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The PersonalBusiness: Run Your Personal Finance As a Business.
You should run your finances like a business: for a profit! You'll become financially free and wealthy running your PersonalBusiness. It’s simple: analyze your income and your net worth like you’d run a business, making a profit by cutting your expenses to retain your heavily taxed earned income, rather than spend it. Investing your profits in economic primary trends, your money begins working for you rather than you working for your money. Your unrealized investment income grows tax free through the power of compound interest.
The Tools for Running Your PersonalBusiness
The income statement and the balance sheet are the tools you use to run your life like a business. These tools help you understand how your financial decisions affect your retained earnings and your net worth. The income statement shows you exactly where your money comes from and where it’s going. Through the income statement, you can pinpoint wasteful spending, or spending that would be better directed to building your wealth. The balance sheet “balances” your assets and liabilities showing you your net worth. The balance sheet is a tool that helps you understand the affects of financial decisions on your net worth. The income statement and the balance sheet help you stop worrying about monthly payments and start focusing on your financial freedom.
Gaining Financial Freedom Is Simple But Not Easy
So, we've talked about what to do to gain financial freedom. Simple isn't it? Well, it may be simple, but we know it's not so easy. In fact, even though the strategies have been around for a long, long, time, most folks don't know them or aren’t able to execute on them.
Spending Like a Superstar?
You may be financially dependent on your job because you spend and consume as if you were already wealthy. When I was young, I expected to rise to the top of my profession and I envisioned that my income would continue to increase dramatically over my lifetime. Indeed, many of us feel we’re going to set the world on fire when we leave school, and our professional successes will provide all the money we could ever need. It is possible to become such a superstar, but highly unlikely.
This anticipation of ever greater income keeps many people dependent on highly taxed earned income (their jobs). Spending your income on consumption by living the wealthy lifestyle keeps you from ever becoming wealthy. Indeed, we confuse the ends (the wealthy lifestyle) with the means (living frugally) to become wealthy. Richard Russell Russell wrote for John Mauldin’s book “Just One Thing” the following, and I think it succinctly covers this point:
“For the great majority of investors, making money requires a plan, self-discipline, and desire. I say "for the great majority of people," because if you're a Steven Spielberg or a Bill Gates you don't have to know about the Dow or the markets or about yields or price/earnings ratios. You're a phenomenon in your own field, and you're going to make big money as a by-product of your talent and ability. But this kind of genius is rare.”
Rare indeed! And even superstars end up bankrupt and penniless if they’re not good money managers. If you’ve been around awhile, you probably realize the truth in Mr. Russell’s words. If you’re a young person reading this, just now starting out in your career, you should heed them. Relying on ever increasing income from your employer is the path to indentured servitude. Saving and investing so that your money can work for you is the path to freedom.
The Media Tells Us We Need to be Superstars
Newspapers are filled with stories of entrepreneurs striking it rich. Flip to any business section for the latest photo of a swash buckling entrepreneur beaming from behind the wheel of their Benz. Everybody knows you don't get rich working for someone else, right? Wrong!
Take it from a serial entrepreneur, it ain't so easy to strike out on your own and get rich. In fact, almost every successful business I've seen was started on a sales opportunity, or leveraged a sales opportunity. It wasn't started based on the dream of the founder.
The PersonalBusiness is the Simple and Certain Way to Wealth
So, what do we advise? Start a PersonalBusiness. Quite simply, PersonalBusiness is running your personal finances like a business—for your profit. Your PersonalBusiness is, in our opinion, far, more likely to lead financial freedom than if you were to strike out on your own and try to start a conventional business from scratch. Your PersonalBusiness is almost guaranteed to succeed, for a number of reasons.
First, you learn how to cut your expenses so you can maximize your profits—in the same way a conventional business does. This is what we call the “good defense.” As soon as you start cutting your expenses, your freedom will increase. You’ll have more flexibility and choice in your life. I’m often asked “what’s the best way to cut my expenses.” The answer is your personal income statement that shows you exactly where your money is going, and we’ll talk more about that shortly.
