By Kyle J Christensen, Principles-Based Financial Planner, Owner of Unique AdvantageThe goal isn’t more money. The goal is living life on your terms. – Will Rogers
This is a very important question. I think it helps to start with the end in mind. What is my purpose for investing? Am I just trying to increase my net worth? Or, am I trying to achieve financial freedom through cash flow from assets?
What people should NOT do is simply adopt the “goal” that financial institutions are telling us we should have. Namely, financial institutions are telling us our all-encompassing objective should be “retirement”.
Retirement, by definition, is not really what most people think it is. According to Merriam-Webster, retirement means “to withdraw from active working life”. Retirement is “the age at which one normally retires”. Retirement, in other words, is not a capability. A person can retire without any assets at all. A person can retire and not be able to travel, not be able to donate to charities as they wish, not be able to visit kids and grandkids, and not be able to spend their days however they choose. Retire means to quit. As such, millions of people retire and then become mostly or completely dependent on the government (Social Security and Medicare). According to The 2018 Retirement Confidence Survey, by the Employee Benefit Research Institute, shows that while only 36% of the current workforce believes Social Security will be a “Major Source” of income in retirement, 67% of retirees say that it is. In other words, more than two thirds of all retirees are completely dependent on Social Security retirement income to survive (note: I did not use the word “thrive”). Retire is not truly the goal, at least not by itself.
Something that’s important for all Americans to keep in mind is the strain that Social Security and Medicare place on America’s financial resources. Right now, Social Security expenses are the largest single expenditure in the Federal Government’s budget (check out this report from Social Security). And what is more concerning is that this expenditure is growing exponentially over time. So, it doesn’t take a genius to predict that something is going to have to change regarding Social Security in the future. And those that are completely dependent on it may be in for a very unwelcome surprise. What will be the recourse? Protest? Riot in the streets (like Greece and so many other countries have done)? Part of our goal in investing should be to avoid or minimize dependence on social welfare programs.
If we start with the end in mind, we need to decide what the purpose is for each of us individually. For most of the people I work with, they want to become financially free for their own individualized reasons. They don’t necessarily want to retire per-se. Most want to get to the point where they no longer are forced to work for money. That doesn’t mean they don’t like/love what they do. They simply don’t want to have the continued stress and pressure of being required to do it. They also don’t want “working for money” to be their top priority from a prioritization-of-time standpoint.
So, if a person wants to reduce or eliminate the necessity of working for money, what needs to happen? The answer is two-fold. First, they can reduce their monthly expenses. Namely, they can reduce lifestyle and/or pay off debts. Most people would rather not reduce lifestyle, so they focus more on paying off debts. Paying off debts is a fine objective, but it really only lowers the bar for what will be required in order to be financially free. Being debt-free does not equate to being financially free.
Other than reducing expenses and eliminating debt, what else does a person have to have in order to be financially free? They have to have income derived from something other than working for money. Historically, the only way to receive income is from your own labor or from the labor of others. And the only way to receive income from the labor of others (voluntarily) is to own a business and/or assets that provide something of value that other people want or need more than they want or need to hold onto their money.
What kind of “assets” am I talking about? There are really two major categories of assets. Investment assets and non-investment assets.
An example of a non-investment asset is a house that you live in (unless a portion of it is being used to generate income – i.e. you rent out the basement). A house has value and that value typically appreciates. But, it doesn’t produce income (In fact, it requires a large portion of your income, in most cases). A person could own a home (a residence they live in) worth millions of dollars but that person is likely still not financially free even if the house is paid off. A person usually (I put this caveat in here because, although I know of no one who has become financially free by solely purchasing non-investment assets, there might be someone – I’m open to hearing about them) cannot become financially free by buying non-investment assets alone, regardless of how valuable those assets may be.
An investment asset, on the other hand, is purchased for the main purpose of providing generating income now and/or in the future. Investment assets fit into two sub-categories. There are investments that are primarily designed for capital appreciation (increasing in value – that’s the goal anyway) and other investments that are primarily designed for the purpose of producing cash flow (and they also typically appreciate in value over time – but that’s a secondary benefit to them). Almost all of the “investments” sold by financial institutions are the former and not the latter.
To complicate things further, people can purchase either type of asset inside of a “retirement account” (i.e. 401(k), IRA, SEP, SIMPLE, etc – these are all called “Qualified”) or they can own them outside of a retirement account (this is called “Non-Qualified”). Whether the assets are held inside of a retirement account or not makes a huge difference in two areas. Taxation and cash flow. If an asset is held in an IRA, regardless of the investment type or how long it’s owned, the increase in value of the asset will be treated as Ordinary Income (other than Roth accounts). Ordinary Income tax rates are significantly worse than Long-Term Capital Gains rates. Also, retirement accounts restrict or prevent any cash flow from the assets being distributed to the owner of the account until at least age 59.5 (could be longer if the money is in a 401(k), for example, that where the account owner is still working for the sponsoring employer – the employee has to separate employment first, before being able to take income from the account.) Rules, rules, rules. Because of these rules, it makes little sense to buy income-producing investments and place them in Qualified retirement accounts. As such, the type of investment assets that are placed inside of Qualified Plans are usually capital-appreciation investments.
