One of the reasons I believe most people never succeed at reaching financial independence is because they make things too complicated. They invest in elaborate investments they don’t understand, but heard some guy on television screaming to “buy, buy, buy!” They make fancy moves with their money, like taking out a second mortgage on their home to put down on a vacation home for the additional “tax benefits.”
All the highly technical, overly complicated wealth-building advice in the world can be boiled down to four words, that if followed will practically guarantee financial independence to those who follow:
“Buy Assets, Avoid Liabilities”
That’s it. Simply buy assets. Buy things that increase in value. Buy things that produce income. Avoid spending money earned in exchange for work on anything other than assets.
The problem is, most of us take the exact opposite approach. We buy liabilities. We buy things that depreciate in value – sometimes quite rapidly. We buy “experiences” like magical vacations. We spend an inordinate amount of money on entertainment, eating out, and expensive hobbies.
How do I know this? Because I spent the first 15 years of my adult life doing the exact same thing. I bought things on credit cards, racking up debts I couldn’t pay. I borrowed money to go to school. I spent every dime I earned, and then some, on the latest video game systems and cell phones and crap I didn’t really need.
Sure, a few of those things added some value to my life in the form of entertainment, or making things easier, etc. However, the large majority was a waste, because I can never reclaim those earnings. I can never reclaim the earnings that income could have amassed after being exposed to the magic of compound interest.
Now, I certainly don’t begrudge anyone who aspires to have nice things. In fact, I’ve enjoyed saving cash and buying a few things I put off for a few years while working towards debt freedom.
But one should recognize that for ever frivolous purchase, every spendthrift trip to the mall, we push financial freedom out a little further. If financial independence doesn’t happen to be a goal of yours, and you are quite happy working the rest of your life to pay monthly bills to banks, well, then you won’t have much of a problem continuing this trend.
For the rest of us, financial independence is a strong motivation on our day-to-day spending decisions, and certainly the larger life-altering decisions such as buying a house, a car, selecting a career field, etc.
From Liabilities to Assets
To start on a path towards building wealth you have to have sort of a mindset shift – away from acquiring more liabilities (things that suck money from your wallet in the form of monthly payments or depreciation) – and towards things that increase your bottom line (though appreciation and income).
Consider these two acquisitions, as a small-scale example:
- $200 for a new smartphone. If you decide to buy one, chances are you are taking on another $70-$100 monthly expense in calling and data plans. That’s roughly $1,200 in the first year (including your $200 upfront cost of buying the phone).
- $200 of Verizon stock. Verizon (VZ) currently yields roughly 5.4% in an annual dividend. Your $200 worth of stock would generate about $11 per year in dividend payments. Less than a dollar a month doesn’t sound like much, but it’s certainly cheaper than $1,200 in that first year. (Full disclosure, at the time of this writing I don’t own any stock in Verizon (VZ).
To carry this example further, assuming you decide to reinvest dividends, that $200 investment in Verizon would be worth $260.13 in five years, and that’s assuming no growth in the stock price itself and no increases to the dividend.
How much do you think that $200 smartphone will be worth in five years? Probably not much – an expensive paper weight, perhaps?
The initial investment amount is relatively low in this example, so the argument for buying assets doesn’t seem that compelling. However, multiply that example by five or ten times, to represent what you might spend on “less than necessary” items each month, and we are talking some serious money.
A $2,000 investment in Verizon stock at current yield levels would be worth about $2,601.55 in five years, assuming you reinvested dividends and the stock experiences zero growth and no increase in dividend payouts (not likely for a mature, healthy growth stock).
Another benefit of choosing assets over liabilities is that most of the time, assets don’t continue to drag on your cash flow in the way many liabilities do. In the above example, the monthly service charge for the phone quickly exceeds the cost of the phone itself, and continues to cost money as long as you keep it.
Not true of the Verizon stock, which after your initial purchase (and broker commission) won’t cost you a dime outside of taxes on dividend payments and taxes on any capital gains when you sell.
Flipping the Switch
The next time you are planning a major purchase, remember the above example and then ask yourself a few questions regarding your new potential purchase.
- If I had to prepare a personal balance sheet, would this item be considered an asset or a liability?
- Will this item add to my quality of life?
- Will this item produce income for me, or will I have to spend additional earnings each month to service its ownership (to insure it, maintain it, operate it, etc) ?
- Is the value of this item likely to increase over the next 5, 10, 20 years?
With the answers to these questions, chances are the decision to buy or not buy will become much easier. Always lean towards accumulating assets – in various well-diversified forms (real estate, precious metals, income-producing savings vehicles like CDs or bonds, etc.).
Minimize the acquisition of liabilities. Protect your cash flow earned from paid employment by diverting as much of it as possible into assets.
Be vigilant about protecting your earnings – you worked hard for them!
Be intentional. Give every dollar in your budget a name and stick to your plan.
Do this over time and you will begin to rely less and less on paid employment, and inch ever closer to financial independence.