The Principal Profit Fallacy is a real danger for investors. By understanding how it works and taking steps to avoid it, you can protect your purchasing power and make sure that your investments are truly building your wealth.
In this episode of the Wealth Amplifier, George Antone explains the Principal Profit Fallacy and how to recognize if you are making this common error in your wealth-building plan.
What is the Principal Profit Fallacy?
The Principal Profit Fallacy occurs when investors focus solely on the amount of profit they are making, without considering the impact of inflation on their principal investment. As a result, investors may think they are making a profit when, in reality, they are losing money in purchasing power.
The illusion of profit How does the principal profit fallacy work?
Imagine you decide to invest $100,000, hoping for a profit down the road. This $100,000 is your principal, and the imaginary profit represents your financial goals. It could be in real estate, private lending, stocks, or any investment avenue you choose.
After several years, let’s say five for this example, you successfully get back your $100,000 plus a $30,000 profit. At this point, you might be jumping for joy, believing you’ve achieved a substantial financial gain. However, there are several factors you need to consider to establish whether your investment is actually building your wealth.
Profit vs. Purchasing Power
George emphasizes the importance of understanding your purchasing power.
Reflecting on the example above, assume a coffee cost $1 when you first invested. As a result, you could purchase 100,000 cups of coffee with your principal investment. However, over time, the cost of coffee increased to $1.30 per cup. You have regained your $100,000 principal investment but can only buy 77,000 cups of coffee with that same money. Fortunately, you make $30,000 profit on your investment, therefore you can still buy 100,000 cups of coffee.
The profit Fallacy But think about that for a moment. You have gone through all the trouble of setting up an investment vehicle with the view to building wealth. You might THINK you are ahead by $30,000 – but in reality you have only just broken even.
This is the point where the Principle Profit Fallacy gets really damaging. The reality is, you have not broken even because you will still need to pay taxes on any profit you made on the deal. While you may believe you have made a decent profit on your investment, the reality is that you are actually moving backward financially.
How To Avoid the Principal Profit Fallacy
There are a few things you can do to avoid falling victim to the principal profit fallacy:
Track Your Purchasing Power
Don’t just focus on the amount of profit you are making. It is also important to track how much you can buy with your money over time. This will help you to see if your investments are truly making you wealthier in real terms.
Invest in the right assets
As most investors have come to realize through trial and error, not all assets are equal. Choosing the right asset to invest in, in the right sequence, is critical to your financial success.
Rebalance your portfolio regularly.
As you invest over time, your portfolio will become more concentrated in certain assets. This can increase your exposure to risk and make you more vulnerable to the principal profit fallacy. By rebalancing your portfolio regularly, you can ensure that your investments are spread out across a variety of asset classes and industries.
Large financial institutions rely on teams of actuarial scientists and the power of big data to ensure that they do not fall victim to the Principal Profit Fallacy. However, as an individual, it can be a lot more challenging to see through the veneer of profits to the gritty truth. However, with Fynanc’s Amplified Approach, backed by AI-powered financial technology tools, our members have access to the same tools as large institutions to ensure they reach their financial goals faster, safer, and with more certainty.
