Personal Finances 101
I was trained as a Chartered Accountant (CPA), and I still hold that qualification. I also have a first class honours degree in Accountancy. So you could say I was well qualified to give advice on accounting.
However, what you are taught in:
• School accounting classes;
• Small business classes;
• University accounting classes; and
• On the job accounting and book keeping;is almost exactly the opposite of what you and I need to know about our own personal finances.
Let me give you an example. In traditional accounting, anything that has a current or future value is an asset. So if a company owns a car it is recognized and accounted for as an asset, because it is worth something. On the other hand a liability is anything that requires a current or future payment. Assets are accounted for as positive numbers and liabilities as negative numbers. That is all very well for a company but for an individual you must think a completely different way. This might be a little more difficult for people with accounting or book keeping backgrounds but once you get it, you can make the mental shift in seconds, just like I did.
For you and I accounting for our own personal finances is simple: A real asset is anything that:
• Puts money into your bank account; or
• Increases in value; or
• Is cash; or
• A cash equivalent.A liability is anything that takes money out of your bank account.
It sounds simple doesn’t it? So you shouldn’t be surprised when I tell you:
• Your car is a liability.
• Your home is a liability.
• Your boat is a liability.
• Your vacation house is a liability.
• Your TV is a liability.
• Your pool is a liability.
• Your mobile phone is a liability.
• Your pet is a liability.
• Your household furniture and furnishings are a liability.
• Your hobbies are a liability.
• Your vacations are a liability.All of these cost you money. They all take money out of your bank account. Even if some of them don’t do it every week (for example your furniture), they all need to be replaced, so over time they cost you money.
It is vitally important we realize these are real liabilities that are causing huge amounts of money to disappear from our lives. You might rightly argue that some of these are necessary for living and I agree with you. But almost everyone in the industrialized world falls into the trap of buying bigger and more expensive things than they need. In addition, many people acquire a lot of other paraphernalia they don’t need at all. Some of these “assets” are fun to own but most of us forget they are all liabilities that suck money away from us. You only get to spend money once!
Let’s look at a practical example:
Bob and Sue realize after doing a budget that the cash they have available after they have deducted all of their living expenses is $26,000 per year. Out of this $26,000 they need to deduct their house and car expenses.
Bob and Sue own two cars worth $10,000 each and their home is nicely furnished. The actual money flowing out of Bob and Sue’s bank account for these items in one year is:
Mortgage $200,000 at 4% $8,000
Car loans $10,000 at 5% $500
Car maintenance, insurance and depreciation $2,000
Furniture depreciation $1,000
Total $11,500The ideal decision right now is to invest the extra $14,500 excess cash i.e.:
$26,000
- $11,500
$14,500Bob and Sue should invest this money every year into Real Assets that put additional money into their annual income – simple! Then their annual income continues to grow and not only grow but compound.
“The most powerful force in the universe is compound interest”- Albert Einstein
Critical Principle 4: Compounding your wealth is the most effective way to get rich slowly.
If we use a 5% real return on the original $14,500 and Bob and Sue continue to put $14,500 every year into Real Assets (on a monthly basis), after 10 years they will have $211,514! This is without increasing the monthly payments i.e. this does not include increased salaries or inheritances etc.
Taken further, assume Bob and Sue are 30 years from retirement. Saving $14,500 per year in the same way gives an inflation adjusted total of just over $1,000,000! Bear in mind this is based on a conservative rate of return of only 5% per year. So why aren’t there relaxed millionaires everywhere you look? The reason is simple!
The Bob and Sues of the world do the opposite! They buy what traditional accounting calls assets but are actually liabilities. What most Bob and Sues do is look at their annual excess of $14,500 and they do the following:
Buy a new house with a pool that costs $125,000 more than the old house, buy new furniture for the house, upgrade both cars and buy a boat.
