Create Income from Investment Assets – “Basic Principle #1“
Life teaches Financial Concepts if you’re Receptive. In his book “Rich Dad Poor Dad”, Robert Kawasaki writes “have you ever noticed that there are lots of accountants who aren’t rich? And bankers, and attorneys, and stockbrokers and real estate brokers? They know a lot, and for the most part they’re smart people, but most of them are not rich. Since our schools do not teach people what the rich know, we take advice from these other people. But one day, you’re driving down the highway stuck in traffic, struggling to get to work, and you look over to your right you see your account stuck in the same traffic jam, you look to your left and you see your banker. That should tell you something.” But this Compendium is about gathering together the best practices that are not necessarily studied in school, but are necessary to understand how to invest in order to have the best possible financial personal underpinning. Some of these concepts are taught in schools but the trick of course is to how to know to apply them to real life. Providing that guidance is the purpose of this Compendium.
To get started, the most important thing is about the attitude we each bring to our personal finances. The most important aspect of attitude is one’s outlook on learning. In learning, we’re talking about not what they teach you in school. For what you learned in school is not necessarily what life teaches you, and I would say that life is the best teacher of all. Most the time, life does not talk to you. It just pushes you around. Each push is like saying “wake up there something I want you to learn”. And being self-observant about these opportunities for learning is the first step in personal financial well-being.
Life pushes all of us around. Some give up, others fight. What you want to do is learn the lesson and move on. You want to welcome life pushing you around. To these few people, it means seeing a gap and wanting to learn something. They learn and move on. Ray Dalio is my role model in this regard.
Most people quit or fight, but the successful people learn. If you learn to learn you will become a wise, wealthy and happy person. If you don’t, you’ll spend your life blaming a job, low pay, your spouse, or your boss for your problems. You will live your life live life hoping for a big breakthrough that will solve all your money problems. In addition if you’re the kind of person who has no guts, if you just give up every time life pushes you, you live life playing it safe, doing the right things, and saving yourself for some event that never happens. But the truth is, if you let life push you into submission you really won’t get the kind of life that provides excitement and stability. And for those people that don’t let themselves get pushed along, they might quit their job and go looking for another job, a better opportunity, and higher pay, actually thinking the new job or more pay will solve the problem. In most cases however it won’t. So the first lesson is to remember “the poor and the middle class work for money.” “The rich have money work for them.” And so this book is really about the latter point, how to have your money work for you.
Emotions: On moving forward it’s important to understand there are two emotions that are key to personal finance security. Those are fear and desire. Together these two emotions can lead you in the life’s biggest trap, if you’re not aware of them controlling your thinking. To spend your life living in fear, never exploring your dreams, is cruel to work hard for money, thinking that money will buy you things will make you happy is also cruel. To wake up in the middle of night terrified about pairing paying bills is a horrible way to live. To live a life dictated by the size of a paycheck is not really a life. Being that a job will make you feel secures lying to yourself. That is cruel, and that’s a trap you should avoid if possible. In this point is made because ignorance about money is what causes so much fear and so much greed. And it’s important to use your emotions to think, not to think with your emotions.
Most people fail to realize that life, it’s not how much money you make, its how much money you keep. There are professional athletes who make millions early in their life and were in the poor house by their mid-30s.
So the few simple rules to remember for the following:
You must know the difference between an asset and a liability, and buy assets. “Rich people acquire assets. The poor and middle class acquire liabilities, but think they are assets”. A simple example is if you need transportation and want to purchase a car to supply it among other things you have two choices between buying an old car in a new car. Buying a brand-new mass-produced car would be buying a liability. Buying old classic car investing the difference in keeping it running would be buying an asset.
Another way to look at this is that it is the cash flow pattern of an asset that makes it one. In short assets provide income. Liabilities become expenses and are disposed of. “The Cash Flow Pattern of an Asset” and “The Cash Flow Pattern of a Liability” figures illustrate this.
This pictorial form is shown because later on, when you put together your personal financial plan, it is useful to think of listing all of the sources of income and expenses that you have in any given year (called your cash flow statement) as well as a second spreadsheet showing your assets and liabilities (called a balance sheet). Knowing the relationships between assets and income and liabilities and expenses is a good tool for knowing which items belong in which category.