Second, running your PersonalBusiness will change your thinking. Folks that are good at generating wealth don’t think like folks that are good at consuming wealth. The only way to change your thinking from that of a consumer of wealth to a producer of wealth is through action, and the action we recommend is the PersonalBusiness. By running your PersonalBusiness, you’ll develop a new focus on producing income rather than consuming it. If you’re like me, you’ve caught yourself dreaming about something you’re going to buy and money you’re going to spend. Thinking like that isn’t doing you any favors. Since I’ve been running my PersonalBusiness, my thinking has changed and I’ve lost interest in spending away my income and gained an interest in conserving and investing it.
Third, with the PersonalBusiness, you’ll be avoiding the risks and expenses of starting a conventional business. Sure, plenty of folks start their conventional businesses are successful. First off, the risk: far more new conventional businesses fail than succeed. Almost all new businesses require significant investment at startup. The record keeping and legal formality surrounding a conventional business are significant, as are taxes. Conventional businesses are taxed on salaries, benefits, and all revenue, and they usually carry insurance. These are all expenses and risks the PersonalBusiness avoids.
And finally, the PersonalBusiness is focused on time honored wealth building principles that will last you a lifetime. No matter where you go, experience running your PersonalBusiness will serve you, and all those that rely on you for guidance, very, very well. With a PersonalBusiness, you don’t pay salaries, insurance and benefits, employment taxes (15.3% social security and medicare), and most important you don’t pay taxes on revenue until you realize it.
Stop Wasting Your Money and Start Thinking Like a Business Owner
If successful business owners don't waste their money, why should you? Every time you make a big spending decision without analyzing it financially, you run the risk of throwing money away. Money that could be working to make you financially free. The “low down, easy monthly payment” mindset is only good for wiping out your net worth, and guaranteeing that you're going to be trapped in your job, working longer and harder than you want. Rather than borrowing against your income and buying as much as you can, start thinking about how you can get what you want while still protecting or increasing your net worth. You can do this buy understanding the finances behind your purchase decisions.
Maximize Your Net Worth, Not Your Spending Power
If you're like most people out there, you fantasize about all the things you can buy with your income. And why not? There's a line of people going out the door and around the planet waiting to loan you the money to buy their stuff. They don't want it, so they might as well sell it to you. The biggest reason they don't want it is depreciation. They longer they hold onto it, the more value their stuff loses. One trick to protect your net worth is making the other guy take the depreciation hit for you. For example, a new automobile typically loses 30% of its value in the first year.
The Three Ways to Buy Depreciating Goods
(1) Borrowing to buy rapidly depreciating goods. This is the worst possible scenario to go with. Precious highly taxed earned income is going to be wasted on interest payments, hurting your income statement. Worse yet, the falling value of your purchase is going to hurt your net worth. Good examples of this are cars, boats, electronics, appliances, computers, vacations, clothing, etc.
(2) Paying cash for rapidly depreciating goods. In this case, you don't take the interst payment expense, but your net worth falls as the value of what you purchased falls.
(3) Paying cash for depreciated goods. These goods aren't going to fall in value, and often times will appreciate over time. When you make a cash purchase of depreciated goods, your net worth doesn't really change that much. Some recent examples of cash purchases for depreciated goods I've made are: 32” TV, 1988 sailboat, and 2001 motorcycle. These are all purchases that had little or no affect on my net worth-- I can either sell them for what I paid, or more. My advice to you? Don't take the depreciation hit.
The New Car Example
Like that new car smell, do you? Hey, I like the new car smell, too-- but I like the smell of $17,500 a lot more. $17,500 is about what you'll lose in the first five years if you buy a new $25,000 car (cheap as new cars go) and finance it. That new $25,000 car will cost you $5,000 in interest. If it's a quality, reliable and desireable car, it will probably only lose 50% of its value in the first 5 years. You'd better choose wisely: if you end up buying an SUV, you're probably going to take a 75% hit. Even at 50%, we're still talking about $12,500 worth of your money going to money heaven.
