The oldest Millennials are hitting an inflection point — what should they be thinking about as they begin to grow their wealth, make partner, and get promoted?

They say that if you hear something once, it is an interesting anecdote. If you hear it twice, it could be a coincidence. But if you hear something a third time, you should pay attention. The topic of our piece originated from a situation exactly like this. Over the past month or so, we have had a number of mid-thirty somethings bring up the same discussion about how to handle their emerging wealthy status.

This quandary makes sense intuitively — as there are very few resources that discuss this topic. Dave Ramsey, for all his wisdom and popular appeal, is clearly aimed at an audience with very real financial problems, typically excessive debt. With the bottom 90% of the US population having an average wealth of $84,000, including their primary residence, and carrying an estimated average $132,158 in total debt, Ramsey and other financial pundits have been savvy to recognize that there is a real need and desire for help in getting back to zero.

For the emerging wealthy, they do not need to reduce debt, but are looking for the next steps as they begin to accumulate wealth. For many, this stage in life arrives in the mid-late thirties. About this time, these high achievers are likely in-line for a first big promotion in the corporate sector, making partner in their legal or medical practice, etc. What we seek to do in this piece is lay out a framework for consideration, including identifying some of the most common wealth detractors people encounter.

To assist with this discussion, we built a career model for a hypothetical, high achieving professional, starting from the age of 22 until estimated death at the age of 94. We are happy to share our analysis, but at the risk of becoming overly technical, we have left out some of the specific details.

Human Capital Rich, Not Financial

For our hypothetical individual, she is human capital rich, but not financial. Human capital is the embedded earnings potential of an individual. Its value is a mixture of education, drive for achievement, grit, and timing. In our case study, we estimate for our individual a human capital value of $2.9MM. This $2.9MM represents the net present value today of the all the salary income the individual is likely to earn over the course of her career.

Graphically it looks something like the chart below. The area shaded blue is the cumulative lifetime earnings, while the red is the accumulated financial capital. To make modeling easier, we look at cumulative lifetime earnings. Financial capital is the savings the individual accumulates as they save and invest over their career.

As you can see, early on, lifetime earnings potential far outweighs financial assets. Over time these lines converge.

As you can see, in the mid to late 30s, financial capital begins to move off the bottom. So what should our hypothetical individual do from here? Below we outline several steps which we think improve the potential for wealth accumulation.

Step 1 — Manage your downside risks

There is an old saying that a six foot man can drown in a river that is five feet deep on average. Obviously, what occurs away from the average can be fatal, known in statistics as ‘tail risk.’For the emerging wealthy, managing tail risk falls into 2 primary categories.

Risk 1 — Because future earnings are the dominant asset, any sort of disability is likely to significantly impair this earnings potential. The heart surgeon who suddenly develops a tremor may still be able to teach, but is unlikely to earn the big bucks. Disability risk management is typically best accomplished through a disability insurance policy.

Risk 2 — While highly unlikely, any health incidents in this age range are likely to be unexpected (i.e. statistically rare) and fatal. The unknown heart condition, sudden development of cancer, brain aneurism, car wreck are all statistically unlikely events, but are generally (and sadly) traumatic in their outcome.

While eating healthy, exercise, and a regular physical will hopefully aid in their early detection, the best way to manage this tail risk is by mitigating its impact on the ones left behind, spouse and young children. Low-cost, term life insurance is an easy and relatively cheap way to convert your human capital into financial in the event of your untimely passing.

Step 2 — Cautiously scale your lifestyle

It is far easier to scale up a lifestyle, than scale down. The principle driving this reality is called hedonic adaptation. Simply put, we become use to a certain level of pleasure, and need more / greater to experience the same joy. For the consumer, this means that the move from the Motel 6 to the Hampton Inn felt like you were living. But after a while, the Hampton Inn feels like the Motel 6, especially when compared to the Four Seasons.