In “The Cash Flow Pattern of a Poor Person” figure, or young person still at home, is shown. Such a person typically has no assets or liabilities, but has a job which produces income, which is then spent flowing into expenses, as shown. In “The Cash Flow Pattern of a Middle Class Person” figure shows how a job produces income which is then used for expenses and to purchase liabilities which also add to the expense line. “The Cash Flow Pattern of a Wealthy Person” figure shows the listing the assets the person holds and how that flows into an annual income stream for that person to wisely spend or reinvest.
All these diagrams were obviously oversimplified. Income from a job varies over a lifetime, and as one approaches retirement switches from a job as the source to retirement benefits and assets as a source as shown in the “Income over a Work-life and Retirement” figure. It is critical to not use retirement benefits and assets to fund or be used as an income source before retirement age is reached.
On the other side of the coin, everyone has their living expenses, the need for food, shelter and clothing. But these graphs do illustrate one important point and that is “the flaw in thinking that money will solve all problems”. More money will often not solve the problem and may in fact actually accelerate the problem depending upon one’s spending habits. The key is to take the income and wisely divide it between spending on expenses, assets and liabilities, with the tendency to spend it as much as possible on assets.
To illustrate this point just a little more, take the case of buying a newer bigger car or a newer bigger home. In both cases newer bigger vehicles and homes typically mean bigger expenses and so, since these are liabilities, the net effect is to increase expenses. So in selecting a home one has to resist the impulse to buy a bigger, flashier house, because you realize it would not be an asset, it would be a liability, since it would take money out of your pocket. This is difficult because a nice home is an emotional thing. And when it comes to money, high emotions tend to lower financial intelligence. As a matter of observation I know from personal experience that money has way of making every decision emotional. The following points can be made when it comes to buying a house:
1. When it comes to houses most work all their lives paying for home they never own. In other words, most people buy a new house every so many years each time incurring a new 30 year loan to pay off the previous one. Even though people receive a tax deduction for interest on mortgage payments, they pay for all the other home expenses with after-tax dollars. This is true even after they pay off their mortgage.
2. Property taxes have a way of going up and up. This is especially problematic after you retire, because every increase puts a strain on the retirement budget and for some people it forces them to move.
3. Houses do not automatically go up in value. There are many times when the market falls or stays flat for decades.
4. The greatest losses of all are from those of missed opportunities. If you have all your money tied up in a house you are forced to work harder because your money continues blowing out the expense column, instead of adding to the asset column. This is the classic middle class cash flow pattern. If young people would put more money into their asset column early on, their later years would get easier, especially as they prepared to send their children to college. Their assets would’ve grown and they would be available to help cover expenses. All too often, a house only serves as a vehicle for incurring home-equity loan to pay for mounting expenses.
In summary, this example shows the end result in making the decision to own a bigger house or bigger car that is too expensive and lose the chance to start an investment portfolio early on. This impacts an individual’s financial well-being in the following three ways:
1. Loss of time, during which other assets could’ve grown in value.
2. Loss of additional capital, and which could have been invested instead of paying for high maintenance expenses related directly to the home.
3. Loss of education. Too often, people count their house, savings and retirement plan as an asset, and because they have no money to invest, they simply do not invest. This costs them investment experience. Most never become what the investment world calls a “sophisticated investor”. It should be noted with emphasis that the best investments are usually first sold to “sophisticated investors”, who then turn around and sell them to people playing it safe.
I’m not saying don’t buy a house; I am saying “understand the difference between an asset and a liability”. When I want a bigger house, I first buy the assets that will generate the cash flow to pay for the house.
“An educated middle-class person’s financial statement” figure shows pictorially that the amount of assets generating income is very small and the person is constantly trapped in a rat race. In contrast is a Rich person’s personal financial statement that results in a life dedicated to investing and minimizing liabilities as shown in the “Rich Person’s Financial Statement” figure. This shows pictorially why the rich get richer. The assets generate more than enough income to cover expenses with the balance invested in more and more assets which continue to grow. Therefore the income these assets produce grows as well.
Just to close on this point, the “Why the Rich Get Richer” and “Why the Middle Class Struggles” figures show pictorially the patterns just described.
