You have started your journey towards Financial Independence
and are stashing away money, having found some space in between your income and
expenses. But what do you actually do
with that money?
It is time to put your money to work for you. You want to invest your money into assets,
which will make you more money. At the
same time, you want to avoid locking it away in liabilities, which will
diminish your money. What’s the
difference? To put it simply, if you
lost your job tomorrow, assets would feed you while liabilities would eat
you! Understanding the difference
between an asset and a liability is critical to Financial Independence.
Key asset classes:
Equities
When companies issue shares of stock, they entitle the
owners to a share of the equity in that company. Generally, when those companies make a
profit, they will reinvest some of the profits to help grow the company and pay
the rest out to the shareholders in the form of dividends or share buy
backs. Both methods help drive the value
of the shares higher, and so the share prices rise over time. This dual nature of dividend payouts and
share price appreciation makes stocks as a whole one of the highest returning
passive asset classes over time.
Those last two words, “over time,” are important. As anyone who has watched the financial news
or lived through 2001, 2008, or 2020 surely knows, stocks can fluctuate in
value quite a bit. Stocks are best
utilized in a buy and hold strategy, allowing decades for compounding returns
to do their work.
This graph really demonstrates the power of compounding investing returns. The numbers are not a typo, the S&P Index really has grown to almost 1 Million percent100% of the original value being the starting point, so 1,000,000/100 = a 10,000 times growth over 94 years. of it's original value in 1926 when Standard & Poor's started computing the composite price index of 90 stocks. It was expanded into the S&P 500 in 1957, and remains today the 500 US stocks with the largest market capitalizationThe total worth of the company, which can be calculated by multiplying the stock's share price by the number of outstanding (publicly owned) shares.
Furthermore, the invention of mutual funds and ETFs
Exchange Traded Funds have allowed even individual investors to own large
baskets of diversified companies. This
allows your financial returns to track the whole market, which is consistently
driven upward by human ingenuity and productivity, rather than being tied to an
individual company’s fate.
This graph shows the identical data as the previous graph, but this time on a log scaleSee that instead of each tick on the vertical axis being a constant amount, it is another factor of 10. A log scale makes exponential growth look linear.. Over the long term, the recessions of the 2008 Financial Crisis, the 2001 Dot Com bust, the 1973 oil crisis, WWII, and even the Great Depression as show up as minor dips before the stock market resumes it relentless rise due to the underlying value being created.
Trading single stocks in short time frames can be
exhilarating, like going to the casino, but passive wealth building strategies
center around the diversification of low-cost index funds.
Bonds
Besides equities, the other major paper asset is bonds. While stocks represent ownership, bonds
represent debt. Companies and other
organizations like governments can raise capital for their operations by
issuing bonds to investors. These bonds
are generally structured to pay out a certain return, called a coupon, over a
certain period of time. At the end of
that period, the maturity date, the original capital is returned to the bond
holder.
Generally, bonds see a lower overall return than stocks. For someone that buys a bond at issuance
and holds to the maturity date, the rate of return is linked solely to the
coupon rate. This coupon rate is lower
for the lowest risk bonds like US Treasury bonds and higher for riskier types
of bonds like corporate bonds. If the
bond issuer goes bankrupt, the bond holder is in danger of losing payments or
principle. This scenario is unlikely in
the case of a large government, so the coupon rate is low, and more likely for
individual companies, so the coupon rate is accordingly higher.
Bonds can also be traded on the open market and prices tend
to rise and fall with interest ratesA bond with a certain rate becomes worth
more when interest rates drop and loses value when interest rates rise. or
major news about the bond issuer (e.g. if a company previously viewed as stable
was suddenly found to be on the brink of bankruptcy). In practice, some of this individual risk can
be mitigated with a similar diversification strategy as equities; bonds can
also be purchased within diversified bond index funds.
With the coupon rate remaining fixed, bonds tend to trade in
a narrow price window around their face valueThe original price the bond was
issued for, most often in even increments like $1,000. This stability along with the consistent
coupon payouts are the real strength of bonds.
They cannot match equities for return, but they can be part of a draw
down strategy: helping to smooth out market fluctuations while living off your
wealth.
Real estate is actually a diverse asset class that shares
some common themes, basically that you own some property and rent it out to
tenants. The classic example is the
single-family home which you own but rent out to another tenant. Duplexes, triplexes, and four-plexes complete
the residential real estate space. These
types of units are also perfect for doing a “house hack” where you live in one
unit and rent out the others, severely reducing or even totally subsidizing
your own living costs. The original
house hack, getting roommates, can also be done in the unit you are living in
for additional income or as a way to make a single door property affordable.
Above four units in a building would be considered a
commercial apartment building, a distinction important for financing and tax
implications, but otherwise following the same fundamental investing and
operating principles as the smaller residential buildings. In addition to residences and apartments, you
can also invest in office complexes, retail space, storage units, mobile home
parks, and so on. The basic tenants of
real estate are purchasing a property, often with the advantage of leverage
Financing, usually in the form of a loan from a bank, so that you can make a
larger investment than you could have on your own., and generating a cash flow
from the tenants in excess of the operating and financing costs.
Appreciation of the price of the property can also generate
returns, but this falls into two categories: forced and market. With forced appreciation, you invest in
improvements in the property and therefore the value of the property
increases. On the other hand, market
appreciation is up to the whims of the market.
When it happens, it’s a great bonus but the long-term investor makes
sure the numbers work without counting on market appreciation. This is what is meant when they say the money
is made going into the deal, not on the way out.
Business Ownership
Ultimately, real estate itself is a type of small business
ownership, just a common and repeatable one.