Now their outgoings are:
Mortgage $325,000 at 4% $13,000
Car loans $40,000 at 5% $2,000
Car maintenance, insurance and depreciation $4,000
New furniture depreciation $3,000
Boat maintenance and depreciation $2,000
Boat loan $20,000 at 5% $1,000
Pool maintenance $1,000
Total $26,000Now Bob and Sue are keeping up with the Joneses but the problem is the Joneses (and almost everyone else) are spiralling into a poverty trap. What is worse, every five or ten years as their salaries increase Bob and Sue upgrade everything again so they never have any Real Assets. This is why most people never achieve financial independence.
Remember Real Assets are assets that put money into your bank account. There are really only five classes of Real Assets:
• Your own business.
• Real estate.
• Equities (stocks).
• Interest Bearing (for example bank deposits, treasury bills).
• Liquid commodities (i.e. commodities that can be turned instantly into cash for example gold).If you really understand this chapter and put into practice only spending your excess cash on Real Assets, in 10, 20 or 30 years you will be wealthier than 90% of the people around you. If you are in the position where you have no excess cash, chances are it’s because in the past you have spent your excess cash on liabilities and upgrading. If you are serious about being independently wealthy I suggest you spend the next five minutes completing your own (or your family) Personal Real Balance Sheet and your own Personal Real Budget.
Write down your current financial position below:
Personal Real Balance Sheet
Real Assets Real Liabilities
i.e. Put $ in my bank i.e. Take $ out of my bankEquities/stocks (see the list of expenses, next page)
Bank deposits and similar
Profitable businesses
Real estate (not the house you live in)
Liquid commoditiesPersonal Real Budget
Weekly Net Income (Salary, Interest, Rent, Business Income, Dividends, Royalties etc)
Less Weekly Expenses
Groceries
Gifts
Clothing – Adults
Clothing - Kids
Presents for Kids
Presents for Us
Presents for Others
Cleaner
Take Out Food
Eating at Restaurants
Cars - Insurance and Taxes
Car Maintenance and Service (for each car)
Petrol/Diesel all Cars
Boat or other Recreational Expenses
Property Taxes
Mortgage
Property Insurance
Contents Insurance
Life Insurance
Health Insurance
Gym Membership
Magazine Subscriptions
Vacations
Tithing
Other Giving
Electricity
Home Phone
Mobile Phones
Entertainment
Cafes
Lunches
Haircuts
Alcohol
Section Maintenance
Babysitters
Pool Maintenance
Other (could be a number of other expenses not listed above)You may be shocked to find that you have zero or very few Real Assets. In that case, today is the day you had a revelation of how to become independently rich.
Start by deciding not to upgrade where you don’t need to. Don’t “spend up large” when you don’t need to. Don’t “splash out” or “max out the credit card” or take an expensive vacation. These can all wait until you are independently wealthy. Next look for ways you can downsize. Downsize you house (i.e. your mortgage), downsize your car, downsize your expensive hobbies and toys. All of these “nice to haves” can wait until you are independently wealthy.
You may also be surprised just how much you are spending on “living”. Unless you already live very frugally you can easily cut 10% of your monthly expenses.
I want to finish with a wonderful example of someone who took these principles to heart from a young age:
John Marks Templeton
When John Templeton and his wife married, they made a resolution to save 50% of every pay check they received. In addition they gave away a tithe (10%). They lived only on the 40%. John Templeton was 25 years old and not earning much. They also had a rule that their rent could not be more than 16% of the money they had left over after they had paid taxes their tithe and their 50% investment i.e. rent was 16% of 40% = 6.4% of their total income. They furnished their property with very cheap second hand furniture. Templeton also furnished his early offices with second hand furniture. He never had a credit card, and he never had a mortgage (he later always paid cash for his properties). At the time of his death in 2008, he was a self made Billionaire. He attributes a great deal of his wealth to his thrift and his belief in the power of compounding interest.
I recommend his wonderful book, “The Templeton Plan”.
To illustrate his point on compound interest, here is a quote from his book:
“In history we’re taught that the Indians were foolish to sell Manhattan for so little [beads worth $24]. But if you look at the reality of compound interest you’ll find that if the Indians had invested their money at 8 percent interest at the time of the sale, they would now have $11 trillion. That is more than the value of all the real estate in the entire Western Hemisphere today!”
That was written in 1987. Compounding at the same rate until 2011 this would amount to over $60 trillion.