But this rule means that in addition to generating income from your job you should also proactively create and manage an income stream from the assets you hold. Over the long run your income will shift from income generated from working for others to income generated from your own assets. This becomes true for everyone at their retirement but some people convert their job into their own business offering much earlier in life.
To make the distinction here, when someone asks us “what business we are in”, we often reply with what our profession is. Physicians often state that their business is practicing medicine, but this is really their profession. For those physicians that own and operate their own practices their true profession is really the accumulation of income producing real estate, as they purchase real estate office space that they rent to themselves and to others. Businesses do not require my presence. I own them, but they are managed or run by other people. If I have to work there, it’s not a business. It becomes my job. Examples of our businesses are our stocks, bonds, mutual funds, income generating real estate, notes and IOUs, royalties from intellectual property such as music scripts, and patents, etc.
Just as people tell you to “find a job that you love”, advice for financial security is defined as “find assets you love”. If you don’t love it, you won’t take care of it. The goal of course is that once a dollar goes into an asset it never comes out, it just stays there and continues to compound until you need it in retirement or for an emergency.
As one’s asset base grows larger and in particular if one starts their own “LLC” or “S Corporation”, they can take advantage of the government’s tax structure significantly reduce the taxes they pay in the amount of assets they can protect from government taxes. This utilizing a Corporation wrapped around the technical skills of accounting, investing, and markets can fuel explosive growth in one’s financial position. An individual with the knowledge of the tax advantages and protection provided by a Corporation can get rich so much faster than someone who is just an employee or small business sole proprietor. The difference is profound when it comes to long-term wealth.
These statements are true because a Corporation can do many things that an individual cannot. Like pay for expenses before it pays taxes. Said simply an employee’s earning get taxed and then the employee try to live on after-tax income. The Corporation, in contrast, earns money, spends everything it can on what it needs, and then is taxed on the remainder after expenses. It is one of the biggest legal loopholes that the rich use.
When thinking about taxes it’s important to remember there are three different types of income as an accountant sees it. They are (1) earned income, (2) passive income, and (3) portfolio income. When someone tells you to go to school, get good grades, and find a safe secure job, they are recommending that you work for earned income. When the book “Rich Dad Poor Dad” said “the rich don’t work for money, they have their money work for them”, it was talking about passive income and portfolio income. Passive income, in most cases, is derived from real estate investments. Portfolio income is derived from paper assets such as stock, bonds, and mutual funds. The key to becoming wealthy is the ability to convert earned income into passive income and/or portfolio income as quickly as possible. Remember that the taxes are highest on earned income. The least taxed income is passive income. This is yet another reason why you want your money working hard for you. The government taxes income you work hard for at a much higher rate than the income created when your money works hard for you.
Exercise: Make an excel spreadsheet with one sheet each for your Income, Expenses, Assets, and Liabilities. The Income sheet entries (categories and amounts) can come from your tax returns or checking account statements. The expense sheet entries typically come from checking account and credit card statements (unless you are still using cash as a payment vehicle). Typical expense categories are food and clothing, housing, utilities, transportation, insurance, healthcare costs not covered by insurance, taxes, debts, education, gifts, savings and investments, recreation, care for yourself or others, and miscellaneous. The list of assets is usually small and you can list the items (paperwork) you are keeping in your safe deposit box or home safe. The list of liabilities can be derived from looking at where some of your expense items are coming from (taxes and maintenance on a car). The remaining liabilities are from notes you owe that are in your safe deposit box or home safe (like a home mortgage). Consider updating these spreadsheets at the end of each calendar year (usually in January). Make a summary sheet to show how for you, your income, expenses, assets and liabilities are changing over time.
From another good source, three rules of thumb for a successful financial life are: (1) Don’t have debt rise faster than income, (2) Don’t have income (or certainly your expenses) rise faster than your productivity (your fair market value), and (3) Do all you can to raise your productivity (seek educational and learning experiences).
Sources and References:
- “Rich Dad, Poor Dad”, Robert Kiyosaki, Warner Business Books, 1997
- “Principles: Life and Work”, Ray Dalio, Simon & Schuster; First Edition (September 21, 2017)