What is your net worth? Let me see, probably close to a million. So what? Are you financially independent? No. Why? ’cause I don’t have enough cash flow to replace my W2 income. Ok then, net worth is a worthless metric. But it projects my comfort into the future.
And so it goes on and on…
Does it sound familiar? There are two schools of thought. One says be conservative, save, invest for growth, have little to no debt and build your net worth slowly. The other school scoffs at this conservative approach, and instead propounds building wealth and cash flow through acquiring assets, leverage and working out deals.
None of them are wrong. However what is right for you (and me) is important. For that, it is extremely important to understand the benefits and risks attached with each approach.
In more practical sense, you will do both in the right proportions that you are comfortable with.
The Net worth approach:
Here your main cash flow is your W2 income. Your ability to live below your means gives you the leverage to save and invest the rest.
As you invest your money into stock mutual funds, CD, money market, bonds and a house of your own to live in, you are increasing your net worth slowly. This is how most people start and someone starting off should. The difference between income and expenses, is the main contributor to your net worth. Additional is the appreciation and growth that your investments achieve. You also pay down mortgage of your house which builds equity, adding to your net worth.
In my opinion, this is a perfect approach to build wealth as long as you enjoy what you do in your W2 job and have a good work-life balance.
This is also the simplest since there is no extra debt burden (except probably your house, which you can pay down if you want). Your investments are also passive and takes hardly any time from your schedule, except occasional re-balancing and tracking.
With a spreadsheet like Excel, you can easily calculate your projected net worth in “t” years in the future, assuming a “r” rate of interest (or growth).
However this approach takes a lot of time and patience, disciplined living on a budget and regular investments. You will not have something to brag about in a few years, but you will sleep in peace as you have liquidity, less or no debt and enjoy your work.
The risk of this approach is if you retire early and do not have enough corpus to live off for the rest of your retired life.
The Cash Flow approach:
The cash flow approach on the other hand, only focuses on generating cash flow. It means you have enough assets or mechanism (businesses, activities) which generate cash month after month, in a predicable fashion.
This can be achieved with several avenues for example:
- Rental property investing
- Commercial property
- Dividend paying stocks
- Passive income from books, royalty of other IP, YouTube videos etc.
There are many resources on Internet to give a list of passive income ideas.
However in the cash flow investing approach, I wish to draw attention to the big ones like Rental Property Investing and Dividend Stocks.
These are two ways which makes a very predictable cash flow stream if done right.
However to get this predictable cash flow, one has to do the investment right. For example, real estate has many hidden costs and running expenses, which if not taken into account will quickly convert an on-paper cash flow asset into a black hole for your money.
Similarly dividend stock investing, if not researched correctly can cause the principal investment value to go down. Same for income producing corporate bonds, where the ability of the company to make the regular payouts needs to be researched.
Last but not the least, income producing real estate is typically obtained through leverage, which means steadily increasing debt.
For example, if you want to generate $5000/mo in cash flow from real estate, you need to buy as many houses that will in total produce that much positive cash flow. Lets say each house produces $200/mo in positive cash flow after mortgage, taxes, insurance and expenses. Now you will need to manage at least 25 such properties to generate the requisite cash flow. Self managing 25+ properties is more than a full time job, and if you hire a property manager you will have to part with the cash flow (fees), and hence no. of houses under management will need to increase. This is all not to mention that now you have 25+ mortgages in your name. The risk – 10 out of 25 properties suddenly loses the tenants and remains vacant for 3 months. Now you have to be able to make 10 mortgage payments every month from other sources of income for an extended period of time.
I am not saying Real Estate Investing is bad, lots of millionaires and billionaires have achieved their wealth creation through this. However you need to know yourself and act accordingly after you understand all the risks involved.
A combined approach:
Is it possible to have best of both worlds? Sure there is, if you are not in a hurry to get out of your job and have the patience to slowly build both your net worth and cash flow.
A few simple ideas which comes to my mind are below. I have done some myself and plan to do the rest.
- Increase your income and live below your means. This is very obvious, yet the most difficult to do consistently.
- Invest consistently 15-20% of your income into stocks, bonds and cash. See post: Emotional Investing
- Live in and then rent – Convert your existing house to a rental once you move out to another one. Or just rent out a portion of your house. This has the advantage that the mortgage you have is an owner occupied one (less interest rates typically), also it is paid up consistently as you spend more years and gets factored in your regular budget. See post: Don’t twist your ARM, fix it !!!
- Pay off your old houses completely but do not sell. Convert your equity play into a rental now. The paid off house will generate much better cash flow with substantially less risk, as there is no mortgage payments to worry about. See post: The Paid Piper of Hamelin
- Find sources of passive income which you can buy with your accumulated savings, like investing in a profitable business, crowd funded real estate etc. These have much less risk if you do your homework, at least there is no risk of foreclosure etc.
- Write a book or start an online course about your area of expertise.
In short, increase your net worth and cash flowing assets in a sensible fashion, with less to no debt and consistent action.
Here are some of my previous posts which may inspire the above principles.
Enjoy the journey and the destination will follow.