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:
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.
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.
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.
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..
“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.
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!