I think we all want to develop abundance in life—abundant joy, abundant fulfillment, and abundant wealth. I’m highly unqualified to discuss the first two areas, but it doesn’t take a counseling degree to observe that few people have abundant wealth. In fact, most spend their lives in a cycle of financial scarcity.
I live in Los Angeles—an expensive city where people go to work every day, earn money to pay the rent, car loan, and cable bill, and hopefully have a little left over to go to brunch on the weekend and play a few rounds of golf. If someone is really ahead of the curve, they might put a small fraction of their paycheck into a 401k. And if they own a house, at least they’re forced to “save” the small amount of their mortgage payment that actually goes to principal. The result is a 40ish-year cycle of financial scarcity, which we fondly refer to as the “rat race.”
Of course, there’s nothing inherently wrong with paying bills and working hard all your life—those are actually good and fulfilling things. I also recognize that many lower-income individuals may genuinely have no other choice. But the vast majority of us choose a cycle of scarcity. I think we need to challenge our mindset and determine whether there is a smarter way to live.
Is there another choice?
The rich don’t live in a cycle of scarcity. “Obviously,” you’re thinking. “They spend their time on yachts, traveling the world.” That’s true. But at some point—maybe generations ago—someone learned the simple secret to lasting wealth that enables the rich to enjoy their yachts and vacations, while continuing to build more wealth:
The secret to wealth is to only spend money you earn—twice.
Most people think about their income all wrong. They think that they should spend the money they earn from their jobs on themselves (“After all, I work hard, and I deserve it!”). Do you think your new BMW is a way to pay yourself for all your hard work? Actually, it’s a way to sign yourself up for several more years of the “earn, pay bills, spend remainder, and repeat” cycle. The scary part is that some people don’t even realize that their consumption choices create a monetary vacuum that can only be filled with longer and harder hours at work. To create wealth, you need to put the money you earn to work!
Even a high-paying job does not create wealth if, instead of retaining that wealth and putting it to work, you put it in someone else’s pocket. In fact, high-income individuals are often worse at retaining their wealth than moderate earners (they’re under-achieving wealth builders). This jumped out at me recently when a law firm partner (who probably makes a high six- to low seven-figure salary) told me that she was excited to have finally paid off her law school debt. REALLY? Someone with that salary level could have quickly paid down the student loans, and then used her high income to create lasting wealth and income streams. Instead, she likely used her income to buy cars, a nice house, and some other toys first, while her debt sat on the back burner for the last 15 years, creating wealth for someone else.
No matter what your income level, the only way to break out of a cycle of relative poverty is to pay yourself—FIRST.
How do I pay myself?
You can’t “pay yourself” by buying nice things. When you buy things, you actually pay someone else and add more “liabilities” to your life. Liabilities, like a car, a house, a cable bill, or a shoe collection, are things that cost you money, and pay you nothing in return. More importantly, they rob you of the opportunity to buy an asset that would actually pay you over and over again in the future.
The only way to truly pay yourself for all your hard work is to take the money that you earn, and buy something that fits in your assets column. Assets are things like stocks, rental properties, businesses, royalties, loans on which you are the lender, and bonds. Whether you’re weird like me and actually have an assets and liabilities column or not, let me assure you that both exist, and directly influence your life.
How do I buy assets and avoid liabilities?
The difference between an asset and a liability is simple, but it escapes 99% of people who keep buying liabilities, sometimes thinking they’re actually buying assets. A lot of the blame is due to our incredibly effective advertising and consumption culture that either tries to sell something as an “asset” (a house, or a nice watch), or tries to convince people that they “need” something that is squarely a “want.”
Take home ownership as one of the most common misconceptions about assets and liabilities. Common knowledge tells us that a home is a person’s “biggest investment” and “most important asset.” It’s actually the opposite.
Admittedly, owning a home can carry a deep psychological value that’s hard to quantify with money. And you have to live somewhere, so you might as well live somewhere you enjoy! But don’t be deceived into thinking your home is an asset. In most cases, home ownership is a trade of about 30 years of working your day job to pay the mortgage, taxes, and repairs on a house that will likely increase in value only with inflation.