Other businesses can also generate income. The variety of such opportunities is beyond
the scope of this article, but the trick from a financial independence point of
view is to work on the business, not in the business. There will be some management required, just
like in real estate ownership, but it should be able to produce income without
your constant input. There is a fine
line between being a business owner and just being self-employed.
If you ever look at buying a business but would have to work
40+ hours a week to make it profitable, you are just buying a job. In such an opportunity, figure out how much
hiring a full-time replacement “manager” would cost, subtract that from the
earnings of the business, and reevaluate the investment. Note that being an entrepreneur and working
in your business can be a great path to start to build wealth, but that is
just a different flavor of a job, not a passive investment like we are
discussing here.
Now that we’ve seen some assets you should be using to grow
your money, let’s take a look at some classic pit falls that aren’t actually
assets.
Deceptive Liabilities:
Vehicles
Cars you may often hear erroneously referred to as depreciating
assets. While it is true that cars
generally depreciate, a privately owned automobile is almost never an asset and
instead falls squarely in the liability category. Not only do you have to purchase or make
payments to acquire the vehicle, but the car requires maintenance and fuel to
operate. Even when you aren’t
operating it, it requires insurance,
licensing fees, and, in some states, personal property taxes. In urban areas you may be
hit with parking fees or in the suburbs you may be paying a higher mortgage and
property taxes for that garage over your fleet.
You probably also spend your time and money keeping it clean or even
upgrading it.
In other words, you have to put money in to actually use and
own the car, even one that is fully paid off.
Of course, there is a benefit to all this, as there is a huge gain in
transportation efficiency with an automobile.
In some locations with great weather and maintained bike paths, you
might be an environmental hero by eschewing a gas guzzling car and grabbing
your groceries with a bike a trailer, but in other cities and suburbs your pedal
powered savings would quickly be offset by medical bills or worse. Often, a vehicle is a necessity, and replaces
more expensive e.g. Uber, Lyft, taxis or inconvenient and slow e.g. bus,
subway options.
In general, I recommend only paying for what you need. Don’t buy something too big. You can always rent a truck from Home Depot
or Enterprise for that one time in five years you need to move some
furniture. Only get as many seats as you
need for immediate family, not for those rare occasions that you want to take
the whole soccer team. How often will
you notice the 9th and 10th speaker? Or need the extra 100 horsepower? Or wish you had the built-inPlease never
pay extra for the nav option in this era of ubiquitous, self-updating, GPS
enabled smart phones. doodad instead of the doodad you already have? In general, cars are expensive and have a
large impact on your financial journey, so work hard to keep the core costs
down.
Used versus new is always an interesting question. A new, expensive car will never make
financial sense. However, for the mechanically challenged, a new, affordable car with
a strong warranty might. Even then, the
depreciation in the first few years for most cars can be so severe that a
few maintenance and repair bills will never make up for the head start the
lower priced used car gets. For those
that are mechanically inclined and willing to get their hands dirty, these days YouTube
and Google can tell you nearly everything about how to fix your car
yourselfEven for difficult jobs
requiring specialized tools, I’ve often found buying the tools once
costs no more than the repair would and now you have the tools, allowing
further repairs at minimal to no expense..
Housing
“Your house is your biggest asset.” It’s a phrase you’ve probably heard
before. It’s almost correct, but only if
you replace “asset” with “liability.”
Your house is an asset for your mortgage lender. They paid for your house, and now you pay for
all the maintenance, repairs, property taxes, and insurance while paying them
back with interest. For you, it’s
clearly a liability, eating your money every day.
Of course, there is benefit here as well. You have to live somewhere. If you don’t own a home, you would have to
pay rent. In that sense, it effectively
reduces your expenses. Whether it is more
cost effective to buy or rent depends on the market, the specific property, and
your personal circumstances, but is a calculation deeper than we will go into
in this article. Much like cars, we
come to the general conclusion of don’t get more than you need. Housing is likely to be your highest expense,
so saving here can have an outsized impact on your wealth.
Some people do make money with real estate, but it’s with
the previously discussed rental properties, not with their personal residence. Even if you get lucky and get above average
price appreciation in your neighborhood, it is unlikely to offset the high
costs of home ownership. Then there is
the opportunity costWhat else could you be investing in with the money you
are tying up in this?. If instead of
buying the house (or more house than you need), you invested that money to grow
in the market, the market would outpace even the hottest residential real
estate markets once the expenses are accounted for. So only buy as much house as you need and start
investing the excess.
Doodads
Then there are the more obvious excesses. Boats, watches, second houses, pools, exotic
cars, airplanes. Rich Dad Poor Dad
author Robert Kiyosaki labels these types of things as doodads. They all share in common recurring costs that
eat into your journey to wealth. These are the play things of the truly wealthy, so the aspiring wealthy try
to look and feel wealthyKeeping up with the Joneses by owning them as well, but just end up working their
whole life to pay for them.
A boat, for example, does not only reduce your wealth by the
cost of the boat. You may also have to
buy an expensive truck and trailer to tow it or you may be paying fees to store
it. Due to the high drag water creates,
boats are horribly inefficient on fuel.
With limited spots to fill up, marinas can charge a premium. You will be paying insurance and licensing
fees for the boat, truck, and trailer. Like
any vehicle, maintenance will be expensive.
In most climates, you will have to pay to winterize it. You will now be the proud owner of way too
many life jackets and inflatable thingamabobs.
Someday, you may have enough passive, compounding wealth
that all the costs of your favorite doodads add up to peanuts for you. In the meantime, you are locking yourself in
to additional extra recurring annual expenses.
Every $1 you spend is $1 further away from your financial independence goal,
but every dollar you add to your annual expenses is like adding $25 to your
goal. This is known as the 4% rule of
thumb, which we’ll look at in the next article.
In the meantime, if you really need to hit the water, look into renting
that boat for the day!
Comments
Post a Comment