Maximize Your Profit by Cutting Your Expenses
People often ask me, “how do I cut my expenses? I don't know where to start.” The simple truth is, I don't know where you should start, either. In fact, I know some of you are afraid to spend anything, because you feel like your personal finances are out of control.
Finding Out Where Your Money Goes: the Income Statement
The first step to cutting your expenses is figuring out where you make your money, and where you spend it. The income statement, also called the profit & loss statement, is the tool you'll use to find out where your money comes from and where it goes. If you google “personal income statement,” you'll turn up dozens of examples you can use. The basic form of the income statement is simple:
retained earnings (profit) = income – expenses
Here's a good example of a personal income statement.
Examples of your income are net wages (after taxes), realized investment income, gifts, and perhaps stuff you've sold (my personal favorite). Examples of expenses are food, clothing, transportation, entertainment, communications (phones, tv, internet), and various.
Subtract your expenses from your earnings, and you have your retained earnings, or “savings.” Your savings are what you're going to invest to start growing the investment side of your income and balance sheet.
A Word About Cash Flow: I want you to note that we're not talking about “cash flow” here. Cash flow is the amount of money coming in and going out over a defined time period -- it has nothing to do with how much profit you make. Some "gurus" in the personal finance community misuse the term “cash flow.” What you care about is your profit-- your retained earnings, not “cash flow.” Cash flow is something you only need to know in order to manage payments, and isn't going to help you cut your expenses. If anyone tells you to focus on your “cash flow,” you should ask them why.
Income Statement Identifies The Biggest Expenses Ripe For Cutting
I've read dozens of bad articles on cutting expenses. If you're spending $100,000/year, it's not going to do you much good to save $100/year on that gym membership, is it? The income statement is going to pinpoint your biggest expense categories, and it's going to be up to you to figure out how to cut those expenses. Cutting your expenses will change your thinking, you’ll start looking for a way to reduce your debt, get more bang for your buck, and leave the other guy holding the depreciation bag.
There are two primary types of expenses, fixed and variable. Fixed expenses are typically basic repeated monthly expenses, and they're difficult to change quickly witout refinancing loans, selling off assets, etc. Housing, insurance, medical care, debt service payments, and the like, are going to be tough places to save money. Variable expenses are expenses you have more control over. Cutting your variable expenses will hinge on giving up things you don’t need and reducing the usage of goods and services you do need, such as food, clothing, and transportation. Paying down your debt is a great way to free up some cash flow for investment. We have a forum on debt, so keep an eye out for future articles on debt reduction.
However, if you find yourself in a situation where your variable expenses are fairly low, and you're still unable to save and invest, then cutting these “fixed” expenses will become necessary. This might mean downsizing your home, reducing your insurance costs by increasing your deductible or reducing coverage (as reasonable). Your variable expenses, on the other hand, are easier to change, because they're amenable to substitution or just plain old belt tightening.
I want you to keep this in the forefront of your mind: for every dollar in expenses you save, you're saving two dollars in gross salary. Uncle Sam takes 50% or more of every dollar you spend, so saving one means you don't have to earn two. Now for a little anecdote. I have a close friend that has far more financial resources than I, and he's trying to gain financial freedom just like the rest of us. One day we were talking, and he was explaining how he loathed spending money. He told me he felt his income was just sand running out of the bottom of a funnel, and he felt extremely frustrated. I suggested that he complete a thorough income statement. He followed my recommendation, and discovered that one area he could really cut back was insurance. My friend’s realization was this: even though many of his possessions weren’t depreciating that rapidly, insuring them was really expensive. By reducing his possessions, he had less to insure and maintain.
