A Simple Framework for Wealth
Create, capture, compound, avoid catastrophe and over-consumption.
I’ve been working on a few more reference posts to create a framework with which to analyze stories and extract valuable fragments. Beyond looking at investors, I was trying to formulate a broader ‘lifecycle’ formula for financial wealth that would quickly highlight key drivers in someone’s journey. The simplest one I could come up with looks like this:
Factors determining the increase of wealth:
Creation of economic value
Capture / control of that value
How much leverage is being applied
Period of time during which the capital compounds
It’s analogous to thinking about whether a company is a “wonderful” business that creates shareholder value:
Does it create value for its customers?
Is it able to capture this value (does it have pricing power and a moat to protect against competition such that it can preserve a high return on capital)?
How much can it grow, how much capital can it employ, and with what capital structure?
And for how long (when does either the moat crumble or the value creation get disrupted)?
Factors determining the decrease or transformation of wealth:
Over-Consumption (the Vanderbilt model)
Catastrophe (substantial loss of capital, not part of the ordinary course of business)
Whatever is left eventually becomes part of one’s legacy
Where do you find yourself in this framework?
We can look at one’s career, and its potential to create wealth, through this framework. For example:
Unskilled worker: low economic value creation and no capture or control. Can compound their savings in the market.
Professional: higher value creation and capture/control if they are self employed or in a partnership. Not a lot of leverage (compensated by the hour).
Small business owner: control but lacks leverage. Likely limited value creation due to competition/low barriers to entry.
Managerial class: possibly high leverage by virtue of the company’s scale. Value capture depends on politics and demand for their skillset. Equity compensation in the employer could become very meaningful (is it a wonderful business whose equity value compounds?).
Startup entrepreneur: technology offers the potential of very high leverage but capture depends on need for capital and dilution of ownership.
Proprietary investor/trader: value creation depends on ability to do better than a passive owner of the market. Full capture and control. Ability to create leverage without risk of catastrophic loss is a superpower.
Professional investor: value creation is a thorny topic. Has potential for high leverage in the form of other people’s money. Captures value with ownership of the firm.
I’m not suggesting there is an ideal category to be in, though some are limited in their potential. It really depends on what you are interested in, what you are good at, and what opportunities are available to you. Much depends on the first component, value creation. If a startup finds product market fit and develops a moat, it could vastly outperform being a senior executive at a large tech company. If you run your own fund, outperform, and manage to raise substantial capital, the sky becomes the limit. But those are big ifs. In general:
Create as much value as you can
Figure out how to capture the value and control your destiny (or at least make yourself indispensable such that the owner cannot cut you out)
Apply leverage without risking catastrophe
Compound your capital at a high rate for the longest possible period of time
If you are far on the labor side of the continuum between labor and capital (if you are being compensated for your work product vs. your capital allocation judgment), you are creating value but your opportunity to reinvest and compound is limited. Finding the right partner to compound with could be invaluable. See this little recent anecdote: Why Didn't the Nebraska Farmer Sell His Berkshire Hathaway Shares? at
A friend of mine had dinner with a Nebraska farmer who bought shares under $50 (today those shares have 4 extra zeros: $500,000). This farmer still owns most of his shares. A 10,000 bagger! That is back to back 100 baggers in the same stock. He put a few bucks in and now has tens of millions. Why didn't he sell?
… treatment of shareholders created a valuable intangible asset that transcended any difficulty that a particular business line might be facing, and I think the Nebraska farmer recognized this. In effect, these long-term shareholders had a very simple thesis: Buffett is a smart guy. He's honest. And I believe he's going to do well long-term.
These people may not have been “sophisticated” investors, but they were very wise investors (and wisdom is better than sophistication). What really mattered was that Buffett was at the helm and his incredible capital allocation skills combined with the integrity he treats shareholder capital would eventually create a lot of value in whatever businesses Berkshire ventured into.
In other words: Buffett created value, he applied leverage, he had a model that allowed compounding over a long period of time, and he treated his partners fairly. He did not seek to capture all the value created at Berkshire.
I don’t mean to imply that the goal of life is to scale this chart to the top and accumulate as much wealth as possible. Far from it.
Instead, think of the chart as a kind of balance sheet. In order to have any wealth in the first place, you must master the left-hand side (your assets). You have to create, capture, and compound. The right-hand side describes what can happen to your wealth. To retain it, you have to avoid over-consumption and catastrophe. If you do all of this well, you earn both the luxury and the responsibility to be thoughtful about how to use it. Because eventually, it decreases to zero for all of us. You can’t take any of it with you.
Thank you for reading,
A Simple Framework For The Drivers of Wealth
When pursuing wealth, ask yourself:
How much economic value do I create?
How much of this value do I capture? (Do you own/control your work or what is your relationship with the party who does?)
How much leverage is being applied to my work? (Including capital, labor, technology/code, content/media, and networks)
At what rate and for how long can I compound my capital?
About the capital you have already retained, ask yourself:
How much of my capital do I consume?
How much is exposed to the risk of catastrophic loss (bad decisions, bad luck, or ‘acts of god’)?
How much am I returning to society?
And what should happen to whatever is left?
Superb article. Simply superb. Thank you for sharing.
Excellent article! Great thought process.
We worked through a very similar mental process recently. We wrote down our thoughts is a two-part series on The Wealth Creation System.