The Financial Wealth Ratio

old money mansion

When it comes to money there is a simple ratio which tells us the real story of how wealthy we are. Here it is:

Financial Wealth = Passive Income / Earned Income.

We should be aiming for a number which is greater than 1: The reason this is such an important formula is that it takes into account the most important and scare resource – time. While it includes money, it goes beyond it. It infers that earning money from control and ownership of assets is far superior to earning money through labour – regardless of how big the earned portion of our income may be. Passive income does not require our time to be earned.

So what things are included in Passive Income? They include but are not limited to Shares (Dividends), Property (Rents), Licensing Rights (Royalties)… the assets we’ve acquired or built which put money into our pockets. What it is not, is the net value of those assets, just what they generate in real returns – actual cashflow.  Much like a salary is a ‘real’ return on our labour.  And while trading large capital assets may generate actual cash returns, that return is singular and only available at the point of transaction. Unless we happen to be in the business of trading assets, it doesn’t provide a true month to month reflection on our cash position. Passive income is about earnings and probability of those earnings to be maintained over time.

Why Passive is more important than Earned: Speaking of probability, another reason passive income is so vital is that it has a high probability of increasing. Rents and corporate earnings in most developed economies increase at around 10% per annum. Wages on the other hand increase annually at less than 3% per annum. Passive income also removes the power of others. When we earn wages, we are at the whim of the work environment, the company, our boss, the economy, technological upheaval, and all other manner of things which make having a job inferior. Earned income is riskier than than passive income because it generally is not something we control. Sure we can influence it by becoming more skilled and valuable to the marketplace, but we can never have total decision authority like we can with allocating our money to a portfolio. Word of warning – passive income, doesn’t mean it shouldn’t be actively managed, or that we don’t need to earn money to acquire it – it takes effort, but builds independence. In other words a passive attitude doesn’t build passive income, quite the opposite.

As mentioned in an earlier post about building financial wealth passive income is the money we earn when we are not in the room. This is actually more important than total income is. Firstly, passive income usually grows over time. Rents go up, anyone who has rented a house knows this pattern. In good companies earnings increase over time. Secondly, passive income is important, because it should be regarded as bonus money. We can manage to live on the earned portion of our income. We know this is true because most people start with zero passive income – unless you’re a trust fund baby. The passive portion becomes it’s own eco system of building more of itself – think compound interest. More on this later.

A story about the Stars: Not those in the sky, but rock stars, sport stars and movie stars. There is no shortage of stories about these people going broke. Bankrupt after earning zillions of dollars. In fact this statistics is very telling: By the time they are retired for 2 years, 78% of NFL players are bankrupt or under severe financial stress. This documentary – ESPN 30 for 30 Broke is worth watching on the topic. How is this even possible? The reason rock stars and sports stars go broke is because they have a poor ratio. Pure and simple. They earn big, have bad spending habits and don’t create a good financial wealth ratio while they have the chance. It should be easier for them than anyone, and most don’t take their opportunity. They don’t de-risk their future.

A story about the Rich: Look at any rich (financially rich) people you know, famous, or even that local business person you admire and you’ll see a good ratio. They own properties, have equity stakes in successful businesses and make the majority of their money from the passive side, not the earned. Even most employees who get rich – think CEO’s – become so from share options more than they do from pure wages. The pattern is clear.

How to hack your ratio: The trick is to move money from the earned income denominator to the passive income nominator. Until at some point there is more passive than earned income resulting in a ratio of 1 or greater. So long as we keep our spending in check, once we earn more money passively than actively, work becomes a choice for both type and frequency. Another hack for building this equation in your favour is ensuring your earned income and passive income are in the same realm or industry. This usually gives you an advantage in your passive income building as your skill base moves you up the learning curve of both sides of the wealth equation. This strategy often results in bigger returns both earned and passive as they interact interdependently. Stick what you know, and leverage knowledge advantage to beat the averages.

Know your ratio: We should know your position, your ratio. You should have a plan to increase the passive portion. The problem is that most people go through life aiming to increase the earned portion more than they do the passive portion. This ends up as a micro version of the rock star problem. The life style spending increases with the income. Knowing your ratio allows you to aim and game the system. To set targets for increasing the passive side. If your ratio is 5% this year, then aim to acquire investments to make it 10% next year.

Other advantages with the Wealth Equation: In most economies the taxation system gives large advantages to passive income. Often dividends are fully franked (the tax is already paid for you). You can offset your earned income with the expenses associated with generating your passive income. You don’t have to pay tax as you earn this money (PAYE), and can earn interest on the returns before it gets taxed. As well as many other structural benefits, such as paying lower corporate tax rates (30% company vs 45% top rate for a mere human) via holding the passive income assets in a private company.

How to build Passive Income: Save at least 10% of what you earn and invest it. The two simplest places to invest would be residential property and index shares. Invest the return on investment from the passive income into more passive income generating assets – never spend any of it. If we can manage to do this, then as soon as our ratio is 1. Work becomes a choice not a necessity.

To do: Add improve your wealth ratio to your goals list for 2015.

New book – The Great Fragmentation – out now!

How to build financial wealth in 1 sentence.

cityhead

The way in which all financial wealth is built, time immemorial is this:

Find a way to make money when you are not in the room.

This formula has never actually changed. All the traditional investments fit this definition. Property, Rents, Dividends, Interest, Equity and even creating a startup which becomes bigger than us. Essentially, we need to invent more than 24 hours in a day through the labour of others. We need revenue which is controlled rather than earned. We can build it, or buy it, either way can work. Some ways are faster than others. But if you want to generate money, then you need to bethink this maxim. It tells all about the financial future.