Which brings me to my final point about cutting expenses: it's addictive. Once you find yourself “downsizing” and reaping the additional retained income, you're going to want more. It's a freeing force in your life. You're finally beginning to stop thinking about putting money into someone else's pocket, and keeping it in yours.
Invest Your Retained Earnings in Economic Primary Trends
Let's talk about investing and trading. Here at HowWealthWorks.com, we're focused on investing in a particular asset for longer than a year. Sure, we might execute a trade or two on the side for fun and learning, but we're long term investors first and foremost. Why? Unrealized gains and compound interest. Trading, after all, is really just another form of earned income, and that's not what we're about. However, keep in mind that as you become a more sophisticated investor, it may behoove you to learn how to trade. One final thought on trading: a wise man once said that trades that have lost money are “investments.”
Keep an Eye on Your Net Worth with the Balance Sheet
You've probably heard people bandy the term “balance sheet” about but may never have understood it. Well, “balance sheet” is simple: it's merely a means to determine your “net worth.” A balance sheet “balances” assets with liabilities (often money you owe on your assets, or otherwise) to give you your net worth, or “owner's equity.” We're going use the term net worth, since it's a generally accepted personal finance term.
Here's the simple equation for the balance sheet:
net worth = assets – liabilities
What's the balance sheet for? To show you your net worth, after that and how your financial decisions affect your net worth. Retained earnings (savings) from your income statement flow into your balance sheet, making your net worth grow. Principle repayment of your liabilities, like credit card debt or mortgage payments, flow out of your income statement as expenses and show up on your balance sheet as decreased liabilities. Unfortunately, the interest portion of the debt repayment is a pure expense and, of course, adds nothing to our net worth. Entrepreneur.com has a good example of a balance sheet.
Together, the balance sheet and income statement give you a pretty good idea of your financial position and how to go about improving it. In fact, once you've developed some “owner's equity,” you'll find that banks are very interested in your income statement and balance sheet-- more so than they'd ever be interested in your “credit score.”
Much like the income statement is the roadmap to cutting your expenses, the balance sheet is the roadmap to growing your net worth and investment income. In the beginning, you'll be focused on growing your net worth by reducing your liabilities-- especially if your liabilities include high interest rate credit card debt, vehicle debt, or other consumer debt. Why? Because the “assets” financed in such a way depreciate faster than you can reduce the liabilities through debt repayment. Take a look over in our cars forum for a good example of how expensive consumer debt on a vehicle can be.
Although you might be tempted to focus entirely on reducing your debt at the beginning of the process, I encourage you to start investing, as well. Your investments, of course, will be entered as assets on your balance sheet. Why invest before all of your high interest rate debt is paid off? Because you need the education and the start to stay interested. Gaining your financial freedom requires that you invest. I encourage you to get a start, however small, as soon as possible.
Investing and Profiting the Easy Way
This brings us to the “answer” that many investors are searching for week in and week out. Investing in primary economic trends to minimize capital gains and putting your money to work through the power of compound interest. The value of an investment that earns compound interest grows exponentially over time. In just a few years, your investments will be generating more income than any amount of earned income you're able to save.
IRS research has shown that rich people get that way by maximizing unrealized income and minimizing their realized income. The unrealized income is allowed to grow unfettered by taxes through the almost miraculous power of compound interest. This is something that traders don't do: traders maximize their realized income by trading.
Trading is the harder way, and probably the losing way.
I'm sure you've heard of millionaire day traders, and possibly your friends telling you about the large piles of money they've won at the stock trading website. I'm here to tell you it isn't true. Although some folks make money trading stocks, they are by and large the rare exception to the generally accepted rule: small retail traders get slaughtered. For every winning trade, there's a loser. And the winner has the superior information, strategy, and resources to move in and out of the market ahead of everyone else. One HowWealthWorks.com reader is a former successful day trader that realized over the long haul, day trading is too much work, too risky, and quite frankly, lines the pockets of government with 28% of any gains made trading. Not only must you win in trading, but you must win enough to cover your gains taxes.
