How Do You Use Cumulative Advantage to Build Wealth?

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We’re all familiar with the observation that “the rich get richer,” and with good reason: it can be traced back at least as far as the Gospel of Matthew. This principle of cumulative advantage, the so-called “Matthew effect,” refers to the greater ease of acquisition of wealth by those who are already wealthy.

This phenomenon doesn’t just work with money. Research has found patterns of preferential attachment in all kinds of networks, from the social and biological to engineering and computer science. It seems to be a universal underlying principle that nodes, which can represent information, relationships, money, or other valuable resources, tend towards a power law distribution.

But for those who don’t want to be mired in financial mediocrity, how do people begin climbing the ladder in the first place? How can you use the cumulative advantage to gain an edge?

Exercising rational agency

Everyone’s financial situation is unique. Not only do we have varying levels of wealth, but the inputs and outputs can be different. Often, these reflect not just unequal job opportunities, but also diverse individual attitudes, levels of financial literacy, risk tolerance versus aversion, family background, and social or lifestyle influences.

A poor student might earn their degree on a scholarship, land a high-paying job, and quickly pay off their student loans, putting them in a solid financial position. Another graduate from the same school who’s accustomed to a more lavish lifestyle might not prioritize their debts, spending as much as they earn, and effectively living paycheck to paycheck.

These things happen because most people aren’t rational economic agents. We quickly lose our ability to make the right money decisions when faced with multiple choices or conflicting factors. To simplify decisions, we yield to heuristics by sticking with personal biases or outsource decision-making to influences on social media.

Start being different by acting rationally. Recognize how much you can really afford to spend every month, and stick to your budget. If you must indulge or make a big purchase, plan for it, and look up available credit card promos and deals to get a discount or perks.

By being consistently disciplined, your net income should exceed expenses on a monthly basis. This creates a small advantage over the many households that can barely break even or are steadily falling further into debt.

Wielding leverage

money management

Ensuring your net cash flow is positive is a solid start, but it still leaves you with a long way to go. Those who build wealth are willing to explore different ways to make their money go further. For example, you can enjoy living in a world-class hub like Singapore, but you’d better know how to hunt for bargains unless you’re already commanding a high salary.

Alternatively, there’s the expat option, which allows you to take advantage of geoarbitrage: you can earn a first-world income while living in a low-cost country. This is especially appealing to younger employees who can work remotely, and whose entry-level pay might not cut it in an expensive city.

Either way, with further adjustments, you can increase your monthly cash flow. Now, where does that money go?

The conservative answer would be to a savings account. While that’s a good place to stash your emergency funds, it hardly makes sense for building wealth. Savings account interest rates don’t keep up with inflation.

The cumulative advantage comes from increasing inputs passively, and that means making higher-yield investments. Maybe you start with the stock market or real estate, then eventually move up to provide capital for a friend’s business venture. Or you can leverage debt to start a business yourself.

A sustained commitment

The phrase “building wealth” implies that you don’t become rich quickly or accidentally. Your involvement and effort must be sustained over time.

The richest people in the world didn’t make their fortunes by earning a paycheck. They might have started out as salaried employees, but they diversified. They took risks and pursued opportunities. In essence, they made it a full-time occupation to build wealth.

Your goal might not be so lofty, and that may be for the best. Only a few can become billionaire investors, and luck plays a big part in outcomes at this level. But you can still grow your money considerably compared to others if you embrace this as a lifelong commitment.

And you can take steps to pass down elements of that positive feedback loop to the next generation. This is why wealthy parents send their children to top schools and impart to them a sound understanding of finances. The small advantages you accrue during your career might afford you a modest lifestyle, but end up building a fortune for your kids.

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