New book – The Great Fragmentation – out now!

The average success story

While success is in the eye of the beholder, I heard an interesting fact recently about intelligence and financial independence.  And that fact was that the vast majority of financially independent people have average or below average intelligence. We are talking here about raw intellectual capability. This would seem counter intuitive to everything we are taught to believe in school, the corporate world and life. That we have to be ‘smart’ to accumulate financial advantage. Turns out the opposite is true and social researchers put it down to one simple thing:

“People of average intelligence are not overly impressed with how clever they are.”

Sounds like a silly thing to say, but it gives average people like you and me a big advantage. It means that we know we have to work hard, and maybe even a bit harder. And it also means that we don’t think we know everything already and so we have on open mind to learn new things and methods.

Turns out that some of the key factors in the success equation are about being average.

Top 10 vital life signs money has no impact on

It’s good to remind ourselves of what we already know. One of these things is the really important stuff which our financial position has no influence on. Here’s my top 10 list.

  1. Being a good family member: Integrity, love, caring, effort, understanding and being able to listen have no price.
  2. Our fitness levels: Having a gym membership, or exercise equipment is not a requirement. Walk, run, push up. Move.
  3. Eating health foods: The healthiest foods are the cheapest. Fruit, vegetables, raw oats, milk, water.
  4. Being happy: We’ll be as happy as we chose to be, right now. I know plenty of rich miserable people.
  5. Education: Library cards are free, all libraries have internet access. University courses are now free.
  6. Enjoying who we work with: If we don’t like who we work with, we can leave. We are not trees. Our roots are not fixed in the ground. Walk on.
  7. Giving: Sharing what we are lucky enough to already have costs nothing. Whether it is a physical good, advice, or knowledge. At the time of giving there is no price.
  8. Friendship: The to and fro of sharing life with a friend is a pure gift.
  9. Faith: Not necessarily the religious type, but the ability to believe in something, anything which makes the future a place worth arriving at.
  10. Work: The joy that comes from doing. The willingness to put in effort now, because it’s worth doing, not because of the reward.

Why did I decide to write this blog post? Well, last friday I had lunch with a friend who I hadn’t seen in a while. During the lunch I got to thinking about how there was nowhere I’d rather be at that moment. That no amount of wealth would change how enjoyable it was, or create a desire to be elsewhere. That moment was in itself one which existed outside of our financial construct. Turns out, that most of the important things do.

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Most people I know…

… want to get rich so they don’t have to care about the company they work for, or the crappy project they are doing. Once they make bank they can do what really turns them on.

I used to be that guy.

Now I just do what really turns me on, and all of a sudden I don’t care so much about how many zeros are in my bank account.

My father once told me; “Regardless of how rich you are Steve, you can only eat 3 meals a day, lay your head on one pillow and enjoy the company of those around you. Money is an illusion. The art of becoming wealthy is actually knowing what it means.”

Needless to say my dad is the richest man I know.

So what we ought do, is not let the Industrial Complex redefine wealth on our behalf and make us live a life of postponing what we care about. Because once we can feed ourselves and have somewhere warm to live, the rest is in our minds.

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Property Investing 101

A startup blog regular – Josh Moore has been asking for as post on Property Investing. Which like anything can be treated like a startup. It’s a big topic with a million books on it. But I have had a side interest in it for some time. So here are some tips on stuff that I think is worth knowing when investing in property. A bit of a 101 guide:

  • Property returns on average about 10%. Which is quite similar to the share market on.
  • Banks will lend much more money for property investments due to lower volatility than shares.
  • You should buy investment properties that you, yourself would like to live in.
  • Land goes up in value. Concrete and air does not increase in value.
  • Period buildings (unique styles, historical) have higher capital growth than the average property.
  • Rental returns are usually below 5% per annum.
  • Property investment can be a quicker path to wealth than shares due to leverage (borrowing money).
  • Getting someone to manage a property costs about 7% of the rent per week. (so you wont have to fix toilets)
  • You should always allow for 6 weeks a year vacancy on rental properties.
  • High capital growth properties & areas, tend to have lower rental yields.
  • High yield properties tend to have low capital growth.
  • Areas going through gentrification usually have greater capital growth.
  • A rental guarantee is a lie – the rent for the guarantee period is usually built into the selling price.
  • Auctions are invented by real estate agents who want it to sell quick to get their money.
  • Homes on busy roads have a higher turnover of renters and reduced yield.
  • Homes near water (river, beach, lake) grow faster and fetch a premium.
  • Tax benefits of property investment in Australia are a significant advantage.
  • You can draw out profits (capital gain)  from a property that has grown in value and not pay tax on it
  • You can buy insurance against tenants in case they damage your house (Landlord Insurance).
  • Investors should choose between yield or capital growth when investing.
  • Capital gains tax on selling is 50% lower if you’ve held the property for over 12 months.
  • Property investing is very dependent on government policy, technological change, and infrastructure.
  • The key to investing is compound growth. Trading removes the power of compounding.
  • Trading properties & developing, is not investing, they are more like running businesses.
  • Trading properties is expensive – acquisition usually costs between 6-9% of market value.
  • Disposing of property usually costs around 3-5% of market value.
  • The property market can go through long periods of sustained stagnation, 10% returns is 100 year+ average.
  • Buying properties off the plan is risky. The saving in stamp duty can be a false friend.
  • Mortgage insurance is for the bank, not the mortgage holder.
  • The word mortgage is French, meaning; An engagement until death.
  • I believe that property is a get rich slow category
  • The biggest land holder on earth is ‘The Catholic Church’

Hope this helps getting you off and running in your property ventures. Good authors on the subject include; Jane Somers and Dolf De Roos.

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