_________________
Dave
You should run your finances like a business: for a profit! You'll become financially free and wealthy running your PersonalBusiness. It’s simple: analyze your income and your net worth like you’d run a business, making a profit by cutting your expenses to retain your heavily taxed earned income, rather than spend it. Investing your profits in economic primary trends, your money begins working for you rather than you working for your money. Your unrealized investment income grows tax free through the power of compound interest.
The Tools for Running Your PersonalBusiness
The income statement and the balance sheet are the tools you use to run your life like a business. These tools help you understand how your financial decisions affect your retained earnings and your net worth. The income statement shows you exactly where your money comes from and where it’s going. Through the income statement, you can pinpoint wasteful spending, or spending that would be better directed to building your wealth. The balance sheet “balances” your assets and liabilities showing you your net worth. The balance sheet is a tool that helps you understand the affects of financial decisions on your net worth. The income statement and the balance sheet help you stop worrying about monthly payments and start focusing on your financial freedom.
Gaining Financial Freedom Is Simple But Not Easy
So, we've talked about what to do to gain financial freedom. Simple isn't it? Well, it may be simple, but we know it's not so easy. In fact, even though the strategies have been around for a long, long, time, most folks don't know them or aren’t able to execute on them.
Spending Like a Superstar?
You may be financially dependent on your job because you spend and consume as if you were already wealthy. When I was young, I expected to rise to the top of my profession and I envisioned that my income would continue to increase dramatically over my lifetime. Indeed, many of us feel we’re going to set the world on fire when we leave school, and our professional successes will provide all the money we could ever need. It is possible to become such a superstar, but highly unlikely.
This anticipation of ever greater income keeps many people dependent on highly taxed earned income (their jobs). Spending your income on consumption by living the wealthy lifestyle keeps you from ever becoming wealthy. Indeed, we confuse the ends (the wealthy lifestyle) with the means (living frugally) to become wealthy. Richard Russell Russell wrote for John Mauldin’s book “Just One Thing” the following, and I think it succinctly covers this point:
“For the great majority of investors, making money requires a plan, self-discipline, and desire. I say "for the great majority of people," because if you're a Steven Spielberg or a Bill Gates you don't have to know about the Dow or the markets or about yields or price/earnings ratios. You're a phenomenon in your own field, and you're going to make big money as a by-product of your talent and ability. But this kind of genius is rare.”
Rare indeed! And even superstars end up bankrupt and penniless if they’re not good money managers. If you’ve been around awhile, you probably realize the truth in Mr. Russell’s words. If you’re a young person reading this, just now starting out in your career, you should heed them. Relying on ever increasing income from your employer is the path to indentured servitude. Saving and investing so that your money can work for you is the path to freedom.
The Media Tells Us We Need to be Superstars
Newspapers are filled with stories of entrepreneurs striking it rich. Flip to any business section for the latest photo of a swash buckling entrepreneur beaming from behind the wheel of their Benz. Everybody knows you don't get rich working for someone else, right? Wrong!
Take it from a serial entrepreneur, it ain't so easy to strike out on your own and get rich. In fact, almost every successful business I've seen was started on a sales opportunity, or leveraged a sales opportunity. It wasn't started based on the dream of the founder.
The PersonalBusiness is the Simple and Certain Way to Wealth
So, what do we advise? Start a PersonalBusiness. Quite simply, PersonalBusiness is running your personal finances like a business—for your profit. Your PersonalBusiness is, in our opinion, far, more likely to lead financial freedom than if you were to strike out on your own and try to start a conventional business from scratch. Your PersonalBusiness is almost guaranteed to succeed, for a number of reasons.
First, you learn how to cut your expenses so you can maximize your profits—in the same way a conventional business does. This is what we call the “good defense.” As soon as you start cutting your expenses, your freedom will increase. You’ll have more flexibility and choice in your life. I’m often asked “what’s the best way to cut my expenses.” The answer is your personal income statement that shows you exactly where your money is going, and we’ll talk more about that shortly.