The point being of all this, it is easy for lifestyle expenditures to creep upwards alongside bigger paychecks. As those raises and bonuses stack up, we would caution that it is important not to let your lifestyle ramp commensurately with it, but instead think about saving an increasing portion of your take home pay. That way, you still experience the increased income from the well-earned promotion, but also help to set aside assets than can begin to grow.

One helpful tool we use is what we call the 7x rule. Prior to making any purchase of size, multiply the purchase price by 7. Assuming you are thirty-something, this ending figure is roughly what the value of the same dollar amount would be invested in the market at a 7% annual return until your retirement. So for example, the $50,000 BMW you want today is equivalent to $350,000 at retirement. Now obviously you have to have transportation, so compare that to the $35,000 used BMW, which is worth $245,000. So roughly a $100,000 differential that you can determine if the incremental happiness/utility is worth.

Step 3 — Balance Savings and Spending

This relates to our discussion from Step 2. There is a tension between enjoyment now, and having to endure a significant cut to lifestyle upon retirement. Some folks will naturally be savers, and others spenders. Regardless of your natural proclivities, landing somewhere in the middle is likely the best course of action.

We think a ‘tick-tock’ cadence in spending probably makes sense. For example, you set a goal to pay off an additional portion of your home mortgage, say $10,000. Once that goal is reached, you save towards and go on a nice vacation. After the vacation, you can revert back to a savings goal.

Overtime, we believe this nicely balances enjoyment and prudence — and likely will help you stay the course to achieving your financial goals over time.

Step 3a — What to do about student loans?

A common factor for most emerging wealthy millennials is some level of student loans. The massive increase in education costs over the last 40 years has meant that some level of borrowing has most likely be necessary to help support undergraduate and any graduate studies. There are a lot of statistics thrown around regarding student loans, but it would appear that on average college seniors are graduating with $30,000 or so in student loans.

These loans may offer a number of different features which allow the individuals payment to adjust to levels of income. Interest rates on federally backed loans may sit between 4% — 10%. Finance theory says in this circumstance that if you can borrow at 4% and invest in the stock market at 7%-8%, you should be willing to make that investment.

We think that is an incomplete view. The early career period is about further exploration of your gifts and talents, and determining where they are best deployed in the workforce. To do that well, we believe nimbleness and mobility are important. Significant student loan balances in our view hinder your ability to find the right career. They may lead you to stay longer than you should in a high-paying, but less than ideal job. As well, there is a real psychological toll that impacts you from having high debt levels. There is a reason the major world religions have offered very specific and pointed advice about the pitfalls of excessive debt.

So for student loans, we think the best course of action is to get aggressive and get them paid off. Then you can move on and enjoy building out your career. Important caveat — if your employer offers a 401K match, we would suggest hitting that level first. Not doing so is leaving free money behind!

Step 4 — Start Investing

After protecting against downside risk, watching against excessive spending, having some enjoyment of your income, and hopefully paying down your student loans, you may have begun to accumulate additional cash flow for investment. Here are some quick steps to think about:

Step 1- Hit 401(k) Match and Max Out 401k — 401k’s are made with pre-tax dollars, and are taxed at withdrawal during retirement. Many firms offer a match for any contributions up to a certain level. You should fund your 401k until you max out. This is literally free compensation that you are leaving on the table

Step 2 — Fund After Tax Plans — After hitting up to your 401k match, we think it makes sense to fund your after-tax retirement savings next, such as a Roth IRA. Assuming you are not excluded income-wise from making a Roth contribution, we think it makes sense to make the maximum Roth contribution today, as your income levels and corresponding standard of living are likely to be higher in the future.

Now what to invest in specifically is an additional question beyond just structuring the location of the savings from a tax perspective. With lower dollar amounts, using index funds is a prudent way to begin to build an investment portfolio. As assets build, the advice of a qualified investment adviser may be a benefit as well.

