume you owned a house or inherited one that was in your possession for 20 years, with an average inflation of 3% per annum. Assume it was bought for $350,000 and sold for $1 million. Do you know approximately 45% or $450,000 of your selling price is just inflation! Your value gain or “real” profit is roughly $200,000. Don’t take my word for it, check out the inflation calculator. Now comes the funny money part: you have to pay taxes over the full profit whether profit or inheritance taxes. Ouch!

Keep a close eye on your real estate portfolio, your bonds and savings accounts. Inflation is a killer and over time it makes more money in numbers but it is only funny money, it has no real value… only for the tax authorities and the Guinness book of records.

So how do you keep ahead of the funny money?

To find out, join i-Cthru.