Second, running your PersonalBusiness will change your thinking. Folks that are good at generating wealth don’t think like folks that are good at consuming wealth. The only way to change your thinking from that of a consumer of wealth to a producer of wealth is through action, and the action we recommend is the PersonalBusiness. By running your PersonalBusiness, you’ll develop a new focus on producing income rather than consuming it. If you’re like me, you’ve caught yourself dreaming about something you’re going to buy and money you’re going to spend. Thinking like that isn’t doing you any favors. Since I’ve been running my PersonalBusiness, my thinking has changed and I’ve lost interest in spending away my income and gained an interest in conserving and investing it.
Third, with the PersonalBusiness, you’ll be avoiding the risks and expenses of starting a conventional business. Sure, plenty of folks start their conventional businesses are successful. First off, the risk: far more new conventional businesses fail than succeed. Almost all new businesses require significant investment at startup. The record keeping and legal formality surrounding a conventional business are significant, as are taxes. Conventional businesses are taxed on salaries, benefits, and all revenue, and they usually carry insurance. These are all expenses and risks the PersonalBusiness avoids.
And finally, the PersonalBusiness is focused on time honored wealth building principles that will last you a lifetime. No matter where you go, experience running your PersonalBusiness will serve you, and all those that rely on you for guidance, very, very well. With a PersonalBusiness, you don’t pay salaries, insurance and benefits, employment taxes (15.3% social security and medicare), and most important you don’t pay taxes on revenue until you realize it.
Stop Wasting Your Money and Start Thinking Like a Business Owner
If successful business owners don't waste their money, why should you? Every time you make a big spending decision without analyzing it financially, you run the risk of throwing money away. Money that could be working to make you financially free. The “low down, easy monthly payment” mindset is only good for wiping out your net worth, and guaranteeing that you're going to be trapped in your job, working longer and harder than you want. Rather than borrowing against your income and buying as much as you can, start thinking about how you can get what you want while still protecting or increasing your net worth. You can do this buy understanding the finances behind your purchase decisions.
Maximize Your Net Worth, Not Your Spending Power
If you're like most people out there, you fantasize about all the things you can buy with your income. And why not? There's a line of people going out the door and around the planet waiting to loan you the money to buy their stuff. They don't want it, so they might as well sell it to you. The biggest reason they don't want it is depreciation. They longer they hold onto it, the more value their stuff loses. One trick to protect your net worth is making the other guy take the depreciation hit for you. For example, a new automobile typically loses 30% of its value in the first year.
The Three Ways to Buy Depreciating Goods
(1) Borrowing to buy rapidly depreciating goods. This is the worst possible scenario to go with. Precious highly taxed earned income is going to be wasted on interest payments, hurting your income statement. Worse yet, the falling value of your purchase is going to hurt your net worth. Good examples of this are cars, boats, electronics, appliances, computers, vacations, clothing, etc.
(2) Paying cash for rapidly depreciating goods. In this case, you don't take the interst payment expense, but your net worth falls as the value of what you purchased falls.
(3) Paying cash for depreciated goods. These goods aren't going to fall in value, and often times will appreciate over time. When you make a cash purchase of depreciated goods, your net worth doesn't really change that much. Some recent examples of cash purchases for depreciated goods I've made are: 32” TV, 1988 sailboat, and 2001 motorcycle. These are all purchases that had little or no affect on my net worth-- I can either sell them for what I paid, or more. My advice to you? Don't take the depreciation hit.
The New Car Example
Like that new car smell, do you? Hey, I like the new car smell, too-- but I like the smell of $17,500 a lot more. $17,500 is about what you'll lose in the first five years if you buy a new $25,000 car (cheap as new cars go) and finance it. That new $25,000 car will cost you $5,000 in interest. If it's a quality, reliable and desireable car, it will probably only lose 50% of its value in the first 5 years. You'd better choose wisely: if you end up buying an SUV, you're probably going to take a 75% hit. Even at 50%, we're still talking about $12,500 worth of your money going to money heaven.