“Investment advisors” almost exclusively sell capital appreciation investments (i.e. stocks, bonds, mutual funds, etc). This shouldn’t be surprising especially when we understand how investment advisors get paid. They get paid when you send them money and when you leave your money with them. They get paid less when people pull their money out to use it for living, traveling, donating to charities, etc. As such, investment advisors have an inherent conflict of interest. They get paid less if you use your money. So, they don’t want you to use your money. They only want the cash flow to go one direction, which is to them.
One of the biggest problems with capital appreciation investments, as it relates to the achievement of financial freedom, is that it’s almost impossible to know how much is “enough”. How many millions of dollars worth of non-income producing stocks and mutual funds does it take to replace your income? Getting the right answer to this may require the use of an accurate fortune-teller and a functioning crystal ball (which, I’ve heard they stopped selling on Amazon).
Robert Kiyosaki, author of Rich Dad Poor Dad, tells us that a real asset is something that puts money into our pockets. And a liability is something that takes money out of our pockets. Most people put their money into what they think are assets, only to find out that the money only flows one direction for decades, away from the investor and to the financial institution.
Rich dad used to chuckle and say, “It does not take much financial intelligence to find an investment that loses you money. The market is filled with experts telling you how to do that. All you have to do is just give them your money.” Rich dad also said, “Anyone can find an investment that loses money. Why people pay so-called financial experts to do that for them is beyond me.” (Who Took My Money?, Kiyosaki, p 204)
That brings us to the other type of investment asset, cash-flowing assets. The insinuation of Robert Kiyosaki’s statement is that non-income producing assets (capital appreciation investments) are easy to find, easy to participate in, are basically a dime a dozen, and that income-producing assets requires more work, more effort, and more intelligence. This is all true. And this is where we lose people. People, for the most part, are pretty lazy. I’m not trying to be mean here, I’m just pointing out a natural tendency that most of us have (if we’re honest about it). Most people are constantly looking for the easier way to get something done. Most people don’t want to have to learn something new or spend more time working on something that doesn’t bring them immediate pleasure. Most people want to avoid taking responsibility for the outcome of their investments. They’d rather have the ability to blame someone or something else for the outcome (especially if it’s negative). As such, most people invest in capital-appreciation assets because they are easier, more convenient, less time consuming and don’t appear to require any additional level of knowledge or expertise (not that that would improve their performance anyways).
According to the 25-year research done by Thomas Stanley, PhD (author of The Millionaire Next Door) only 12% of millionaires credit their success to “investing in the equities of public corporations”. What about the other 88%? Where do their credit their success? Owning their own businesses and investment property. Both of which cannot be sold or managed by investment advisors. Why is it that businesses and investment property are the main sources of financial success in the United States (and always have been)? Because they produce cash flow, provide real tax breaks (not fake ones like retirement accounts that simply push the tax to a later date), and can employ the principle of leverage ($1 having the ability to move $5).
In order to achieve financial freedom, whether a person invests in capital-appreciation investments or cash-flowing assets, that person must, at some point, receive cash flow from the assets. So, if the person has all or most of his investment money in capital-appreciation assets, he either has to move those funds into something that is designed to produce cash flow, or he has to sell portions of the assets each year in order to pay for his lifestyle. Selling assets is not the same thing as assets generating cash flow. One is killing the cow in order to eat, so to speak, and the other is simply milking the cow.
Wouldn’t it be better to acquire assets that are designed to produce income from the beginning? Wouldn’t it be better to invest in investments where you can employ the principal of leverage?
What happens to your risk of loss in an investment that produces cash flow? Justin Donald, author of The Lifestyle Investor, gives us his response to this question:
Notice the outcomes, especially as they relate to the velocity of money. You have earned cash flow the entire time, you have de-risked the investment because you have your principal out of the deal, and you have been able to get some equity even though all your money is out. On top of all of that, you can participate in big exits over the long-haul. What’s more, you’ve used the same strategy with the same money for all five deals since you’re reinvesting the same principal that gets returned to you on each investment. (p.111)
When do people “de-risk” their investment in capital-appreciation investments? Only when they sell them and pull the money out, which is usually many decades after investing the money (if at all).
Investing in cash-flowing assets increases your income now (not decades into the future), de-risks your principal, and makes you less dependent on your earned income. You can use the same money over and over again (Velocity of Money) versus having all of your investment capital dependent on your ability to keep working for money. When you reach financial freedom you know it. You’ve already been receiving the income necessary to continue your chosen lifestyle. You don’t have to then figure out how to get income from the assets, like you do with capital-appreciation investments.
Investing in cash-flowing assets requires time, effort, expertise, and generally more cash up front than capital -appreciation assets. Those principles (time, effort, expertise) are no stranger to you! Everything in your life that has endured successfully has required those same ingredients. You also know that most successfully enduring things in your life require you to go against your natural tendencies (i.e. studying hard for college classes, exercising, eating healthy, always speaking kindly to people, and so on). Success in finances is no different.
You and I can achieve financial freedom by employing the principles that we know to be true in other areas of our life. We don’t have to be experts in the financial industry to make great investment decisions. We just need to run the investment opportunities that come before us through our known principles in life and toss out the ones that fit the categories of going against our known principles of success and the things that “too good to be true” (i.e. “free money”). We need to learn the principles that other successful people have followed and instead of trying to reinvent the wheel, we can follow their footsteps.
Now, the choice is yours. Are you going to invest in capital-appreciation investments or cash-flowing assets? Are you going to do what’s easy and has led most people to financial dependence, or are you going to choose the path that’s more difficult but has proven to lead to financial freedom more than any other way?