In contrast, a rental house—even though it’s a physical structure just like the house where you live—puts money in your pocket for the rest of your life. Consistently buying assets like a rental property or stocks will have dramatic effects on your financial life!
Do you see now why you need to “earn money twice” before you spend it?
The poor and middle class constantly buy liabilities with the money that they work so hard to make, which means that they have a perpetual need to earn more money. The rich (or soon to become rich) buy assets. Those assets then become “employees” who can work tirelessly, day and night, for generations, continually making more money.
Once your assets start paying returns, you’ve earned money “twice,” and you can use that money to buy liabilities without having to go dig yourself out of a hole. By deferring your liability purchases (or even eliminating the unnecessary ones altogether), you now have an asset that will keep paying you money a second, and a third, and a fourth time. Skip that all-important step of buying an asset first, and you had better enjoy running in the rat race.
Let’s See An Example…
To see how this works in practice, just walk through this simplified example with me. A two-income couple earns a total of $120,000 per year. After taxes, assume they’re left with roughly $90,000. Let’s also assume that basic housing, food, and clothing, etc. cost around $45,000 (which is probably on the high side). After paying for their basic needs, the couple is left with $45,000 for that year.
Most people spend that “leftover” money on their cable bill, nicer cars than they need, iPads, and Starbucks (I do too sometimes—no judgment!). They end up with some nice electronics and maybe a new car, but then have to start the process all over again the next year. If they’re lucky and get a raise at work, they may be able to buy some slightly nicer things the next time around.
Instead, say that our couple bought stocks with that money, and earned a 7% return. The return on that first year’s investment only amounts to about $3,000.
That paltry number is why most people choose the shiny new BMW every time—yay for instant gratification! But not our couple. They’re disciplined, financially savvy, and they know the power of compound returns. So instead of consuming that money, they decide to live modestly for a few years, and continue to build their assets column, allowing those assets to make money for them a second, and a third, and a fourth time. After five years, where are they?
The original $45,000 investment is now worth $63,000, and makes around $4,500 per year, indefinitely.
But don’t forget about the additional $45,000 yearly investments from years two through five. Counting those contributions, the couple would be sitting on $340,000 at the end of five years.
That money makes them nearly $24,000 per year, for the rest of their lives. If they continued this little exercise for ten years total, they would have $750,000, and a yearly passive income of over $50,000—enough to cover all of their basic expenses, forever. (Note that once the couple actually starts living off their investment income, I would suggest a 4% withdrawal rate to allow for some growth, as well as a buffer for withdrawing during a market downturn.)
Is it worth giving up instant gratification to start living like the rich?
Only you can answer that question. I think the answer is a clear yes, but to be sustainable, the means to that goal need to be tempered. Some amount of spending above the basic necessities of life is very nice. However, there are rapidly diminishing returns to consumption spending. (This is especially true when you factor in the future time savings that you could have if you developed passive income streams now instead of spending on consumption.) Most people don’t recognize those diminishing returns, and continue to spend more and more in the hopes of generating greater happiness.
Eating beans and rice at every meal may be a little extreme for most of us. Instead of going cold turkey (which incidentally is not the best thing to eat at every meal either), try to cut out meaningless spending that does not actually improve your quality of life. Think about whether having heated leather seats in your new Lexus will actually improve your life as much as not having to commute to work at all and having 8 more hours per day to spend with your kids. Now that you mention it, would that freedom be worth stepping down to a Civic with cloth seats?
The only way you can live like the rich is to stop spending your money now on liabilities like the poor. Hike more and spend less on brunch. You’ll be healthier, and you can let your brunch money earn you income a second, and a third, and a fourth time. Soon, you’ll realize that financial independence is better than brunch, and you’ll have time to pursue the rest of your dreams.
Invest in your future and reap not only financial gains, but gains in the most valuable currency of all—the time to do what you love.