Maximize Your Profit by Cutting Your Expenses
People often ask me, “how do I cut my expenses? I don't know where to start.” The simple truth is, I don't know where you should start, either. In fact, I know some of you are afraid to spend anything, because you feel like your personal finances are out of control.
Finding Out Where Your Money Goes: the Income Statement
The first step to cutting your expenses is figuring out where you make your money, and where you spend it. The income statement, also called the profit & loss statement, is the tool you'll use to find out where your money comes from and where it goes. If you google “personal income statement,” you'll turn up dozens of examples you can use. The basic form of the income statement is simple:
retained earnings (profit) = income – expenses
Here's a good example of a personal income statement.
Examples of your income are net wages (after taxes), realized investment income, gifts, and perhaps stuff you've sold (my personal favorite). Examples of expenses are food, clothing, transportation, entertainment, communications (phones, tv, internet), and various.
Subtract your expenses from your earnings, and you have your retained earnings, or “savings.” Your savings are what you're going to invest to start growing the investment side of your income and balance sheet.
A Word About Cash Flow: I want you to note that we're not talking about “cash flow” here. Cash flow is the amount of money coming in and going out over a defined time period -- it has nothing to do with how much profit you make. Some "gurus" in the personal finance community misuse the term “cash flow.” What you care about is your profit-- your retained earnings, not “cash flow.” Cash flow is something you only need to know in order to manage payments, and isn't going to help you cut your expenses. If anyone tells you to focus on your “cash flow,” you should ask them why.
Income Statement Identifies The Biggest Expenses Ripe For Cutting
I've read dozens of bad articles on cutting expenses. If you're spending $100,000/year, it's not going to do you much good to save $100/year on that gym membership, is it? The income statement is going to pinpoint your biggest expense categories, and it's going to be up to you to figure out how to cut those expenses. Cutting your expenses will change your thinking, you’ll start looking for a way to reduce your debt, get more bang for your buck, and leave the other guy holding the depreciation bag.
There are two primary types of expenses, fixed and variable. Fixed expenses are typically basic repeated monthly expenses, and they're difficult to change quickly witout refinancing loans, selling off assets, etc. Housing, insurance, medical care, debt service payments, and the like, are going to be tough places to save money. Variable expenses are expenses you have more control over. Cutting your variable expenses will hinge on giving up things you don’t need and reducing the usage of goods and services you do need, such as food, clothing, and transportation. Paying down your debt is a great way to free up some cash flow for investment. We have a forum on debt, so keep an eye out for future articles on debt reduction.
However, if you find yourself in a situation where your variable expenses are fairly low, and you're still unable to save and invest, then cutting these “fixed” expenses will become necessary. This might mean downsizing your home, reducing your insurance costs by increasing your deductible or reducing coverage (as reasonable). Your variable expenses, on the other hand, are easier to change, because they're amenable to substitution or just plain old belt tightening.
I want you to keep this in the forefront of your mind: for every dollar in expenses you save, you're saving two dollars in gross salary. Uncle Sam takes 50% or more of every dollar you spend, so saving one means you don't have to earn two. Now for a little anecdote. I have a close friend that has far more financial resources than I, and he's trying to gain financial freedom just like the rest of us. One day we were talking, and he was explaining how he loathed spending money. He told me he felt his income was just sand running out of the bottom of a funnel, and he felt extremely frustrated. I suggested that he complete a thorough income statement. He followed my recommendation, and discovered that one area he could really cut back was insurance. My friend’s realization was this: even though many of his possessions weren’t depreciating that rapidly, insuring them was really expensive. By reducing his possessions, he had less to insure and maintain.