Step 4 — Concentration — Risk or Reward?

“The fastest way to wealth is a lack of diversification…the fastest way to poverty, a lack of diversification”

For many folks, as a career path unfolds, opportunities present itself for ownership; it could be as a partner in a law firm, investing in real estate assets, a private company etc. In many of my conversations, this opportunity presents significant cognitive dissonance for the individual. Since Finance 101, we are taught that diversification is prudent and not to get too concentrated.

But if you are in the real estate world, you may have acquired a specific skill set around finding, investing in and / or managing real estate assets. Or you may be offered the ability to buy into your practice. In all of these scenarios, this feels a bit like doubling down on where you are already making your take home pay — so you are double exposed to any risk there.

So how should we think about this tension?

Ashvin Chhabra, former strategist at Bank of America Merrill Lynch and now President of a family office for hedge fund billionaire James Simmons, has studied historical wealth accumulation and noted that if you look at how great fortunes are created it is typically through concentration (with control) and non-recourse leverage.

Chhabra’s insight provides a nice template for evaluation of concentration. When presented an opportunity to concentrate your economic exposure, first evaluate if the concentration is accompanied by control.

Concentration

If you are able to own an asset and be in a position to meaningfully affect its outcomes, this can be a powerful way to increase your assets. Concentration without control is dangerous in our view. If you were to look at Lehman Brothers employees or Enron employees who had massive portions of their net worth exposed to an economic asset where they were not in management, they made a dangerous gamble.

If concentration and control are offered, owning the equity of a growing business is a powerful way to grow wealth. Think about it this way, the way our current tax code works, investments in the growth of a company are able to help defer taxes on that year’s profits — i.e. depreciation is tax deductible. The net incentive of this is that the government encourages you to invest in growth in a tax advantaged format. By avoiding the annual 30% tax clip, that is a huge stimulus for wealth.

Moreover, a well-run business should be able to grow at or better than GDP, and lever moderate revenue growth into higher net income growth. It does not take $1 of incremental expense to service $1 of incremental revenue. As such, you now own an asset that is able to grow cash rapidly and in a tax advantaged way.

A favorite anecdote along those lines was from a car dealer who told me that his wife was nagging him to diversify their personal assets away from just the dealership. The only dealer of his brand in the area, he was making a 15% plus average return on his equity in the business. His response to his wife is where else can we make that much on our money? Where else indeed!

Leverage

The second historical path to wealth is through the use of leverage, and preferably without recourse. Using low-cost borrowed money to make money, in general is a pretty sure fire way to make money, if you time the cycle right. That said, construction firms do not fail at 2x the average rate for all businesses without good reason. The real estate business specifically is littered with tales of the high flying developer who makes millions on the way up, but loses it immediately.

If leverage is available and it is non-recourse, this is essentially a heads I win, tails I don’t lose that much. Barring a 2008 type event, where the whole economy is playing this same game, the gamble has generally worked favorably for investors. If leverage is available and it is recourse, caution is the word. Remain focused on the downside, and remember cyclicality! No business or industry has seen linear growth in perpetuity. At some point the piper must be paid, at that time, you want to be cash rich and unlevered.

Conclusion

As time passes and you become more and more wealthy, we think it prudent to think about wealth management like setting protection when rock climbing. As a climber moves up a rock face, he sets protection that limit how far they are willing to fall as they ascend further. At a young age, with lots of human capital, you have nothing to lose, so having a lot riding on your decision perhaps makes sense. But with a spouse, kids, mortgage, school tuitions, etc., the downside risk grows. Harvesting gains (i.e. setting protection) seems only prudent over time.

Ultimately, investing for a lifetime is a long road. By avoiding mistakes and missteps early, investing regularly, and with a bit of prudent financial management, the emerging wealthy individual can put them well on their way towards a productive future and retirement. Hopefully, these steps chart a reasonable course of action to help an individual start down this road with the best foot forward.