Which brings me to my final point about cutting expenses: it's addictive. Once you find yourself “downsizing” and reaping the additional retained income, you're going to want more. It's a freeing force in your life. You're finally beginning to stop thinking about putting money into someone else's pocket, and keeping it in yours.
Invest Your Retained Earnings in Economic Primary Trends
Let's talk about investing and trading. Here at HowWealthWorks.com, we're focused on investing in a particular asset for longer than a year. Sure, we might execute a trade or two on the side for fun and learning, but we're long term investors first and foremost. Why? Unrealized gains and compound interest. Trading, after all, is really just another form of earned income, and that's not what we're about. However, keep in mind that as you become a more sophisticated investor, it may behoove you to learn how to trade. One final thought on trading: a wise man once said that trades that have lost money are “investments.”
Keep an Eye on Your Net Worth with the Balance Sheet
You've probably heard people bandy the term “balance sheet” about but may never have understood it. Well, “balance sheet” is simple: it's merely a means to determine your “net worth.” A balance sheet “balances” assets with liabilities (often money you owe on your assets, or otherwise) to give you your net worth, or “owner's equity.” We're going use the term net worth, since it's a generally accepted personal finance term.
Here's the simple equation for the balance sheet:
net worth = assets – liabilities
What's the balance sheet for? To show you your net worth, after that and how your financial decisions affect your net worth. Retained earnings (savings) from your income statement flow into your balance sheet, making your net worth grow. Principle repayment of your liabilities, like credit card debt or mortgage payments, flow out of your income statement as expenses and show up on your balance sheet as decreased liabilities. Unfortunately, the interest portion of the debt repayment is a pure expense and, of course, adds nothing to our net worth. Entrepreneur.com has a good example of a balance sheet.
Together, the balance sheet and income statement give you a pretty good idea of your financial position and how to go about improving it. In fact, once you've developed some “owner's equity,” you'll find that banks are very interested in your income statement and balance sheet-- more so than they'd ever be interested in your “credit score.”
Much like the income statement is the roadmap to cutting your expenses, the balance sheet is the roadmap to growing your net worth and investment income. In the beginning, you'll be focused on growing your net worth by reducing your liabilities-- especially if your liabilities include high interest rate credit card debt, vehicle debt, or other consumer debt. Why? Because the “assets” financed in such a way depreciate faster than you can reduce the liabilities through debt repayment. Take a look over in our cars forum for a good example of how expensive consumer debt on a vehicle can be.
Although you might be tempted to focus entirely on reducing your debt at the beginning of the process, I encourage you to start investing, as well. Your investments, of course, will be entered as assets on your balance sheet. Why invest before all of your high interest rate debt is paid off? Because you need the education and the start to stay interested. Gaining your financial freedom requires that you invest. I encourage you to get a start, however small, as soon as possible.
Investing and Profiting the Easy Way
This brings us to the “answer” that many investors are searching for week in and week out. Investing in primary economic trends to minimize capital gains and putting your money to work through the power of compound interest. The value of an investment that earns compound interest grows exponentially over time. In just a few years, your investments will be generating more income than any amount of earned income you're able to save.
IRS research has shown that rich people get that way by maximizing unrealized income and minimizing their realized income. The unrealized income is allowed to grow unfettered by taxes through the almost miraculous power of compound interest. This is something that traders don't do: traders maximize their realized income by trading.
Trading is the harder way, and probably the losing way.
I'm sure you've heard of millionaire day traders, and possibly your friends telling you about the large piles of money they've won at the stock trading website. I'm here to tell you it isn't true. Although some folks make money trading stocks, they are by and large the rare exception to the generally accepted rule: small retail traders get slaughtered. For every winning trade, there's a loser. And the winner has the superior information, strategy, and resources to move in and out of the market ahead of everyone else. One HowWealthWorks.com reader is a former successful day trader that realized over the long haul, day trading is too much work, too risky, and quite frankly, lines the pockets of government with 28% of any gains made trading. Not only must you win in trading, but you must win enough to cover your gains taxes.
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Dave
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